Intrinsic Mistakes

“It’s the discounted value of the cash that can be taken out of a business during its remaining life.”

-Warren Buffett

Not to be confused with a pig, value trap, or a zero, that’s what Buffett calls the “intrinsic value” of a company. In Berkshire Hathaway’s 1989 Annual Report, Buffett reminded us that “it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Amen brother.


Realizing that a lot has changed since Berkshire was buying smaller, under-covered, under-valued companies in the 1970s (when the SP500’s P/E was 7-8x), our all-star intrinsic deteriorating-cash-flow analyst, Kevin Kaiser, would love to interview Buffett on where his recent investment in Kinder Morgan (KMI) fits within his aforementioned definition of “fair.”

To be clear, ex-his-partisan politics, I have a great deal of respect for The Oracle of Omaha. I wrote my senior thesis @Yale on what I loved about his bottom-up investment strategy. Today though, I’m reminded of what his forefather, Benjamin Graham, taught us: “it’s a great mistake to imagine the intrinsic value is as definite and determinable as is the market price.”

Intrinsic Mistakes - buffett

Back to the Global Macro Grind

If you have an excel spreadsheet, some Old Wall consensus forecasts, and a calculator, you can pretty much imagine-up any “valuation” for a company that you want. The #1 risk to slapping a multiple on your cash flow number is that you are using the wrong multiple on the wrong number.

Imagine, God forbid, that you were one of these “value” guys who has been buying Energy stocks for the last 2 years on the premise that they were “cheap.” You could have bought the entire Energy (XLE) ETF in Q2 of 2014 at $97 (pre a -45% crash) assuming that the “cash that can be taken out of the business” was going to have $90-120 Oil implied in its cash flow margin…

You could have bought all of Kinder Morgan (KMI) at $42/share at this time last year too.

Since Kaiser didn’t sleep-over at my place last night and I don’t have access to his immediate-term thoughts on the Buffett purchase (hockey players are close, not that close), I’ll show you how a proxy for the right cash flow number looks in the commodity #Deflation Risk space – earnings. Here’s where year-over-year revenues and earnings are on a reported basis Q4 to-date:

  1. ENERGY (23 of 50 S&P companies have reported) = Sales -33%, EPS -74%
  2. BASIC MATERIALS (24 of 27 companies have reported) = Sales -16%, EPS -18%
  3. INDUSTRIALS (58 of 65 companies have reported) = Sales -7%, EPS -4%

I know, I know. If you “back out” those 142 companies from the SP500, “earnings aren’t that bad.” Notwithstanding that I didn’t hear one long-only fund manager ex-out the “earnings are great” narrative at $110 oil, you get how wrong numbers can be.

Income statement earnings and “cheap P/E multiples”, don’t forget, tell you next to nothing about:

A)  A company’s Debt Leverage (Balance Sheet)

B)  Credit Risk Profile, Covenants, etc.

C)  And/or where their profits are in terms of the cycle

That’s why we cyclical bears love shorting “cheap” stocks. When the profit-cycle slows and the credit-cycle deteriorates – newsflash: “cheap” gets a lot cheaper.

This is where buying a levered company at a “wonderful price” gets really dangerous. You can ask Carl Icahn about his purchases of #Deflation Risk companies like Freeport McMoran (FCX) and Chesapeake (CHK) about that. He’s Trump’s macro guy though!

Back to the intimate relationship that the PROFIT CYCLE shares with the CREDIT CYCLE:

  1. In the aggregate, 389 companies in the SP500 have now reported their respective 4th quarters
  2. Aggregate SALES are down -4.2% and EARNINGS are down -6.7%
  3. Only 3 of 10 S&P SECTORS have positive year-over-year EARNINGS growth

As a friendly reminder to those chasing US Equities (again) on another slow-volume Liquidity Trap bounce (Total US Equity Market Volume was -8% vs. its 1-month average yesterday)… every time US corporate PROFITS go negative (year-over-year) for 2 consecutive quarters, the SP500 has a greater than 20% crash/decline.

Currently the SP500 is -11.0% from its all-time #bubble high (July 2015), so the least bearish case I can give you this morning is SP (= 20% draw-down from peak). So, instead of trying to find some emotional value in what the S&P Futures are doing, I suggest you watch profits and credits today. Not doing so will continue to be, as Ben Graham called it, a “great mistake.”

Our immediate-term Global Macro Risk Ranges are now:

UST 10yr Yield 1.60-1.84%

SPX 1
RUT

NASDAQ 4155-4517

VIX 21.11-29.04
USD 95.07-97.89
Oil (WTI) 26.01-31.22

Best of luck out there today,

KM

Keith R. McCullough
Chief Executive Officer

Intrinsic Mistakes - 02.17.16 chart