Thoughts on the Fed's first press conference

The Federal Reserve made history yesterday by having its first press conference.  Key takeaways include:

• Economy is weaker than planned.  As a result, the Fed has reduced its full-year forecast for economic growth slightly.
• Fed intends to intend QE2, but will maintain the size of the balance sheet.  There is little possibility of QE3.
• The end of the "extended period" is a couple of Fed meetings away
• Ending reinvesting is tightening of monetary policy
• The value of the USD is the problem of the U.S. Treasury, not the Federal Reserve.

My thoughts on the press conference:

• Yes, the USD is more of the problem that should  be dealt by the U.S. Treasury.  But, the issue is that Chairman Bernanke is not taking blame for the policies that he's pursuing is one of the primary causes of the fall in value of the USD
• Chairman Bernanke did not take blame for the rise in commodity prices as calling them "transitory" or temporary.  A few moot points.  First, around 80% of the world's commodities are traded in USD.  Second, when there are negative real interest rates, the inflation trade (i.e. commodities) is going to be on steroids.  Thus, Bernanke (as with the USD) not taking at least partial blame for the rise in commodities was troubling.
• The overall tone of his messages were not hawk-ish, but at least less dove-ish.
• In a previous post, I posted an article that likened Fed policy to house party gone mad.  I still stick with that assessment.  As before, the market was usure whether there would be a QE3, this means the party could go onto in the morning.  Now, at least with implicit no to QE3, the party is going to keep going, but end at 6 am and could end badly.
• I'm bearish on the market following QE2 because of the reaction to the news of the press conference.  During the conference, the USD hit a new three-year low.  In addition, there is extreme complacency in the market when one looks at how gold trades, stocks continuing to go up, and little volatility as measured by the VIX.

How should investors play the market:

A CNBC article highlighting last night's Fast Money show hits the nail on the head, in my opinion.

Trader Brian Kelly also found Ben Bernanke’s comments bullish for stocks. “If there's going to be even a minor uptick in inflation investors will put money to work in assets that will beat inflation and that makes the stock market the place to be. The outcome is a much higher stock market.”

Company Analysis - National Presto Industries (NPK)

I do not want to appear as a genius or sly investor.  I was reading an article on thestreet.com that highlighted National Presto Industries (ticker:NPK) and felt it was a company that I would be interested in analyzing and potentially adding to my portfolio one day.  Investing in these names offers huge upside as they may continue to grow (higher price and higher dividends) and may be undervalued leading to be a potential buyout target.  NPK did not appear on those screeners since the regular dividend it pays is low and yields less than 1%.

Note: I have changed the DCF model I have used to value NPK slightly.  I do not believe it would have a material impact on other companies I have highlighted on this blog.  I feel this new methodology is cleaner and more transparent.  As always, if you feel an investment idea is worth pursuing, please do additional research and/or contact a financial advisor.

Firm overview

National Presto Industries (ticker: NPK) is a diversified manufacturing company.  The company operates in three key segments: housewares/small applianes, defense products, and absorbent products.  Housewares/small appliances include the wide variety of Presto products, which can be found at Wal-Mart; Wal-Mart is a major customer.  Defense products sell products to the U.S. Department of Defense.  Absorbent products include the sale and manufacture of adult diapers.

Investment rationale

Key reasons to initially look at this company include the low valuation and high dividend yield (after factoring in the annual special dividend).  Once an investor digs deeper in the company, an investor finds a company that has solid management who generates cash effectively and effective re-invests cash in the business.  This is proven by increasing returns on common equity.

But, like most manufacturers, NPK is highly tied to the recovery of the U.S. economy.  Most of its products are sold through Wal-Mart and most of household items they sell are discretionary.  As consumers become more confident, they will begin to purchase discretionary items like small appliances.  If Wal-Mart’s sales increase, so should NPK’s.  One interesting sidenote is although NPK’s household appliances are primarily sold through Wal-Mart, the firm has found a way to increase margins over the past ten years.  As a potential investor, this indicates to me the firm has effective costs controls and/or can pass on higher costs to consumers (both are pluses).

