The Definition And Value Of ‘Financial Slack’ by David Merkel, CFA of Aleph Blog
This was my first article published at RealMoney, in October 2003, I think on the 17th.
As investors go, I am a “singles hitter.” I don’t get many investments where I more than double my money. But I bat a high average when I invest. One of the keys to this is insisting that the companies that I invest in possess “financial slack.” Financial slack means that a company can make a few mistakes, and not get killed. This is the equivalent of Ben Graham’s margin of safety.
If you run a portfolio with a small number of stocks, it is important to avoid companies that destroy your capital. It is difficult to recover when your capital has been impaired. A good defense allows the offense to play aggressively, without losing sleep at night.
The market is a cyclical beast, with cycles inside cycles. The market has a cycle of its own, but industries have their cycles within the cycle of the market. This is where I find my advantage in the market – analyzing industry cycles. Industries go in and out of favor. The time to buy a company in any industry is when it is out of favor; as a matter of risk control (and humility) the companies to buy when an industry is out of favor are those with financial slack. If you are wrong about the industry, you won’t lose much; if you are right, the gains will be significant.
My example for today is the steel industry. The steel industry is economically necessary for our world, but is in decline in the US. The older integrated steel mills are inefficient compared to the mini-mills, and foreign competition. The foreign firms have varying advantages – cheaper labor, and governmental subsidies, both implicit and explicit.
Steel is a cyclical business that follows the pricing of steel. This may sound obvious, but the finance textbooks teach us to look at companies in a mode that assumes constant earnings growth. This is a rare condition in the real world, and non-existent with cyclical companies. With a cyclical company, watching the pricing trends of the commodity produced is the most critical factor in short-run stock performance. Longer-term, it comes down to:
- Buying industry leaders with impeccable balance sheets.
- Reasonable operating leverage – they should be profitable at the cycle trough
- Buying them when the industry is hated. Buy them cheap.
- Only buy firms that use free cash flow at cycle peak in a way that prepares for the trough.
Point 1 comes down to size and financial leverage. Points 2 and 4 suggest a corporate humility that arises from restraining the increase of productive capacity when times are good, and a willingness to invest when times are bad.
Point 3 is the hardest point. In growth industries, P/E ratios are a reasonable measure for valuation. In cyclical industries, P/B [price-to-book] and P/S [price-to-sales] ratios are more reasonable, because earnings are less stable and reliable. With cyclical companies, P/E ratios are typically lowest at the cycle peak, when companies have peak earnings, and high-to-nonexistent P/E ratios at the cycle trough.
Other issues around steel
There are a number of structural problems around the steel industry. Tariffs to protect US production prevent inefficient capacity from exiting the industry. The hint of removal or increase of tariffs can move steel stocks markedly. Second, labor unions have not figured out how deeply uncompetitive the US steel industry is. Between total compensation costs and work rules, the unions help make many US steel uncompetitive. Finally, pension liabilities are often large relative to the total capitalization of many steel companies. It is no surprise that one of the key issues regarding emergence from bankruptcy in the steel industry involves reduction of pension benefits.
Conservative investors investing in the steel industry will look for companies that do not have large pension deficits, and companies that are non-union, or where the unions have made peace with management. They will also look for companies that can exist without tariff protection. (Perhaps politicians will realize one day that more jobs hinge on the use of steel, rather than its production, and eliminate tariffs because it preserves more jobs, but I doubt it.)
In my investing, in the past, I have made money on AK Steel [AKS], Algoma Steel (insolvent), and Nucor [NUE]. When steel prices were higher, low cost producers (at that time) like AK and Algoma did well. Their main problem was their debt loads; a company that is operationally efficient still has to service its debts. EBITDA is all very good if you are a bondholder, but stockholders need free cash flow – AK and Algoma had none of that as steel prices fell.
In this uncertain environment, I am invested in Nucor. With little debt, a non-union workforce, and relatively low cost production, Nucor is an acceptable stock for conservative investors. Nucor has been a consolidator of steel assets on the cheap amid the many bankruptcies that have plagued the sector. When steel industry conditions normalize, they will earn a good return. It has a strong focus on return on equity. It should earn a about $1/share in the trough, and perhaps as much as $5/share at the peak.
But is it the right time to own Nucor? Is it cheap enough? I made my last purchase in the high 30s, and would purchase more there. In the high 40s, I am a little more indifferent, because I would sell Nucor in the low 60s. Given the normal level of profitability for Nucor, I view it as a buy below 1.3x book, and a sell at over 2x book.
I do not have a position in POSCO [PKX], but am considering it for my portfolio at present. POSCO, formerly Pohang Iron and Steel, is the third largest steel producer in the world. It is based in South Korea, and is presently the lowest cost producer in the world. Debt is low, and if you can trust Korean GAAP, it has earned consistent money for nine out of the last ten years. It trades around its book value, and 7x 2004 earnings – very cheap, unless we get a new war on the Korean peninsula.
As with any investment, the risks must be weighed against the likely returns. I have one Korean company in my portfolio. Do I want to double my risk? That is my main question on POSCO. Absent that, I would rate it a buy for those who can tolerate the risks involved.