GDP Number

Seems everyone is satisfied with the second release of GDP today. Down 1% in Q2. However, when you read the details, it's not so rosy. Federal government was up over 10% and government overall was up 6%! That's not sustainable, especially as tax receipts continue to fall. Bottom line is take that piece out of the equation and you're looking at down over 2.5%. Then, another savior is the declining trade balance, slipping on account of more timid personal consumption and much less private investment. That shifting trade balance has limited the damage significantly. But when things start to head the other direction, the imbalance will again widen and act as an anchor (presuming the dollar doesn't take an enormous beating).

I like reducing the GDP to what really creates wealth for people, by looking at income side. Starting with disposable personal income, I net out interest and transfers (fair to net these since they are included as income and are excluded from GDP), I add undistributed corporate profits and wage accruals less disbursements, since these are essentially someone's yet realized income, and finish it off by netting off government lending/borrowing, since that ultimately belongs to everyone. Finally, I deduct out the money made by Americans overseas, and add in that made by foreigners here, to make this an index of 'domestic' income, as opposed to 'national' income. All of this ends up being similar to net national factor income with some adjustments-mainly government borrowing and direct taxes. At any rate, that number on a per capita basis is now lower than at any point since Q3 of 2003. That's pretty bad. Additionally, this number was -3.8% annualized in Q2, that decrease similar to the trailing 4 quarters of -4.0%, and it's now been negative seven straight quarters. In nominal dollars the past 2 years has been the worst for this index since BEA started quarterly data, but not in real terms (that happened during the 1973-1974 crash, thanks to double digit inflation).

WACC

One thing you must know if you want to estimate the intrinsic value of a company is the expected return on investment. To use a model on current value of future cash flows, you must have a discounting rate. One approach often used is the Weighted Average Cost of Capital (WACC). Basically, it looks at the capital structure of a company to determine the overall discount rate. That includes more than just the return on the common equity, but the return on other invested capital as well, most significant the debt (If one includes the value of all invested capital in valuation, it's also important to include interest payments as cash flow since this is a return for the debtholder). For example, a company that is financed by 50% debt and 50% equity capital and that has an expected return rate of 6% for the debt and 10% for the equity would have a WACC of 8%.

If you take this a step further, you could see how a company could have an optimal debt load. As more debt is added, the marginal rate for each new dollar of debt generally increases. At some point that marginal rate reaches the return necessary for the equity and that's where the debt load is optimal.

The return required for the equity usually depends on the beta, standard deviation or some other factors that consider risk.

My opinion of this is straight forward. First, in valuing a company, I'm interested in only the intrinsic value of the common equity and thus the only cash return of importance is that which flows to the common equity (that is, not interest, preferred dividends, etc.). Second, I think 'risk' for equity is not tied to any technical factor such as beta. Technical data that describe price fluctuation is not that important for me, since the only technical info I care about is the current price and whether it represents a discount or premium. More important is (1) what is the variation in the cash flow (the bigger the variation, the easier to err in valuing a company) and (2) what is the risk that my capital will be protected from loss. This second item is where debt comes in for me. Just as more subordinated debt carries a higher rate due to the higher risk, so too does equity carry a higher rate based on the amount of debt 'ahead of it in line'.

For example, take two companies of the same industry and size that should have the same return requirement for the capital. In fact, I would argue that theoretically both SHOULD have the same average rate of return regardless of capital structure. If A is 100% equity, it may have an 8% required return for that equity. If B is 50% debt, it may have a 6% return on debt and 10% on the equity. Again, what is not important is what the debtholders require, but what does matter is how much debt there is. The way I create a scale on this is thus: If I had $10,000 invested as debt in company A and I was the only debt and there was $10 billion in equity as well, I should probably expect no more that the treasury rate. My capital may be safer in that scenario that a treasury note. On the other hand if I owned all the equity $10K in company B and it had $10B in debt, I'd expect more or as much return as the most subordinate debt, which would be junk bond level. Usually your average case is somewhere in between. But when you buy debtless Google, you essentially have capital at both extremes and everywhere in the middle too. When you buy a debt-laden company, you still get the junk bond end and some portion of the middle of the continuum, but not the safe end. Those seats are taken.

Generally, I think 8% to 10% is a reasonable expectation for return in the safest companies and that rises maybe to the high teens for those companies that make you wonder how long it will be before bankruptcy wipes you out.

Options can be less risky than stocks

Given this is a value investing blog in name, talking options may not be what you'd expect. And such ridiculous statements like "Options can be less risky than stocks" just show I don't know what I'm talking about. Well, let's look at the math of some scenarios. There are four basic options positions: long/short call/put. Here's how each could reduce risk as compared to holding the same equity.

Buying a put to 'insure' your long stock position - this is the most obvious. You pay some premium, but you assume no downside risk south of the strike price. If the equity crashes, you come out smelling like a rose compared to those with a simple long position, and if it goes up, you still benefit. All for a bit of premium.

