Highest Valuation Metrics Ever: Analysis

Welcome to the first update of the new fourth quarter financial statements of U.S. Companies.

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Q3 2020 hedge fund letters, conferences and more

The recent SEC filing update has just started and the volume will be sparse until December annual filers report in the coming weeks. These year-long financial statement have a later filing deadline than quarterly filings do and it will be early March before the update is complete.

The first companies to appear are the small population with fiscal quarters ended November. The most interesting feature of the third quarter just completed is the large number of companies in crisis mode with sales growth negative and lower. Aggressive cost reduction at the production level has improved gross profit margins (lower variable costs) and lower white-collar headcount has reduced SG&A expenses (lower fixed costs) and enhanced the operating profit margin.

Negative Sales Growth & Aggressive Cost Cutting

Both result in layoffs and the growing unemployment claims in recent weeks suggest that the fourth quarter will not show a trend change. Investors have become accustomed to the central bank creating money at whatever rate is necessary to shore up asset prices.

This has created a false assessment of the (low) level of risk in financial assets. With corporate growth falling broadly and steeply and share-prices tracing all-time highs and now financial assets are very risky. Until we can gauge the timing and magnitude of a post coronavirus economy, valuation measures will be very deceptive, so be sure to stay with companies with exceptional fundamental attributes.

Otos Total Market Index: Highest Market Valuation in Record

Our benchmark, the Otos Total Market Index has declined by 16% relative to the index of long treasury bonds since the September, 2018 high. Current price-to-sales (valuation) is the highest level in the record of the Index.

We have collected all the recent quarter 2020 sales data for 1,519 comparable record companies in the Otos Total Market Index representing 100% of the capital value.

The Otos Total Market Index capital weighted average sales growth rate last quarter was low 4.6% and falling. The proportion of Index market capital accounted for by rising sales growth companies is up to 45.5%, compared to 40.0% last quarter.

The Index is recording a falling gross margin and the proportion of total market capital accounted for by rising gross profit margin companies is up to 40.4% compared to 38.0% last quarter. Inventories are down, improving the chance of a future increase in the gross margin.

SG&A expenses are high in the record of the Index and falling. That implies that the Index has further capability to support their profit margins relative to sales with lower costs; but for how long?

The gross margin is already falling at a more rapid rate than SG&A expenses, producing a deceleration in EBITDA relative to sales. The shares have been highly correlated with the direction of the profit margins.

Opportunities to buy depressed shares are fewer now after the recent market advance. Look for companies with strong gross profit margins and choose rising sales growth with a good financial condition and whenever possible buy stocks with depressed share prices.

Shift to Active Management now and maintain a portfolio of companies with high & rising profitability.

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The more stable the pot appears, the better the attributes. Green and gold are good. Red is bad and the more intense the red the more urgent the call to action.

When considering a new investment I generally expect to hold it for a minimum of 2 or 3 years; if you have a dissonant view about a certain security (and that is the secret to making a decent return in the stock market) you can’t expect Mr. Market to suddenly change his mind just because YOU purchase the security. It takes time. After all, how long does it take YOU to change your mind about an investment? and remember, Mr. Market is quite a stubborn fellow. Prone to excess, but quite a stubborn fellow. A company generally needs to demonstrate that it is on a track to exceed Mr. Market’s expectations for a number of quarters if not years before Mr. Market can swallow his pride and re-price its equity. I think we can acknowledge that changing ones mind about an investment is perhaps one of the MOST difficult thing for an individual to do, and Mr. Market, after all, is just an amalgam of individuals.

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So how is it that I have exited my last investment, NACCO Industries (NC), after less than 2 months? Well, incredible as it may seem, Mr. Market has changed his mind about NC and revalued it (and it’s spin-off progeny, Hamilton Beach (HBB)) by close to 70% in less than 2 months! Is it possible that by spinning off the Hamilton Beach, NC management has increased the intrinsic value of the now-separate companies by 70%? I hardly think so. Perhaps NC was trading at only 60% of its intrinsic value in the first place and the spinoff lifted the shroud from Mr. Market’s eyes? Well, maybe. I’m just not sure that pre-spin NC was trading at 50% or 40% of its ‘intrinsic value’ and so I have exited my position with a quite reasonable 68% gain.

My primary reason for selling is that my initial thesis has proved out; the spinoff repriced the equity to take into account the two different businesses. And secondly, the shares have already risen beyond my target exit price and I no longer see the same upside as I did at the time of my initial investment. The future for the two companies does look a bit fuzzy right now; we haven’t seen stand-alone company performance yet for either one. Furthermore, on a short-term horizon, 3rd quarter earnings will be released for both companies this week. Will they disappoint? I don’t know. Perhaps not and both securities will rocket to another 70% increase. But then again, there could be a disappointing earnings announcement with a resultant fall in one or both share prices. With this uncertainty and the market in such a heady state overall I think it is prudent to take a bit of money off the table.

As you will remember NC had (and still has) a two class share structure; class A shares are publicly traded on the NYSE while class B shares are held by the controlling family and have 10x the voting rights of class A shares. When Hamilton Beach (HBB) was spun out of NC on Sept 30 each NACCO shareholder, whether class A or B, received one class A share and one class B share of Hamilton Beach for each NC share owned as of the record date. I would have thought that shareholders of NC class A shares would receive only class A shares in HBB and class B shareholders class B shares, but this was not the case. All NC shareholders, whether class A or B shareholders, received the same securities in the spin-off. The issue here is that HBB class B shares are not registered on any exchange and therefore not salable. In order to sell your HBB class B shares you must first exchange them for class A shares. As I have now discovered from my broker the class B shares are not in book form so there must be a physical exchange!! In short, this appears to mean it will take up to 6 weeks for HBB class A shares to appear in my account after my exchange request. Oh, and, of course, there is a $30 fee to do this! So to dispose of all my shares, besides selling the NC and HBB shares in my account, I have also had to short a number of HBB shares equal to the class A shares that I will receive after the exchange is completed and the class A shares delivered. Hopefully the mechanics will work out without too much difficulty (or cost).

As to a new position, yes, I have begun accumulating shares in a preferred issue that I will post about when I have a full position… it’s a rather illiquid security and I don’t want competition from my two readers out there!

As always, the above is my view on the aforementioned securities; please do your own due diligence as I am more likely to be wrong than right!

Article by Long Term Value Blog