Fourth Quarter 2011 Perspectives Newsletter
Little Big World
Marian Kessler
Political upheaval in Libya and Egypt, the Japanese tsunami, a weakening Chinese economy, an S&P downgrade of US sovereign debt, a European debt crisis, fears of Greek default, European bank re-capitalization discussions, a burgeoning European Union bailout package, growing uncertainty surrounding the economic viability of the Euro, financial fallout from the EU crisis including a bankruptcy filing from MF Global and ongoing concerns about global investment bank health…. All of these events, and many more, contributed to unprecedented stock market volatility during 2011. One in seven trading days during the year witnessed a greater than 2% move. Yet the broad market, as measured by the S&P500, ended the year exactly where it began, at a price of 1257.6. One could surmise nothing much happened all year…
The push-pull nature of global economic prospects confused investors, who vacillated between the anticipation of improving domestic prospects and an unmistakable deterioration in Europe and within the European Union. Optimism stemming from improving US manufacturing, surprisingly strong holiday retail sales and tight inventory controls, particularly impressive given the still-high level of un/underemployment, was offset by a growing skepticism that the EU and the Euro could remain intact in their current incarnations. Sovereign stresses threatened the political foundation of the Union and the financial structure of a shared currency. French President Sarkozy and German Chancellor Merkel are now wielding the sword of austerity at a recalcitrant Greece and it appears increasingly likely an EU solution will require more extensive political change, financial reform and fiscal restraint.
In the meantime, the European Central Bank (ECB) balance sheet expanded sharply to a record 2.75 trillion Euros ($3.55 trillion), as European leaders struggled to shore up the weak links while smoothing the ruffled feathers of the stronger EU members. The latest round of bailout funding, totaling 820 billion Euros, exceeded QE2 by 50%. And still, it doesn’t appear to be enough. In her annual New Year’s Day address, Chancellor Merkel predicted “next year will no doubt be more difficult than 2011.” The overhaul to the fiscal rules that govern Europe’s joint currency continues into 2012 and most EU partners have been forced to slash public spending in order to comply with structural changes aimed at stabilizing European economies and the Euro. European banks are heavily tapping the ECB deposit facility but appear to be hoarding the cash to show rising capital ratios, in accordance with Basel III guidelines, rather than lend. Liquidity remains a coward. Until the fiscal, monetary and political deliberations become more concrete and EU participants agree to and comply with more stringent constraints, Europe will probably remain in recession and financial markets will continue to fret over sovereign debt and weakening European demand. We’re not out of the woods yet.
Despite Europe’s struggles and potentially weakening economic indicators in China, the US economy and US corporate earnings are clearly on the upswing. Gradual domestic economic improvement, solid corporate profitability and record levels of balance sheet cash have been largely overlooked as investors were shaken by daily headlines with employment concerns as a backdrop. Since 2009, cash levels from conservation, employment reductions and productivity increases, have grown substantially. According to Ned Davis Research, there is $1.6 trillion of cash equaling nearly 7% of company assets, sitting in corporate coffers, earning essentially nothing. Although an estimated 40% of this cash is held overseas and will probably not be repatriated unless given a tax break, many companies have tremendous financial flexibility. The chart below illustrates the sources and uses of the 500 companies in the S&P. Cash from operations and low cost debt financing/refinancing exceeded cash utilization by more than $100 billion. Thus, many large companies have the ability to return cash to their shareholders in the form of dividends, or reinvest in projects, markets or geographies that would enhance long term profitability.
There are a handful of stocks owned by clients of Becker Capital that offer a window to the world and help us gauge change in business activity and economic climate. Companies like 3M, Visa and FedEx are truly global companies, providing goods and services to customers intra- and inter-country. These three provide relatively immediate insight into consumer behavior, import and export markets and commercial/industrial supply and demand. 3M sells a little bit of everything to virtually everyone worldwide – from Post-its to surgical supplies to optical film. Visa processes consumer transactions globally; consumer response to fear and greed are immediately captured in transaction data. And FedEx delivers into the global trade markets.
The Becker investment team collects information accumulated from discussions with company managements, company peers and competitors and the analysis of strategy and financials; data from disparate sources help us to provide context in our bottom-up stock selection process. Take FedEx for example. As early as mid 2007, FedEx was discerning economic softening, particularly in domestic activity, well before the developing crisis became broadly apparent. By late 2007, FedEx management was expressing concerns about weakening domestic and international economies. In their annual report for the year ended May 31, 2008, management stated, “Fiscal year 2008 results clearly reflect the pressure of rapidly rising fuel prices and a weakening economy.” Anticipating a “challenging” second half 2008 into 2009, initiatives were mandated to reduce costs, including streamlining operations, changing compensation structure for salaried employees and reducing the capital expenditures budget to conserve cash.
In 2007, well before the financial crisis, FedEx and several other bellwether companies provided valuable early indications of economic headwinds that could impact the anticipated profitability of our equity holdings. Our team reassessed our expectations for owned and monitored stocks, emphasizing what companies could earn in a recession, rather than the relatively optimistic outlook embraced by most investors, judging from stock market sentiment. Instead of emphasizing price/earnings and price/book multiples – typical value manager metrics- we looked at the anticipated spread between return on invested capital and cost of capital, in a late 2008 and 2009 recession. We certainly did not anticipate the magnitude of the ensuing financial meltdown, but FedEx and others did help us to focus on companies with fortress balance sheets, sustainable positive cash flow and a positive return on capital – help that positioned client portfolios to weather the downturn and participate fully in the economic improvement and market upswing in early 2009.
Today, FedEx is a stronger entity with greater balance sheet flexibility than in years prior to the 2008 crisis. Since 2009, the company has gained share in the growing $18 trillion global trade and services market. So what is the company saying today that could give us insight into global economic health in 2012, particularly in light of Europe’s struggles? From discussions with the company, including a management visit late last year, we have gleaned that FedEx believes 2012 will be a reasonably good year. The weakness experienced in express volume in the last two quarters reflects a view that Europe entered a recession in mid-2011. Yet demand and pricing power, particularly in LTL freight and US domestic express, are significantly better than three years ago. Management stated that base rates have increased approximately 6% year over year in the last few quarters. Going forward, FedEx feels very good about their ability to continue to get strong rate increases, helped by the departure of DHL from the US domestic package market in 2009. International express pricing continues its upward trend and is fueling the company’s overall growth. Global sourcing is expanding and ecommerce continues to drive international trade and transportation. The company intends to increase capital expenditures 10% in the coming year to $4.2 billion with $2 billion dedicated to buying the more fuel efficient 767 and 777Fs for long haul flights. There is $2 billion of cash on the balance sheet and $1 billion of debt. FedEx has substantial capacity to increase its dividend (an 8% payout) or otherwise reward shareholders.
The impact of a European recession and the structural challenges that lie ahead for the EU should not be discounted and are not likely to be resolved soon. Europe’s struggles are slowing global growth. However, at this juncture, judging from conversations with a broad swath of companies, 2012 should prove to be a decent year, with rolling geographic recessions rather than wholesale decline. An integrated, fundamental research process is not infallible, but it does provide perspective on consensus expectations.
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Referenced stocks percentage of portfolio: FedEx 2.2%, 3M 2.2%, Visa 2.1%. Price/earnings is a valuation ratio of a company’s current share price compared to its per-share earnings. Price/book is a valuation ratio of a company’s current share price compared to its per-share book value.