Where are we now in the Stock Market Cycle?

And Unilever PLC

 

Astrologer casting a horoscope, 1617, Robert Fludd, courtesy Wikipedia.

 

It is the time of year when financial journalists, stockbrokers and anyone vaguely interested in the stock market offers an opinion on what the stock market will do this year. They have the power of prediction of the astrologers of yore. 

 

Howard Marks of Oaktree Capital Management is a self-styled contrarian investor. To understand where we are in a market cycle, Marks sets out a simple checklist that he calls "The poor man's guide to market assessment". For each consideration he has set up a pair of answers. Check one of the two for each consideration. "And", he writes, "If you find that most of your checkmarks are in the left-hand column, hold on to your wallet." Oaktree Capital Management applies Marks's principles to the $71 billion debt, property and equity investments the company manages. Mr Marks has a personal fortune of $1.5 billion. 

 

Considerations	Unfavourable	Favourable
Economy	Vibrant	Sluggish
Outlook	Positive	Negative
Lenders	Eager	Reticent
Capital Markets	Loose	Tight
Terms	Easy	Restrictive
Interest rates	Low	High
Spreads	Narrow	Wide
Investors	Optimistic	Pessimistic
Investors	Sanguine	Distressed
Investors	Eager to buy	Uninterested in buying
Asset Owners	Happy to hold	Rushing for the exits
Sellers	Few	Many
Markets	Crowded	Starved for attention
Funds	Hard to gain entry	Open to anyone
Funds	New ones daily	Only the best can raise money
Recent performance	Strong	Weak
Asset prices	High	Low
Prospective returns	Low	High
Risk	High	Low
Popular qualities	Aggressiveness	Caution and discipline
Popular qualities	Broad reach	Selectivity

From The Most Important Thing: Uncommon Sense for the Thoughtful Investor by Howard Marks

It is likely most people will check the left column more frequently than the right.

James Mackintosh, of the Financial Times Short View column (8 January 2014), points out that UK investment trust discounts are at an historical low. In the past low discounts have always been followed by a period of stock market underperformance over the following 12 months.

Shiller's graph for the Cyclically Adjusted Price Earnings ratio (CAPE - the current price of the S & P 500 share price divided by a rolling average of 10-year earnings) is commonly used as a measure of where we are in the stock market cycle. This is because a 10-year rolling average for earnings is a more reliable indicator than taking a single year. Here he compares it to long-term interest rates. As one might expect, CAPE ratios are higher when long-term interest rates are lower. In my valuation model this is reflected in the discount rate, which depends on long-term interest rates.

 

Courtesy Robert Shiller's Yale website, click to enlarge

Depending upon your reading of these tea leaves, stock markets in the US and the UK (the FTSE All Share is closely correlated to the S&P 500) are either midway towards a bubble or they are nearing the top of its regular cycle. Goldman Sachs, in its Monday telecast, is now predicting a 'correction', but that the FTSE 100 will end 2014 10% up on 2013.

What to do? It is at these moments when rule-based investing comes to the aid of the party. Stick to a tested methodology to value individual stocks and other assets that has worked for you in the past.

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Unilever PLC

 

Ad for Lux soap from the 1920s, courtesy Wikipedia

 

Unilever was reviewed at this blog in April 2013 (see http://thejoyfulinvestor.blogspot.co.uk/2013_04_01_archive.html).  To resume:

 

The present management has staged a remarkable turnaround since 2005. Marketing is concentrated on 14 brands each with sales exceeding €1 billion, and emerging markets now account for 55% of the company's sales.

 

Financial results are strong.

1. Earnings per share have increased by 11% pa from 2001-3 to 2010-12 and the dividend per share has increased by 18% pa from 2001-2012.

3. Return on equity averages 31% on an historical basis, but this has fallen to 15% on retained earnings. Equity per share has increased by 7% pa since 2001.

4. Free cash flow of €27 billion in the past 5 years has paid for capital expenditure and the dividend with €6 billion to spare.  This was used to reduce debt.

5. Net debt is down from €26 billion in 2000 to €7.6 billion in 2012. Unilever has a long-term credit rating of A+. 

Yet the price of Unilever shares (in blue) is back where it was at the beginning of 2013 while the FTSE 100 (in green), of which it is a component, has increased by 12%.

 

Graph courtesy Barclays Stockbrokers, click to enlarge

 

What has happened?

 

1. Analysts have reduced earnings expectations for 2013 to 3%. The reduced earnings expectations for 2013 are the result of adverse currency movements against the Euro of the US dollar and many other currencies. And Unilever sold Skippy for $0.8 billion. Once revenues are corrected for currency fluctuations and Skippy, they are up by around 5%, compared to 6.9% in 2012 (excluding acquisitions and favourable currency movements in that year).

 

2. Net debt jumped by €4.2 billion in the first half of 2013. This was almost entirely the result of placing €3.8 billion into an escrow account to buy out the minority shareholders in Unilever's Indian subsidiary. In the end, Unilever paid €2.5 billion for a smaller number of shares and the difference will go back into cash at the 2013 year end. And future attributable profit deductions for minorities will be considerably lower, though Unilever does not inform us by how much.

