First Quarter 2016 Investment Climate: The 187 Portfolio

The 187 Portfolio

 

In 2007, I transformed an individual equity tracking model I had built into a more dynamic market assessment tool that I call the 187 Portfolio.  The Portfolio consists of 187 companies that I selected based on their forecasted strong growth potential.  The industry representation is broad.  The market size is both large and small.  To give you an idea, the average market cap of the group is $38.4 billion.  Skewing this to the upside are $200 billion+ companies such as: Amazon, Apple, Facebook, General Electric, Google (Alphabet), Microsoft, Verizon, and Wells Fargo.  On the small cap-side the portfolio includes companies under $1 billion in market cap such as: Adtran, Blackbox, Dynamic Materials, Calgon Carbon, Greenbrier, Lattice Semiconductor, Pharmerica Corporation, Ultratech Inc, and a number of others.  The portfolio is designed to represent the overall market in support of my search for investment opportunities in individual companies, and it also serves as an indicator of the health of the overall market.   I should note that the portfolio does undergo changes as a result of companies being acquired or when a company falters in a manner that indicates it will not succeed in its business mission.  These events result in new additions to keep the Portfolio company count at the 187 level.

 

This work has presented wonderful investment choices for me, and it has invariably given me the signals of when the overall market is at turning points.  The discussion below will focus on the market signals presently being given by the 187 Portfolio.

 

  1. Is the market expensive today?  The 187 Portfolio indicates we have an expensive market.  It is not at peak levels of being overpriced, but the level of caution being flashed is very real.  Key metrics I look to from the model focus on cash flow, cash flow growth, operating margins, cash and debt levels on the balance sheet, dividends, EBITDA, enterprise value, and market value.  To put in context what one measure of historical comparison is telling us, consider the following table that compares the price of the Portfolio to the Cash Flow of the Portfolio for each March month end period from 2007 to today.  To be clear this compares March 2007 price and cash flow to March 2016, then March 2008 to March 2016, etc.   What it indicates is that cash flow growth and price increases are very well correlated through 2011, but have now reached that point where increases in price without further increases in cash flow would violate the historic correlation.  Forward cash flow growth projections are low, so we have a meaningful concern when looking to the future for higher prices.
price cash flow
March-16 % change % change
vs 2007 60.02% 74.79%
vs 2008 58.98% 60.68%
vs 2009 142.87% 99.58%
vs 2010 73.62% 66.53%
vs 2011 42.52% 34.30%
vs 2012 49.04% 18.97%
vs 2013 36.86% 16.04%
vs 2014 18.50% 10.76%
vs 2015 1.73% -2.11%

 

  1. Current Cash flow multiples and Discounted Cash flow values: The Current Price to 2016 Cash Flow projections yield multiples that are above the historic norm.  We presently have a cash flow multiple of 18.38X versus the historic average of 16.48X.  This higher multiple would be reasonable if the rate of cash flow growth projected into the future was higher than the norm. In that regard, looking back in time we find that the actual CAGR of cash flow for the portfolio since 2007 is 5.5%, and the current full year projection for the year 2016 is 4.74%, below the historic CAGR.  Of greater concern is that the March 2016 to March 2015 comparative cash flow projections indicate a contraction in cash flow of a negative 2.11%. Future price increases given the current Price to Cash Flow multiple is doubtful absent some accelerated growth that is presently not anticipated.   In regard to Discounted Cash Flows, each company is assessed based on its current price and the computed value of a share of its stock based on its current and projected cash flow change over time, discounted back to today.  For the portfolio there will always be equities that are fairly priced, under-priced, and over-priced.  Historically, the number of companies within the Portfolio that trade in the market at a price above their DCF value is 60.  Presently we are at 72 companies trading above their DCF value.  When we are materially above 60 the market has subsequently sold off.  The high CP>DCF count was 85 on January 17, 2014.  The low count was 22 on September 30, 2011.  For reference purposes, the January 2014 excessive DCF number led to over a 1,000 point decline in the DJIA over the next 17 days, while the September 30, 2011 low was followed by a 1,600 point rally in the DJIA over the next month.

 

  1. Average cash flow per share forecast 2016 versus 2017:  The market projects average cash flow per share for 2016 of $3.89, whereas the cash flow per share for 2017 is projected at $4.28.  The spread of $.39 is the lowest projected annual dollar growth over the past five years, and given the higher denominator compared to prior years, the lowest percentage growth since 2009.

 

  1. Enterprise Value divided by EBITDA and Debt levels:  This measure provides an indication of the companies (markets) ability to provide sufficient liquidity to support the needs of the business, particularly when high leverage or debt is present.  Currently the 187 Portfolio has a 12.25X EBITDA to EV ratio (meaning the Enterprise Value is 12.25 times the size of EBITDA).  This is above the historic average of 10.78X.  Why do we have this higher multiple?  Consider that the change in debt for the Portfolio from 2009 reveals a 45% increase in debt.  That growth in debt would be acceptable given the growth in cash flow over this period, except for the fact that actual cash on the balance sheet has declined by 10.57%.  I interpret this mix of information to be reflective of the C-Suite decisions to utilize cash and leverage to facilitate high Stock Buy-backs and Dividend increases, driving up stock prices versus a growth agenda that would increase EBITDA in a manner that would drive down the EV/EBITDA ratio.  Short term stock price decisions vs long-term reinvestment choices often come home to roost in a less than favorable way over time.

 

  1. Dividends:  There is an argument present today that even with the sense of our current market being expensive, it should be expensive given the alternative investment choices in this very low to negative interest rate environment.  It is an argument that carries meaningful weight.  However, given the breadth of the economic, market and portfolio discussion above, a discussion that highlights many data points of valuation concern, the perceived investment for dividend argument over fixed income as a justification for an expensive stock market seems to lose some strength when one considers the chart below.  I do not see any evidence of a meaningful change in the dynamics to support a higher level of equity valuation vs fixed income.  As noted above the cash flows and growth rates are modest, and the interest return over dividend return noted below remains range bound between 1.09% and 1.83%.  In balancing risk vs reward, the dividend argument is not strong enough for me to place greater value on equity investments.
2016 2015 2014 2013 2012
Dividend Rate 2.38% 2.13% 2.31% 2.33% 2.09%
10 year Treasuries 1.88% 1.96% 2.74% 1.94% 2.32%
Fed Funds Rate 0.36% 0.11% 0.08% 0.16% 0.15%
Interest Yield Gap -1.14% -1.09% -1.83% -1.24% -1.83%

Author: Thomas Connolly

Tom possesses a rich and diverse background that includes deep investing experience, senior corporate executive positions, and roles as a Regional Managing Partner and Global Industry Leader within Ernst & Young. He has advised executives on some of the largest acquisitions and dispositions in the Media and Entertainment industry, including clients such as Comcast, Citibank, Sony, Dalian Wanda and Publicis. Tom is a Certified Public Accountant with a Masters Degree from Columbia University. His skills are further accompanied by a personal passion for the study of economic trends and evolving market dynamics.

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