Key risks NPK include the concentration of customers.  Like the Wal-Mart scenario stated above, NPK also heavily relies on the U.S. Department of Defense.  If U.S. defense spending is materially reduced or NPK loses any contracts for whatever reason, this may have a material impact on the earnings power in the future.

Sales & profitability

Total sales have grown from $119.1 million to $479.0 million in the years 2001 to 2010.  When compounded, this is 16.7% per year.  The firm only had one year of negative profitability; the year was 2001. 

In addition, the firm has increased gross margins, operating margins, and net margins during this time.  Gross margins increased from 21.0% to 23.7%.  Operating margins have increased from -1.9% to 20.3%.  Net profit margins increased from 5.3% to 13.3%.  Net profit increased from $6.3 million to $63.5 million.  When compounded, this is 29.3% per year.

	Sales	Net profit
2001	$119.1	$6.3
2002	$124.8	$8.7
2003	$125.7	$15.5
2004	$159.0	$15.4
2005	$184.6	$16.4
2006	$304.7	$28.0
2007	$420.7	$38.6
2008	$448.3	$44.2
2009	$478.5	$62.6
2010	$479.0	$63.5

Do these trends indicate NPK has a durable competitive advantage?  Sales are increasing; which is positive.  A firm with a d.c.a. typically has a gross margin of 40% or greater.  At year-end 2010, NPK had a gross margin of 23.7%; over the ten years analyzed, this ratio was consistent, which is a plus.

Capital structure

The firm does not have any outstanding debt.  In addition, the firm typically holds plenty of cash on balance sheet, in addition to investments in marketable securities.  Per the Form 10-K, municipal bonds make up a majority of the investments in “marketable securities.”  Per the Form 10-K, marketable securities are sold in order to meet short-term liquidity needs.

Do these trends indicate NPK has a durable competitive advantage?  Yes.  Firms with a d.c.a. typically do not hold any debt, or little debt in general.  NPK does not hold any debt, in addition to being cash rich.  At year-end 2010, NPK had a current ratio of 5.2; in other words, NPK had 5.2x more current assets than current liabilities.

Capital efficiency

Since the firm does not have any debt, leverage should not play a huge role in capital efficiency.  The most common metric for capital efficiency is return on common equity (ROCE).  ROCE for NPK has increased since 2001; ROCE increased from 2.7% to 18.5%.  Long-term investors typically like to see high, consistent ROCE.  The fact ROCE has been increasing each year indicates NPK’s management is making productive use out of retained earnings; this should continue to increase in the future.

	Return on common equity
2001	2.7%
2002	3.6%
2003	6.3%
2004	6.0%
2005	6.2%
2006	10.0%
2007	13.1%
2008	14.2%
2009	18.6%
2010	18.5%

A favorite metric of Warren Buffett is return on unlevered net tangible assets.  Mr. Buffett has said a “great” company has a return of 25% or greater; this ratio can exceed 100%.  Return on unlevered net tangible assets has increased from -1.5% to 34.3%.

Dividends and share repurchase

NPK does pay a dividend, but does not engage in a share repurchase program.  Annually, the firm pays a regular dividend of $1 once a year.  Given the current closing price of around $111 per share, this equates to a dividend yield of less than 1%.  In addition, the firm pays a special dividend based on the previous year’s profitability once a year. 

NPK paid a total dividend of $8.25 per share earlier this year; this is a $0.10 increase from the previous year.  Since 2001, the dividend grew approximately at a rate of 16.9% per year.  The dividend growth rate is slower than rate in growth of net income; net income increased 26.9% during the same time.

	Dividend
2001	$2.00
2002	$0.92
2003	$0.92
2004	$1.17
2005	$1.67
2006	$2.12
2007	$3.80
2008	$4.25
2009	$5.55
2010	$8.15

Since the situation is different for NPK as most of the yield is from the special dividend, it is important to look at previous years to spot a trend.  The payout ratio, when using net income, has varied fro m 40.6% to 218.8%.  The payout ratio, when using free cash flow, has varied from being negative to 138.7%.  In 2010, when using net income, the dividend payout ratio was 88%.  This payout ratio is high, but should not be considered alarming; the firm elects to return cash to shareholders through this special dividend versus share repurchase.  When combined, both dividends and share repurchase frequently exceed either 100% of net income of free cash flow.