 

Some of Unilever's brands, including Lux soap, go back to the 19th century. The company's brands span all markets and many of the top 14 are either the largest or second largest in their respective markets. Revenues from emerging markets grew by 9% in the first 9 months of 2013, and it was Europe and North America where sales stagnated. But both markets should resume their growth with the economic recovery.

 

Management is reducing regional and local marketing staff by 12% with the purpose of reducing costs and the duplication of functions. This follows other global consumer companies that have either done something similar or have announced it. Unilever is aiming, in addition, to save $400 million on global advertising by forcing down rates rather than less exposure.

 

At the current price of 2406p, Unilever shares trade on an estimated 2013 PE ratio of 18 and yield 3.7%. Including the expected 2013 results in my valuation model, the shares are good value.* Preliminary results for 2013 are due on 21 January.

*Eps growth of 9% p.a., average PE of 18, 15% return on equity, dividend payout ratio of 67% of earnings, discounted by 10.8% (3.8% SLXX +  2% operating risk + 5% margin of safety) for the years 2014-2018.

 

Cautious investors will note:

 

1. Emerging markets growth is in decline and there is no guarantee that it will recover its former vitality.

2. The competition is intense from the likes of Heinz, Colgate, Nestlé, Procter & Gamble and Reckitt Benckiser, and local producers in places like China and India.

3. The growth in Unilever's earnings per share has declined in recent years.

4. Management has a large number of 'soft' objectives on social and environmental issues that might distract them from profit making and cash generation.

 

 

The Latest Bubble - Bitcoin

And A Portfolio of AIM shares (8) Utilitywise PLC

 

Simulated black hole Magellanic Cloud, courtesy Wikipedia

Bitcoin has no taste, no touch, no mass, no physical presence at all. It is a money transmitter on the internet like PayPal, but whereas PayPal clears accounts in seconds, Bitcoin can take up to four days. Thanks to the promise of anonymity, Bitcoin is favoured by purchasers of drugs and online gambling. China has banned its use as a medium of exchange. The United States does not allow international bitcoins to be converted into real money - the US dollar.

How then is Bitcoin perceived as a store of value and compared, by its enthusiasts, to gold? And how can something with no intrinsic value see its price multiply by hundreds of times in the space of a year?
 

Bitcoin price in US dollars courtesy Mt. Gox.

Bitcoin was invented in 2009 by a mysterious group or individual calling itself Satoshi Nakamoto. He or they invented a series of algorithms that, supposedly, simulate gold. The Bitcoin model is maintained by a self-appointed organization called the Bitcoin Foundation. Its chairman styles himself 'a serial entrepreneur' and its vice chairman was once a hacker going by the nickname of 'Yankee'. Their objectives are to standardize, protect and promote Bitcoin.

Bitcoin's appeal is based on clever marketing:

·         John Authers of the Financial Times writes 13 December, "The genius of the new currency is that it has built-in scarcity." The number of bitcoins in circulation is supposed to be limited to 21 million. This appeals to people worried about the recent expansion in the money supply of major currencies (quantitative easing). But what can be done by computer scientists can be undone by computer scientists. And hackers have created their own unauthorised bitcoins.

 

·         New bitcoins, up to the supposed maximum 21 million, are 'mined' by computer scientists called 'miners'. As the number of available bitcoins diminishes the difficulty of 'mining' them increases. This is an elaborate game with a payoff in bitcoins for successful 'miners'.

 

·         Visually, virtual bitcoins have been designed to look like gold coins and they use a symbol akin to the dollar. Users can hold them in bitcoin 'wallets'. For people hoarding gold via exchange traded funds, a bitcoin might seem more real than a gold coin.

 

·         Bitcoins are held in anonymous 'blocks'. This ensures that ownership cannot be traced back by the tax authorities or anyone else.

 

·         The Bitcoin Foundation's motto is 'Developing a more open economy', suggesting an altruistic purpose to the venture.

Speculators can buy bitcoins from specialist suppliers, such as Mt. Gox, Coinbase or China's BTCtrade. They issue a unique code for the purchased units.

While most of the speculative buying seems to have come from China, Americans are not far behind. The Winkelvoss twins of Facebook fame have bought some and they have applied for authorisation to launch a bitcoin exchange traded fund. Coinbase has raised $25 million to invest in the virtual currency.

As in the case of any bubble, seemingly sound arguments support the rising price. The main rational argument is that Bitcoin, as an internet currency, will require so many billions of dollars to support its eventual role as the preeminent money transmitter. Divide that number of billions by 21 million and, hey presto, a bitcoin could be worth $1,000, $5,000 or $10,000. Or nothing at all. Bitcoin could be a black hole, sucking in dollars and renminbis that will disappear forever.