Covered call - this is essentially the opposite of the above position. Here you own the stock, but are short a call. If the stock skyrockets, it does so without you, as the call you sold will be exercised away. And you still are on the hook if the thing tanks. But, you get paid for this position. So, if things turn bad for the equity, you'll be hammered. But at least you have a little premium in your pocket. Again, your maximum loss will always be less (by the value of the premium) than just holding the equity.

Cash covered put - This is a scenario in which you essentially hold cash in order to insure someone else's stock. If the stock tanks, it's yours. And if it goes up, it's not. But this is insurance, and you get paid to provide it. So if the equity drops, both you and your friend holding the stock will both lose, but at least you'll have the premium.

Long call with cash to purchase - Most people probably don't do this. The glory of buying calls is that you get all the upside on the stock, but you don't have to come up with the full price of buying it. This lets you control 1000 shares for the price of 100, for example. If the price drops or is even flat, your investment can be a total loss. (This is the most common options position, and why options are seen as risky). What if you were satisfied just buying calls on the 100, though. How would that compare to buying 100 shares? The chart would essentially be the same as the put-protected long equity position. If the stock drops hard, your options are worthless, but you still have the cash. And that puts you ahead of the long stock guy.

So that covers all four basic options and how you can structure each to be safer than simply holding the stock. Each have lower maximum risk and lower maximum gain. What's interesting is that in order to do any of them, you often need greater permissions from your broker than for just buying and selling stocks. Particularly the cash-covered puts will often require quite a bit more permission. Now this just covers the risk, return is a different story that I'll get to in a later post.

An economics rambling

I had a conversation recently with someone and I brought up how automation in the industry I work in may prove to someday be the way to go since labor costs tend to go up (generally unionized industry) and technology costs tend to go down. His response was essentially that doing so would be short-sided because once everyone did this, no one would have a job. I'm not one to argue, so I left it at that.

But frankly this kind of thinking could have come from an economist. They frequently think like this (I remember the 'economics' articles on how even wasteful stimulus money could be beneficial.) Let's just think of this in very simple terms. In planet A, they have all kinds of stuff that they build with their hands; on planet B, they have the exact same stuff, but all of it is built by machines they built years ago that require only limited maintenance. Planet B is a better place to live without any doubt. But Planet A has more jobs. So what, both places have the same stuff-that's the point of money and jobs and profits-to improve lifestyle materially. And those on Planet B have greater leisure. Classic case here of making the means the ends. But given the prevalence of the mindset (and other ridiculousness), more so that this recent conversation (the person who I had this discussion is actually very sensible and thoughtful), I'm commenting on it.

Of course the wonderful example today of great economics is Cash for Clunkers. Like World War II and Hurricane Katrina ended up helping the economy, our government essentially paying way to much for cars and then turning around and destroying them is supposedly a good thing. People buy new cars with the money, and that puts autoworkers back on the job, etc., etc. The bottom line is we are going to collectively pay, sorry borrow $3 billion for the right to tear stuff up. And yes, there was a supposed green component in getting "guzzlers" off the road, but the first tenet of being authentically green is to conserve and reuse what already exists and not waste (also a good tenet of sound fiscal management).

I've seen a GDP fallacy argument that the government could just hire people to dig a trench and others to fill it. GDP goes up, and overall nothing actually changes. Always saw that as a ridiculous hypothetical, but it may be coming.

Cash Flow Valuation

As many legendary investors have stated, when you buy stocks, you buy a piece of a business. And as such, it's a good idea to know something about the business. For most retail investors, you can't buy power to even partially control these companies, so you're essentially buying the quality of the business as it is or will be. Someone who buys a business may see a failing company, but have big ideas on how by buying he could turn it around. Not so when investing in corporations.

No all you can do as an investor is buy and sell, make money on dividends and make money on capital appreciation. As with anything you are trading, your goal is to buy at a discount and/or sell at a premium. Since you have no idea really what the market will be buying at a premium in the future (if you did, you would not need research to make money), the only thing you can know is the current trading value of the equity and what it is truly worth. That second piece is the trick.

In valuing businesses, a very common method, perhaps even the standard method, is by looking at the cash flow. The value of the Caterpillar plant isn't what it cost to build it, as the balance sheet says, but what kind of money will accrue due to what happens at that plant in the future. Now cash flow is a lot of things and the bottom line on a cash flow statement is the change in cash which is frankly not very useful. There's operating cash flow with it's several components, investing cash flow, and financing cash flow. Generally, free cash flow is used, and this has a standard definition of operating cash flow less capex, but there are variations. Some call EBITDA cash flow, cash flow metrics are calculated using only the operating cash flow without the capex adjustment. There's free cash flow to the firm and free cash flow to the equity. Warren Buffet uses something similar he calls owner earnings.

Cash flows from the future (once you pretend to know what they'll be) must be discounted at a rate of return. Since different companies have different levels of risk, you must evalute this piece as well. This blog is meant as a brief intro to future blogs looking at varying pieces of a puzzle that combine to give my thoughts on what goes into a comapny valuation. There is no single place in the annual report to find the answers, because the only current number that really benefits you is the cash on hand, which is rarely much and usually has bondholders who would get it first anyway. Everything else gets it's value from the cash it produces in the future.