	Dividend payout ratio
2001	218.8%
2002	72.4%
2003	40.6%
2004	51.7%
2005	69.4%
2006	51.8%
2007	67.2%
2008	65.8%
2009	60.7%
2010	88.0%

If an investor is specifically looking at NPK as a dividend play, it is important to invest with a higher margin of safety.  When using the methodology I used to value this stock, I considered only the $1 regular dividend in my analysis (please see valuation section below).

In the valuation section below, I make some assumptions for the valuation.  If those assumptions hold true and the firm pays out 70% of earnings to shareholders, NPK should pay a dividend of approximately $7.00 in 2012.  The dividend yield would be 4.9% on the intrinsic value calculated or would have a yield-on-cost of 6.34% if the investor were to buy shares at the most recent closing price.  Given a payout ratio of 80%, the firm should pay a dividend of approximately $8.00 in 2012.   

Valuation

Using a DCF valuation model, I calculate the intrinsic value of NPK to be $144.20 per share.  This value is approximately $32.85 higher than the most recent closing price, giving an investor an actual margin of safety of 22.8%.

Key inputs into this model include 6% annual growth and a 19% EBITDA margin.  As for most investments, I like to use a 15% risk-adjusted discount rate.  In my opinion, since NPK has no short-term or long-term debt, the firm has approximately 80% the financial risk of the average company.  Due to broad product line, reliance on government contracts, and the impact of commodity prices, the firm has around 110% the risk of the average company.  When combined, this equates to a 13.2% discount rate.  Thus, given these inputs, the model produced an intrinsic value of $144.20 per share.

In addition, the price an investor should purchase NPK at given the level of risk is $112.21, or a 20.3% margin of safety to the intrinsic value.  The 20.3% margin of safety was calculated as I would like a 30% initial return for any stock.  After adjusting for 6% growth, the 0.9% dividend yield from the regular $1 dividend, and the business and financial risks mentioned above, the risk-adjusted margin of safety is 20.3%.

At current trading levels, the stock appears to be an attractive buy.

This information is for educational purposes only, and the opinions expressed do not constitute a recommendation to buy or sell. Author may have a position in the companies discussed, subject to change at any time. Information on this website obtained from reliable sources, but there is no guarantee of accuracy. Please consult your financial advisor before making investment decisions. Past performance is not indicative of future success.

Reading List - United States / Negative Outlook

On Monday morning, S&P put the AAA credit rating of the United States at risk by placing the United States on negative outlook.  They key point in S&P's action is that the negative outlook is more of an outcome of poor behavior by both political parties in Washington DC versus the United States not being able to service debt effectively.  The rating agency feels with the political gridlock that exists, a solution will not be reached by 2013 to help solve the fiscal problems facing the United States.  Hopefully, this action by S&P will force policymakers in Washington to become serious about the issue.

The markets may have reacted the opposite as you might expect.  Investors sold risk in the form of equities, and Treasuries and the dollar rallied as a result.  The question investors must ask themselves: is this event a fundamental game changer?  If an investor feels given all of the problems in the United States, but the United States is still the best place to invest, this event may be a buy trigger versus a sell trigger.  If an investor feels like this is a game changer and most assets are denominated in US dollars, it may be time to diversify into commodities and emerging market stocks.

Will the negative outlook have a negative impact on the recovery?  The answer to this question is difficult.  Even given the low yields and other fiscal problems, investors still want to hold US Treasuries.  But, as a result of the negative outlook, this demand may slightly decrease and bond yields will increase.  SInce virtually every form of borrowing is based off of the US Treasury, it would indicate that corporate bond rates, mortgages, etc all should increase.  As a result, borrowing costs for firms and households should increase; increased borrowing costs may eat into the rally.  One outcome is that the Federal Reserve may need to continue to use the printing machine to help the United States get out of this fiscal mess.