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A Portfolio of AIM shares (8); Utilitywise PLC

A smart electricity meter, courtesy Wikipedia

 

The Investors Chronicle has chosen AIM listed Utilitywise PLC as its 'Growth Tip of the Year' for 2014 at 244p a share. Might this stock form part of a portfolio of AIM shares? For the selection criteria of AIM stocks see an earlier article at http://thejoyfulinvestor.blogspot.co.uk/2013/09/aportfolio-of-shares-in-aim-1-andthe.html

 

Utilitywise was founded by Geoffrey Thompson and his son Adam in 2006 to offer small and medium enterprises (SMEs) a service to reduce their energy bills. The company's website claims:

"Our energy consultants have direct lines to the energy suppliers. Our consultants negotiate with energy suppliers every day and have ready access to business energy prices unavailable to the general public."

 

90% of the company's revenues is derived from commissions paid by major energy suppliers for procuring business from these SMEs. The remaining 10% of income comes directly from SMEs for specific services designed to save energy. These include the installation of smart meters and IT packages that measure and identify energy savings. In 2012 Utilitywise entered the water consultancy market by acquiring Aqua Veritas Consulting Ltd. (Aqua).

 

With some 16,000 customers, the company has a very small share of the 1.8 million SMEs in the UK and Ireland. Utilitywise claims to be the largest supplier in a very fragmented market.

 

The company listed on AIM in June 2012 at 60p a share. Its shares are currently eligible for 100% business relief for Inheritance Tax, the company has a 'free float' of 74% of its shares and the bid to offer spread for its shares is 1.5%. It is valued by the stock market at 190 million pounds. Directors own 26% of the company.

 

Utilitywise's revenues and profits have grown at a racing pace, as has its share price:

 

Graph courtesy of LSE, click to enlarge

  

On the surface, Utilitywise has performed magnificently since its June 2012 flotation on AIM:

 

1. Revenue is up by two-thirds and earnings per share is up by more than a third year on year.

 

2. Three acquisitions, funded by issuing 5 million pounds in new shares and a 5 million pound loan, all contributed to the company's profit.

 

3. Utilitywise ended its 2013 fiscal year with net cash of 4 million pounds, and the company generated 5 1/2 million pounds net operating cash flow in the last two years.

 

4. Return on equity improved from 18% in 2012 to 19% in 2013. Gross margins are expected to settle around the 45% mark.

 

5. Its customer base has increased by 40% in the year, 34% via organic growth.

 

Looking ahead, 2014 should be another year of outstanding growth in both revenue and pre-tax profit. Consider:

· At the end of FY 2013, Utilitywise had an order book of over 18 million pounds; full year revenue in 2013 was 25 million pounds.

· The annualised contribution from its three acquisitions would add a further 8 million   pounds in revenue and 2 1/2 million pounds to profit without any growth at all.

· And its sales force at the beginning of FY 2014 was 86% higher that the sales force at the beginning of FY 2013.

At the present share price of 240p, Utilitywise trades on an historical PE ratio of 28 (once adjusted for non-recurring costs), and a dividend yield of 1.1%. The broker forecast for 2014 places Utilitywise shares on a forward PE ratio of 20 and a yield of 1.5%. The valuation from my financial model values the shares at about the current price, when based only on earnings considerations.* There is not enough data to use the equity per share and return on equity valuation models.

 *EPS growth of 20% p.a., average PE ratio of 18.5, discounted at 11.8% (3.8% SLXX + 3% operational risk + 5% margin of safety) for the five-year period 2014-18.

 

There is one serious caveat. Accounts receivable plus accrued revenue represented 228 days sales in 2013 versus 77 days in 2012. This extraordinary increase was due to an increase in accrued revenue of 9.5 million pounds in FY 2013. Accrued revenues "relate to commissions earned, not yet invoiced or paid and are discounted at an appropriate rate." (Annual Report). Non-current accrued revenues (revenues that will not be billed until after the end of the following year) accounted for 7 million pounds of the increase in reported revenues. While this accounting treatment of accrued revenues is consistent with the guidelines set out by IAS18, it does have consequences for the company.

 

If Utilitywise had not included non-current accrued revenues in sales, FY 2013 revenues would have been 18 million pounds instead of 25 million and the company would have reported an adjusted pre-tax profit of 4.8 million pounds instead of 7.8 million pounds. This helps to explain the sharp decline of cash conversion, year on year, from 172% of post-tax profits in 2012 to 25% in 2013.

There is also the risk that the contracting party will not pay out as agreed. Utilitywise claims that its customers are 'blue chip' and the company discounts future revenues at 3% per annum. While this may well be reasonable, Utilitywise is not the cash producing company it seems to be on the surface. Its debtors require financing.

And the prudent investor will note:

1. Utilitywise is an intermediary between energy and water suppliers and users. Intermediaries can sometimes be squeezed.

2.   The company's share price peaked at 288p at the beginning of 2014 and was trading at only 89p in April 2013.

3. Managers can lose control over fast growing companies - and Utilitywise's staffing levels have more than trebled in the last three years, with three acquisitions in the last 15 months.

4. Recently, two directors are buying the shares at between 204p and 230p a share.