When I recommended returning capital in 2016, I felt small cap stocks were broadly overvalued. The cash in the portfolio I was managing was rising to record highs and I was unable to find investments I felt would adequately compensate clients for risk assumed. Hence, I felt the best course of action was to return capital. Two and a half years later, the investment and economic landscape has changed considerably and currently appears to be in transition.
Q3 hedge fund letters, conference, scoops etc
I initially noticed a shift in the macro environment in 2017 when several companies on my possible buy list began reporting rising costs. Later in 2017 and early 2018, I also discussed and documented improving operating trends for many of the businesses I follow. During this period, short-term interest rates also began to increase. The rise in interest rates was an encouraging sign for patient absolute return investors. In my post “Patience a Possible Win Win” I wrote:
“Waiting isn’t easy, but with short-term interest rates trending upward, it’s gotten a little easier. As the later stages of the current market cycle unfolds, I believe patient investors will likely be rewarded with either higher returns on their liquidity or a more attractive opportunity set.”
Interestingly, over the past year we’ve seen both – higher rates, and more recently, an improving opportunity set. In hindsight, I don’t believe the Federal Reserve had a choice but to increase rates and implement QT. Throughout most of 2017 and all of 2018, rising wages and increasing corporate pricing power were too obvious to ignore. Negative real rates simply do not mix well with record low unemployment, signs of labor shortages, and corporations openly communicating their intentions to raise prices.
As wages and inflation picked up steam throughout 2018, the yield on the 2-year Treasury followed. During this time, I became increasingly fascinated with the 2-year and its upward sloping yield. In my post, “Tick Tock Where Does the 2-Year Stop?” I wrote:
“Since I began noticing rising corporate costs in 2017, the 2-year Treasury yield has increased considerably. Trading near 0.50% only two years ago, the yield on the 2-year hit 2.79% today! As someone patiently waiting for the current market cycle to end, I’d like to know the rate the 2-year needs to reach before something in the financial system cracks.”
Assuming the current market cycle’s peak is behind us, it appears the 2-year yield that caused something in the financial markets to crack was approximately 2.75%. Not long after stocks began to fall, the 2-year yield peaked at 2.98% (November 8, 2018). It’s not exactly a high yield for a cycle peak, but one needs to keep things in perspective. The fed funds rate was between 0-1% for nine years! A tremendous amount of debt accumulation, asset inflation, and capital allocation occurred while rates were pegged near 0%. As such, it didn’t take many rate hikes (along with QT) to cause investors to revise their “lower for longer” valuation assumption.
For many absolute return investors, it’s been an incredibly long, frustrating, and even fascinating market cycle. While I continue to be uncertain as to when this cycle officially ends, as I’ve stated in recent posts, I’ve become more encouraged and optimistic regarding future opportunity. In fact, as volatility has increased, several of the small cap stocks I follow are down meaningfully and are trading below where they were when I recommended returning capital. With prices declining and my opportunity set improving, I’ve increased my time devoted to research and finding new potential buy ideas.
After sorting through the carnage on my possible buy list and equity screens, I’ve come to the conclusion that small cap stocks, on average, remain expensive. Several aggregate valuation metrics, such as EV/EBIT, support my bottom-up conclusion. Below is a chart of the Russell 2000’s median EV/EBIT (excluding financials). I prefer EV/EBIT to P/E as it takes net debt into consideration and excludes the impact of what I believe are below normalized interest rates and tax rates.
While I researched potential buy ideas, I was also reminded of how much debt has accumulated on corporate balance sheets this cycle. As noted in my post The “V” or the “L”, one of the most glaring differences between this cycle and past cycles is corporate balance sheets.
Higher debt levels can be seen from a bottom-up and top-down perspective. From a top-down perspective, most aggregate measurements of corporate debt are elevated. For example, the median net debt/EBITDA of the Russell 2000 is currently 3.2x versus 0.9x in July 2007 (the last market cycle peak).
The increase in debt is also noticeable from a bottom-up perspective. For example, United Natural Foods (UNFI) is a company I follow and have owned in the past. Its stock has declined -74% over the past year and is trading well below the price of my last purchase. So why am I not buying? Unfortunately, due to acquisitions, the company’s debt has increased considerably and no longer passes my financial strength criteria.
In my attempt to avoid permanent losses to capital and potential bankruptcies (goose eggs), I follow a simple financial strength rule of thumb. Specifically, I require a debt-to-free cash flow ratio of 3x or less for cyclical businesses and 5x or less for non-cyclical businesses. Debt-to-free cash flow limits have saved me from multiple distressed situations in the past. And given how much corporate debt has grown, I expect the use of leverage limits will become increasingly valuable as the current credit cycle matures.
So why do I use 3x-5x debt-to-free cash flow? As an equity holder, I want to make certain a business can pay off its debt, if needed, before a large bond or credit line matures. The maturity wall for many small cap companies typically hits in 3-5 years; hence, I use 3x-5x debt to free cash flow limits. In effect, I never want to be at the mercy of a volatile credit market or fickle banker. And this is also why I use debt-to-free cash flow instead of debt/EBITDA. In my opinion, debt/EBITDA is less effective in helping me understand a business’s discretionary cash flow and ability to repay debt.
In summary, while many small cap stocks are down meaningfully from their highs, I believe valuations, on average, remain elevated. Nevertheless, given it’s been so difficult to find value for so long, it’s understandable to want to research and possibly buy a beaten-down stock. For absolute return investors diving in and searching for new ideas, happy hunting! Just watch those balance sheets. Financially distressed businesses and potential goose eggs can be devastating to performance and full-cycle absolute returns.