At this point, it is way too early to tell whether this is a positive or a massive sell signal.  It is important to note that in any market conditions, investors can make money.  It is being able to identify those opportunities that truly separate the winners from the losers.  Given the title of this blog, "Value and Yield," it is prudent that investors play some sort of defense in this crisis by investing in dividend paying stocks.  These companies should be safe companies that can grow total dividends.  These companies should be a good hedge against downside risk and possible inflation.

What Downgrade? Pros Shrug Off Warnings from S&P (click here)
S&P US Ratings Cut Good for Long-Term (click here)
Wilbur Ross Interview (click here)

Reading List - April 17, 2011

I know I have not done a reading list for a few weeks, but I feel most of the news in the markets have been continuation of trends that have been highlighted before.  So, below are some of the more interesting articles of the past week or so.

Market disruptions

As I have tried to highlight in previous posts, there is plenty of uncertainty around the market's reaction of QE2.  Below is a link to a video from CNBC of two strategists debating this very point.  Bob Phillips, senior partner at Spectrum Management Group, highlighted a few key points:

• Prudential (ticker: PRU) is trading at around 10x earnings.  Company previously made some acquisitions, some in Japan.  Firm has strong management and is undervalued at current multiple.
• Disruption when QE2 ends.  Investors should raise approximately 20% of their portfolios in cash as part of the uncertainty.

Market Looks 'Worrisome' - Disruptions Ahead: Stock Picker (click here)

JPMorgan's Earnings

JPMorgan (ticker: JPM) had a good first quarter as actual earnings beat analyst estimates.  What is alarming is that total loans at JPMorgan actually went down.  Federal Reserve statistics point to a similar trend, but JPMorgan's earnings point to this actually being the case.  As a result of the contraction in credit, are we headed towards a double dip?

JPMorgan's Earnings Point to Double Dip (click here) 

Michael Burry from The Big Short

Michael Burry, the hedge fund manager who betted against subprime mortgages, recently made a speech at Vanderbilt.  Below are some links to another blog, Distressed Debt Investing, that covered the highlights of the Burry speech:

He was attracted to investing because he was evaluated on performance not whether or not he looked people in the eye or was socially adept

QE “seems” to be working but is really just a big gamble

Don’t tolerate blind faith, figure things for yourself

Doesn’t think large caps are as cheap as others do

Michael Burry: Notes from Vanderbilt Speech (click here)

Pension funds

Jim Leech, president and chief executive at the Ontario Teachers' Pension Plan.  Highlights included:

• Whatever you do, you need to have conviction.
• One has to look far and wide to find opportunities in this uncertain environment.  This plan is leaning to towards commodities.  Key holdings include Toronto Dominion, Transocean, and JPMorgan.
• Worried about commodities, but prepare for uncertainty by having a diversified portfolio.  Need to be part of a run, but cannot put too much risk in your portfolio.
• View on the US: still having housing issues, but long-term you cannot bet against the biggest economy.  Concerns include state debt levels and administrations will come to grips with the issue.  Federal Reserve (i.e. QE2) is in a tough position, but correctly chose there is no deflation.  Issue is now does QE2 fuel inflation and it is too early to tell if it has.
• One of the early adopters of hedge funds and investment has worked out.  Fund is a large private equity investor, but through direct positions rather than fund of funds.

View from a Pension Fund (click here)

The Tale of the Swiss Bank Account

Its something that just needs to be seen...

The Secret World of Swiss Banks (click here)

Company Analysis - Procter & Gamble (PG)

To see full analysis, please click on link below.

