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Sunday, November 22, 2009

How's the Economy Doing? Under the Hood in November

This is an update of our "How's the Economy Doing" periodic series. As a reminder, while our our investment strategy focuses on bottom-up analysis of individual companies, we think awareness of overall macroeconomic conditions is helpful since trends that may impact certain companies or sectors. As always, divergent views exist on where the Market and economy are headed. For example, we published our recent "Time to Go to Cash".... Or is It? article on SeekingAlpha.com (here) and had a number of bearish comments. Per our prior posts, we're fully aware that unemployment and housing remain problems -- please see this Washington Post article: Problem mortgages hit new high at 14 percent - Data mean foreclosures may not peak until next year. However, we believe both Market psychology and corporate fundamentals are in a different place than one year ago. Let's look at some hard data across sectors:
  • Railroads - from Association of American Railroads: "Freight rail traffic was down for the holiday week ended Nov. 14, 2009. U.S. railroads reported originating 281,218 carloads for the week, down 8.9 percent compared with the same week in 2008 and down 17 percent from the same week in 2007. Rail carloads showed slight improvement, up 2.3 percent from the previous week. Intermodal traffic totaled 208,056 trailers and containers, down 7.7 percent from a year ago and 15 percent from 2007. Compared with the same week in 2008, container volume fell 1.5 percent and trailer volume dropped 30.2 percent. While 13 of the 19 carload freight commodity groups were down compared with the same week last year, some increases were seen.... Total volume on U.S. railroads for the week ending Nov. 14, 2009 was estimated at 31.6 billion ton-miles, down 7.9 percent compared with the same week last year and 11.2 percent from 2007.... Combined North American rail volume for the first 45 weeks of 2009 on 13 reporting U.S., Canadian and Mexican railroads totaled 15,357,248 carloads, down 17.9 percent from last year, and 10,681,718 trailers and containers, down 15.9 percent from last year." Link here.
  • Trucking - from American Trucking Associations (yes, ATA is plural) for the month of September (reporting lag): "The American Trucking Associations’ advance seasonally adjusted (SA) For-Hire Truck Tonnage Index decreased 0.3 percent in September, after increasing 2.1 percent in both July and August.... Compared with September 2008, SA tonnage fell 7.3 percent, which was the best year-over-year showing since November 2008. In August, the index was down 7.5 percent from a year earlier. ATA Chief Economist Bob Costello said that the latest reading fits with the premise that the recovery will be moderate and choppy.” Link here.
  • Air - from IATA: "The International Air Transport Association (IATA) reported international scheduled traffic results for September 2009. Passenger demand was essentially unchanged, increasing 0.3% compared to September 2008. Demand for international cargo was 5.4% below September 2008 levels. Load factors for passenger and cargo have returned to pre-crisis levels of 77.1% and 50.8%, respectively. The apparent year-over-year improvement in demand is misleading. It is largely due to comparisons with an exceptionally weak September 2008 when traffic fell sharply (-2.9% for passenger and -7.7% for cargo). Seasonally adjusted statistics show a 0.3% drop in passenger volumes and a 1.4% fall in cargo volumes for September 2009 compared with August 2009." Link here.
  • Semiconductors - from SIA: "The Semiconductor industry Association (SIA) today released its annual forecast of global semiconductor sales projecting worldwide sales of $219.7 billion for 2009, a decline of 11.6 percent from the $248.6 billion reported in 2008. The forecast projects that sales will grow by 10.2 percent to $242.1 billion in 2010 and by 8.4 percent to $262.3 billion in 2011. Link here.
  • Residential Housing Permits and Starts - from US Department of Housing and Urban Development: "Privately-owned housing units authorized by building permits in October were at a seasonally adjusted annual rate of 552,000. This is 4.0 percent (±1.9%) below the revised September rate of 575,000 and is 24.3 percent (±1.9%) below the October 2008 estimate of 729,000. Single-family authorizations in October were at a rate of 451,000; this is 0.2 percent (±1.0%)* below the revised September figure of 452,000. Authorizations of units in buildings with five units or more were at a rate of 85,000 in October. Privately-owned housing starts in October were at a seasonally adjusted annual rate of 529,000. This is 10.6 percent (±8.7%) below the revised September estimate of 592,000 and is 30.7 percent (±8.3%) below the October 2008 rate of 763,000. Single-family housing starts in October were at a rate of 476,000; this is 6.8 percent (±7.5%)* below the revised September figure of 511,000. The October rate for units in buildings with five units or more was 48,000." Link here.
So, aside from housing starts at down 24-32% Y/Y, the hard data shows that most sectors are now seeing 5-10% Y/Y declines, which is an improvement from 10-20% Y/Y declines earlier in the year. Although we're now coming up against easier Y/Y comparisons, the environment clearly remains challenging. In this regard, Annaly Capital Management's (NLY, $18.11) monthly commentary for October includes a less than uplifting, but balanced, summary of the U.S. economic situation:
  • The point of the government’s economic push is to “prime the pump,” to get the economic fires roaring sustainably by throwing on some lighter fluid. In order to call the stimulus efforts a success, we now need the multiplier effect to kick in. Companies that are benefiting from artificial demand need to respond by increasing hours worked and then hiring more workers, creating new jobs and stimulating natural demand for goods and services.
  • Is that happening? The plunge in hours worked that began in 2008, a soft form of lost jobs, has not corrected itself as of the October reading (33.0 hours, tied for the record lowest reading), and new unemployment claims have remained stubbornly above the 500 thousand mark. The rate of job loss has slowed, but we are still losing jobs at a pace consistent with recessions, not recoveries. Third quarter corporate revenues and earnings are up quarter-to-quarter but down year-over-year, and bottom lines were helped by the trimming of headcounts and capital expenditures." Link here.
The Annaly commentary also includes the below graph, which illustrates the stimulus driven spike in consumption expenditures (e.g. "cash for clunkers") and the obvious disconnect with personal income:
Thus, we've still some things to worry about, although we still believe easy Y/Y comps will lead to pockets of growth in 2010 that can support share prices and, hopefully, create new jobs.

What to do from portfolio perspective? Our strategy hasn't changed: as always, we need to pick our spots with a preference for very low multiples of current earnings and growth.

We continue to sleep well owning franchise type businesses that are currently generating significant excess cash flow and have limited to no debt. As before, examples in this category include eBay (EBAY, $22.79) and PetMed Express (PETS, $16.25). Even American Oriental Bioengineering (AOB, $4.18), which disappointed us last week, offers a compelling 17% FCF yield to current buyers. Despite risk factors, we still believe what AOB has established in China is difficult to replicate and worth much more than current levels based on free cash generation.

Finally, per our Approach caveat #2, we may sometimes purchase out of favor companies that offer a meaningful margin of safety relative to current liquidation value and/or normalized asset values. Believe it or not, there remain some names that have not participated in the torrid market rally, but offer what we believe to be significant margins of safety. We may share one such idea in the not so distant future.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long EBAY, PETS, AOB.

© 2009 Jeffrey Walkenhorst
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