<June 18, 2019>
When valuing a small cap stock, one of the first things we ask ourselves is, “What’s normalized?” Specifically, we are attempting to determine the average annual free cash flow a business will generate over a full profit cycle. We prefer normalizing over extrapolating, which can increase the risk of using peak or trough cash flows and generating an inaccurate business valuation.
I was recently thinking about normalizing after reading the Bloomberg article, “One Profit Puzzle Weighs on Stock Investors Staring at a Record”. The article discusses the current profit cycle and the boom in profit margins. The article notes, “At more than 10 percent, net margins are around the highest they’ve been in at least three decades, providing a boon to the bull market.” While this cycle's robust margins have been well-documented, a chart in the article caught my attention. It was a chart of the S&P 500 and its profit margins over the last three market cycles.
While some investors argue this cycle’s elevated profit margins are here to stay, we continue to believe corporate profits are cyclical and remain correlated to the booms and busts in the economy, credit, and asset prices. I thought the Bloomberg chart illustrated this cyclicality and correlation well, particularly as it relates to asset prices.
As can be seen in the chart, the technology and stock market bubble in the late 90’s was accompanied by rising profit margins. Unfortunately for investors extrapolating these margins, the bubble eventually popped and profits collapsed. It wasn’t a New Economy or “productivity miracle” after all – it was simply an old-fashioned asset bubble that artificially inflated the economy and corporate profits.
The housing bubble was also accompanied by buoyant asset prices and elevated profits. Similar to the technology bubble, the cycle eventually ended, asset prices fell, and profit margins plummeted. It was another classic asset bubble that created an unsustainable boom and violent bust in economic activity and profits. The theory that profit margins would remain inflated indefinitely was disproved once again.
The duration of the current market and profit cycle has resuscitated the belief in permanently higher profit margins. Some investors argue margins are being supported by growth in “capital-light” and service industries. Others believe the cyclicality of the business cycle has been tamed by central bank policy and expectations of further intervention.
We’re not convinced and believe today’s profit boom is more likely a result of a prolonged period of aggressive monetary policy, inflated asset prices, and artificially stimulated demand. As we learned in prior cycles, economic and profit booms built on easy money and asset inflation are inherently unstable, and in our opinion, unsustainable. Therefore, we have taken the position that profits remain cyclical and normalization, not extrapolation, is the preferred method for generating accurate asset valuations.
Given today’s investment and economic landscape, normalizing isn’t easy. After ten years of suppressed interest rates, central bank asset purchases, and elevated asset prices, we believe information emanating from the economy has become difficult to decipher. We often question where GDP, interest rates, and profit margins would be without this cycle’s aggressive monetary and fiscal stimulus. In effect, we believe it has become increasingly challenging to determine how much of this cycle’s economic growth has been real versus artificial.
Information gathered from the financial markets has also become increasingly distorted, in our opinion. Investors often ask what the bond market is communicating or what the inverted yield curve means. Considering the Federal Reserve’s bloated balance sheet and threats of future policy intervention, we view the bond market similarly to a hostage with a gun to his head – not a reliable source of information.
There are other distortions in today’s financial markets and economy that have made normalizing and accurate asset valuation more challenging. The most obvious, and possibly most impactful, has been this cycle’s extended period of extraordinarily low interest rates. With the short-end of the curve near 0% for the majority of the current cycle and longer-term rates depressed, we believe interest rates have been a significant contributor in inflating asset prices, demand, and corporate profits.
In addition to extremely low interest rates, corporate tax rates have also declined sharply this cycle and have benefited net profit margins. We find the current corporate tax rate very interesting, especially as it relates to business valuation. Specifically, should investors extrapolate or normalize tax rates when calculating a business’s value? We are two years away from a possible change in political leadership and a reassessment of corporate tax rates. Regardless of this possibility and threat to corporate profitability, investors appear content extrapolating abnormally low tax rates well into the future.
While declining tax rates have helped corporate earnings, they have also contributed to rising fiscal deficits. Although large fiscal deficits can stimulate the economy and corporate profits, are they sustainable? And if not, how should investors incorporate fiscal deficits and their influence on the economy and corporate profits into their valuation models?
To fund fiscal deficits, the U.S. government has needed to issue more debt. Although federal debt has expanded without interruption for decades, is it safe to extrapolate current trends and assume debt can expand indefinitely without impacting interest rates and asset valuations?
Corporations have also issued a tremendous amount of debt this cycle, stimulating credit growth and inflating equity valuations via acquisitions and buybacks.
Other forms of credit growth have become apparent this cycle as well, including student debt and auto loans. Similar to government and corporate debt growth, we believe increases in student debt and auto loans have stimulated the economy and benefited corporate profits.
In summary, there has been a considerable amount of effort and resources expended this cycle to stimulate demand and ultimately, corporate profits. Based on current equity valuations, we believe investors – similar to the last two market cycles – are extrapolating today’s profits and margins too far into the future.
While equity valuations suggest profit margins will remain inflated, we remain committed to normalizing and believe financial markets, the economy, and profits are naturally cyclical. Although normalizing makes a tremendous amount of sense to us, it is not easy, especially during profit and market cycle booms. Just ask the Federal Reserve after it recently tried (and failed) to normalize monetary policy 😊. Nevertheless, with so many macroeconomic and financial market metrics near extreme levels, we believe normalizing is more important today than ever.
Past performance does not guarantee future results. Current performance of the Fund can be obtained by calling 904-747-2345.
There is no guarantee that a particular investment strategy will be successful. Opinions expressed are subject to change at any time, are not guaranteed, and should not be considered investment advice.
As of June 18, 2019, the Palm Valley Capital Fund did not own any of the securities mentioned in this commentary. Fund holdings are subject to change and are not recommendations to buy or sell any security. Current and future portfolio holdings are subject to risk.
Definitions:
Correlation: A statistic that measures the extent to which two variables move in relation to each other.
Free Cash Flow: Free Cash Flow equals Cash from Operating Activities minus Capital Expenditures.
S&P 500: The Standard & Poor's 500 is an American stock market index based on the market capitalizations of 500 large companies. It is not possible to invest directly in an index.
Wilshire 5000: The Wilshire 5000 Total Market Index is an American stock market index based on the market capitalizations of all U.S. companies with readily available price data.