Firm overview

The Procter & Gamble Company (P&G), incorporated in 1905, is focused on providing consumer packaged goods. The Company’s products are sold in more than 180 countries primarily through mass merchandisers, grocery stores, membership club stores, drug stores and high-frequency stores, the neighborhood stores, which serve many consumers in developing markets. It has on-the-ground operations in approximately 80 countries. As of June 30, 2010, P&G comprised of three Global Business Units (GBUs): Beauty and Grooming, Health and Well-Being and Household Care. Sales to Wal-Mart Stores, Inc. and its affiliates represent approximately 16% of its total revenue during the fiscal year ended June 30, 2010 (fiscal 2010). In August 2009, AnimalScan, LLC announced that it has acquired Iams Pet Imaging (IPI), LLC from The Procter & Gamble Company and ProScan Imaging. In October 2009, Warner Chilcott Plc completed the acquisition of the Company’s global branded prescription pharmaceutical business. In July 2010, Sara Lee Corporation completed the sale of its air care business to The Procter & Gamble Company.   Source: Reuters

Investment rationale

Investment rationale includes based on a P/E basis, the firm appears undervalued given forecasted growth, business risk, and financial risk.  When several metrics are looked at, the firm appears to benefit from a durable competitive advantage.  The firm has a strong dividend that appears, for the time being, to be sustainable.  Current dividend yield is 3.10%.  The current dividend provides downside protection, while providing a steady growing stream of income to income oriented investors.  The firm generates cash from operations and has a strong balance sheet.  The firm has strong margins that appear to be growing into the future as the firm's management seeks out operating efficiencies.  Given historical long-term growth and current trends in margins, the firm appears undervalued from both a risk-adjusted P/E and DCF basis.

Highlights

• Firm has strong gross margins.  Margins are >40% indicating durable competitive advantage.  Net profit is slightly <20%; net profit >20% indicates durable competitive advantage.  Growing margins indicate strength.  Firm seeks higher margins through operational improvements and efficiencies.
• Firm has strong liquidity position.  Free cash flow productivity is greater than 90% for all periods analyzed; this ratio indicates the firm generates 90% of net income into free cash flow.  Current ratio is <1; companies with a durable competitive advantage typically do not need a current ratio >1.  Firm has $11 billion credit facility that is a back-up for commercial paper issuance; commercial paper can be used to fund any short-term needs.
• Firm has strong balance sheet.  Debt-to-total capital ratio is below 50%; this level indicates firm is not overlevered.  The firm has a debt-to-equity adjusted for common shares of 20%; this is well below 80%.  An 80% level for this ratio indicates the firm has a durable competitive advantage. 
• Firm is efficient with capital.  ROCE is lower than it was 10 yrs earlier; primary cause is acquisition of Gillette, but ROCE is increasing each year.  Financial leverage index (=ROCE/ROA) is above 2 for each year analyzed indicating effective use of leverage.  The return on unlevered net tangible assets (Warren Buffett's ratio) increased each year and is over the 25% threshold.
• Current dividend payout ratio is under 50% allowing for future growth in the dividend.  Dividend grew at 11%, while total net profit grew at 17%.  Firm has ability to increase the dividend payout ratio.

Valuation

		Risk-adjusted discount rate
	Growth	8.8%	9.8%	10.8%	11.8%	12.8%
Downside	5%	$73.91	$62.78	$54.51	$48.12	$43.05
Base	9%	$95.39	$79.76	$68.23	$59.41	$52.47
Upside	11%	$108.89	$90.42	$76.84	$66.49	$58.37

Based on a risk-adjusted discount rate of 10.8%, the intrinsic value of PG is $68.23 per share.  Currently, this is 9.7% above where shares are currently trading.  The risk-adjusted margin of safety is 12.9%, or the appropriate purchase price is $59.40 per share.  The suggested market price is approximately $2.70 above where it is currently trading.  If there is a sell-off in the stock where it is somewhere in that range, I would purchase the shares.  In addition, the firm indicates a buy with a forward P/E of 14.22.  This is below the "Buy P/E" calculated; the "Buy P/E" is calculated at 19.85.  Given the expected 9% growth rate in addition to less risky business and financial profile, PG should trade at a premium.  As indicated earlier, the stock has a strong dividend.  Given the discount to its intrinsic value and adequate dividend yield, it would be prudent to buy PG on a selloff.

To see full analysis (click here) 

This information is for educational purposes only, and the opinions expressed do not constitute a recommendation to buy or sell. Author may have a position in the companies discussed, subject to change at any time. Information on this website obtained from reliable sources, but there is no guarantee of accuracy. Please consult your financial advisor before making investment decisions. Past performance is not indicative of future success.