Identifying good companies
Christopher Norwood • August 22, 2022

We expect a flat market with plenty of volatility over the next few years

   

Market Update

The S&P touched the 200-day moving average Tuesday before falling back. The upper boundary of the downward trending trading channel is overlapping the 200-day. The 200-day and the trading channel both act as resistance. It will take positive fundamental news over the weekend or early in the new trading week to move the S&P 500 higher. Absent that positive fundamental news, the S&P 500 should trade down in the coming weeks.


The index lost 1.2% last week finishing at 4228.48. It has climbed 15% from its 17 June low. The Nasdaq lost 2.6% last week. It has climbed 20% in the past two months. The stock market is due a rest. A 5%-10% pullback would be normal. A retest of the 17 June low is also possible if the economic news disappoints. Investors seem to believe that inflation has peaked and will fall rapidly. The one-year breakeven rate has fallen from 6.3% in March to 3.0% today, writes Leuthold Group Chief Investment Strategist Jim Paulsen. The one-year breakeven is the bond market’s one-year-forward inflation expectation. Bonds and stocks will sell off if that forecast proves too optimistic. Norwood Economics believes it is too optimistic.


We wrote as much last week. The general view is that inflation will fall to acceptable levels by year-end. The Federal Reserve will be able to stop tightening sooner as a result. The stock and bond markets will do well the rest of 2022 if the consensus is correct. The stock and bond bear markets will resume otherwise.


Regardless, the stock market is once again expensive, making continued gains less likely. The S&P is trading at almost 19x 2022 earnings. Those earnings estimates are likely to fall. The S&P is trading at more than 17x 2023 earnings estimates, which are too high as well. Markets can trade expensive when interest rates are low. Not so much when the Fed is busy increasing the cost of money.

We further wrote last week that the fiscal cliff and Quantitative Tightening are likely to put us into a recession by 2023. The stock market will sell off again in anticipation of a recession. In short, expect more selling this year or next, but do expect more selling. It will continue to be a stock picker’s market. Good companies on sale paying an above-average dividend should continue to outperform. Our base case for the next few years continues to be a flat market with plenty of volatility.


Economic Indicators

The economic data was mixed last week but with a downside bias. The Empire State manufacturing index fell to -31.3 in August from 11.1 the prior month. It is the second largest decline on record. It is one of the lowest levels in the survey’s history. The index for new orders fell 35.8 points. The shipments index fell 49.4 points. Unfilled orders fell for the third straight month.


The NAHB home builders’ index fell to 49 in August from 55. Building permits are a leading indicator. They dropped to 1.67 million in July from 1.70 million. Housing starts also fell to 1.45 million from 1.60 million. Housing impacts some 15% of the economy. Existing home sales fell to 4.81 million in July down from 5.11 million in June.


Retail sales were flat in July after rising 0.8% the prior month. Real retail sales did rise 0.1% in July after declining 0.5% in June, a small positive. Also positive was the Philadelphia Fed manufacturing index which was 6.2 in August up from -12.3.


The leading economic indicators index fell 0.4% in July after falling 0.7% in June. It’s the fifth month in a row that the leading economic indicators index has declined. The Conference Board is forecasting a 1.3% increase in GDP in 2022. It is forecasting a 0.2% increase in 2023. The Conference Board now expects Q3 GDP to be flat. It is also expecting a recession to begin later this year.


 

What Makes A Good Company?

Norwood Economics often writes that it seeks to buy good companies on sale. But how do we define a good company?


A good company has a profitable, well-established business. It has good prospects over the long run. Companies are profitable if their return on invested capital (ROIC) is above their weighted average cost of capital (WACC). Norwood Economics seeks companies that have an ROIC well above their WACC. A good company also has a good balance sheet. We favor companies with an above-average dividend yield as well. Our preference is to have capital returned to us in the form of a dividend. We'd rather decide how best to allocate excess capital instead of the company doing it for us.


Companies that have a higher ROIC than their WACC are profitable. The difference between ROIC and WACC is called an economic spread. An economic spread is a measure of a company's ability to make money on its capital investments. The greater the economic spread the more profitable the company. Companies with bigger economic spreads will have more excess capital to return to shareholders. Excess capital can be used to pay dividends, pay down debt, buy back shares, or re-invest in the company. We want to buy companies where management is making excellent capital allocation decisions. We want to avoid companies that aren’t earning their cost of capital.


Failing to earn at least the cost of capital results in capital destruction. A good example of capital destruction was AT&T’s buy of DirectTV. AT&T overpaid and did not earn an ROIC above its cost of capital. The purchase left AT&T with more debt to service. Cash flow from DirectTV was insufficient to service the debt and provide a return to AT&T shareholders. The stock suffered as a result. AT&T management added insult to injury by misallocating capital on an even bigger scale with its buy of Time Warner. Both the DirectTV and Time Warner acquisitions ended up destroying AT&T's capital. The ROIC did not exceed the WACC used to make the purchases. Those poor capital allocation decisions are a major reason AT&T stock has performed poorly during the last couple of decades.


Buy good companies when they are on sale, and you will earn an above-market rate of return. Earning an above-market rate of return adjusted for risk is the name of the game. A money manager who can’t earn excess return on a risk-adjusted basis (alpha) isn’t earning their fees. Better off indexing instead.


Regards,


Christopher R Norwood, CFA


Chief Market Strategist

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