Author: Bob Gay, GEARS
Covestor model: Luxury Liner
We completed the collection of third quarter financial statements from U.S. companies last week, and the numbers continue to look very good.
Corporate wealth continues to accelerate on average. The majority of the stock market capital value is accounted for by companies achieving an improvement in sales growth and the average sales growth rate moved to a new high. Current annual sales growth, now at a capital weighted average of 17.6%, is the highest in over a decade. The gross profit margin continues to decline in the most recent period and 60% of companies recorded a lower gross margin. Lower operating costs (Selling, General and Administrative expense on most income statements) and lower interest costs produced an improvement in the net profit margin despite the lower gross margin and, on average, companies are accelerating earnings and cash flow relative to sales. A review of these third quarter macro corporate growth numbers and conclusion for asset allocation (buy stocks and sell bonds) is available on my site here. (Corporate financials source: GEARS)
My Luxury Liner strategy is to buy accelerating companies when shares are depressed and impose a hedge when shares are extended. The rally in share prices since the end of September has increased the population of shares trading at extended share prices, and in response I imposed a small hedge position in late October. That stabilized the Luxury Liner’s returns in November, consistent with the strategy.
As shares have continued to move higher I am executing sell decisions that emerged from the third quarter update of fundamentals. In November I was able to execute sell decisions for Newmont Mining Corp (NEM), Rimage Corp (RIMG), Donaldson Company (DCI) and Clayton William Energy (CWEI). The steep decline in share prices at the end of November caused me to postpone selling and now with the very strong market in early December I have resumed.
Once the portfolio adjustments are complete, the Luxury Liner portfolio will be back to its target unleveraged and hedged position, although with the broad and strong improvement in corporate growth ongoing, I expect the portfolio to remain net long.
Generally there was little change in the forces driving corporate wealth in the third quarter. Sales growth was higher and net profit margins were higher as a result of lower costs in the face of a decline of the gross profit margin. This has been the structure of the trend in fundamentals now for the past six quarters since sales growth began to improve in the first quarter of 2010.
The most interesting recent changes are related to company investing trends. Two quarters ago we saw the first increase in capital expenditures relative to sales. In the most recent quarter, capital expenditures continued to advance relative to sales and now at a fast enough rate that free cash flow has recorded the first drop since 2006. For the first time this cycle, companies are investing in property, plant and equipment at a faster rate than cash flow from operations, requiring the sale of securities, the drawdown of cash balances or financing to fill the gap. Historically this has been evidence that corporate growth is hot and demand for capital is rising. It has been associated with rising inflation and higher interest rates.
Corporate cash balances are still high and there is still plenty of room to fund new investments internally, but this new development suggests that, in coming quarters, company earnings will surprise on the upside and that higher inflation and greater demand for capital will push interest rates up from their current historic lows.
The most important decision for investors to make now is to avoid value traps. With corporate earnings growth heating up and demand for capital rising, shares of companies with low and stable growth rates will likely perform poorly. The advance in the performance of lower risk investments since last spring should be used as an opportunity to sell and switch to stocks of companies with improving fundamentals.
