May 21, 2002
“Genius is eternal patience.”
Michelangelo
To Our Investors and Friends:
Michelangelo had it right, if the first five months of 2002 in the equity markets are any indication. Patience has never been more important. Short-term cash investments have outperformed the S&P 500 so far this year and there seems little reason to believe that this will change very much in the next few months, despite the media hype. In our opinion, the primary reasons for this phenomenon are (1) the unreasonably high valuation of the S&P 500 Index relative to prospective earnings growth and (2) the continuing specter of terrorism. Having said that, we see several good, undervalued investment opportunities, which we believe will become even more attractive during the next few months, as market valuations rationalize. For the moment, however, patience is one of our most important disciplines, perhaps second only to our continued intensive valuation analysis of the EVA companies we either own or expect to own in our portfolios.
Given reasonable estimates for corporate earnings growth in 2002 and 2003, the S&P 500 Index continues to trade at record high price/earnings (P/E) multiples. The message here is that investors are expecting significantly greater earnings growth than companies are likely to produce in the near term. The Sell-Side Consensus Indicator, which is a contrarian measure of investor bullishness, is at extreme levels, indicating a strong sell bias. Our own valuation modeling work strongly confirms these statistical indicators, with many EVA companies selling at levels that significantly exceed their modeled valuations.
The threat of terrorism overhangs all valuation statistics. Vice President Cheney said on Sunday, May 19th “The prospects of a future attack against the United States are almost certain…. We don't know if it's going to be tomorrow or next week or next year.” What should we do with this information, as prudent investors? On the one hand, we have observed the incredible resiliency of our economy and the markets in the period since September 11th. This has been especially evident in the strength of retail sales and the real estate market. On the other hand, we have observed that even the hint of a terrorist attack sends the markets down instantly. This is further evidence of a market with values priced for perfection in, what seems to us, a very imperfect situation.
Our strategy under these circumstances is to (1) own only companies that we believe are secure and reasonably valued and (2) continue holding significant proportions of cash in each portfolio, in anticipation of a rationalization of valuations for any of the several reasons outlined above. We are doing this by taking profits where it seems logical and by eliminating positions we feel have little promise. Our typical portfolio is currently at 50% or more in cash investments. We are working on several undervalued EVA companies that we intend to own. However, we are not in a rush, and we expect that we would not commit more than half of our cash in the near term, as a protective measure.
We strongly believe that temporarily holding cash in our portfolios is an appropriate equity investment strategy for our clients, given the unprecedented circumstances in which we all find ourselves. It is very easy to become impatient, with all of the news swirling about us, but we believe that patience, as Michelangelo said, will indeed prove to be the ultimate genius in equity investments during the next several years.
Thank you for your confidence.
Tuesday, May 21, 2002
Friday, February 15, 2002
Client Letter - 2/15/02
February 15, 2002
To Our Investors:
The U.S. economy still appears to be in the trough of the recession, which began nearly a year ago, and the timing of the recovery remains uncertain. While the optimism of the consumer continues to be a bright light, there is still very little visibility on capital spending plans for 2002, which, among other things, dampens expectations for a significant recovery in corporate profits this year. On that basis alone, despite consumer confidence, the equity markets appear to be overvalued. Nonetheless, we hasten to add that we believe this market anomaly will be resolved during 2002, and that we will be well positioned to reinvest our cash in undervalued EVA companies.
Statistically, the price/earnings (P/E) ratio of the S&P 500 index is at a near-historic high of 39.4, based on trailing 12-month earnings. Based on earnings estimates for the S&P index in 2002, the P/E ratio is still well above normal. This unprecedented enthusiasm is discounting a very strong recovery from the current recession, which, as described above, is nearly invisible. This would seem to be an indication that the “bubble” mentality that has affected market pricing over several years is still with us. These statistics are clearly born out by our EVA modeling work and, consequently, we are resisting making new commitments at this time, and have sold some positions to conserve capital.
Beyond statistics, the Enron bankruptcy and the apparently fraudulent actions of management committed under the supposed supervision of Arthur Andersen, one of the largest audit firms in the world, are weighing heavily on the equity markets. We believe that more stringent application of accounting principles by the large audit firms during the next several months will result in more highly publicized problems with large, well-known companies. Not surprisingly, the SEC is also making more inquiries into corporate accounting and public disclosure policies. While this may seem to be negative in the short term, the result of more accurate disclosure should be a long-term positive, especially for those of us who do in-depth financial analysis.
As carefully as we analyze our investment decisions, we have not been immune from these issues. Calpine, which has been one of our core holdings, was immediately affected by the Enron bankruptcy, even though there appeared to be few similarities between the companies. As the stock fell, we intensified our analytical work, gathering projected cash flow numbers, both from several key analysts and directly from the company. Our work shows that the company is significantly undervalued, with a P/E ratio of only about 5.0, based on expected 2002 earnings. With that in mind, we moved to average down our holdings at the end of January, when the company provided 2002 operating cash flow projections, which corresponded well with our previous analysis. Just a few days later, we were very surprised to learn that the SEC was making inquiries about Calpine’s accounting for transactions with Enron, as well as launching an inquiry into potential selective disclosure of earnings projections to analysts. In the current environment, these inquiries are the proverbial “kiss of death,” regardless of the company’s apparent strengths, and we felt compelled to take action immediately to conserve capital. We are currently looking closely at our other holdings to try and anticipate further effects of the current environment.
The inflated market valuations we are experiencing affirm for us that our EVA modeling process is quite accurate. Fortunately, we do not need many opportunities to make our investment process effective and we believe that, as market valuations become more realistic, the astute long-term deployment of our cash in EVA companies will significantly outweigh the short-term transactions we have undertaken to conserve capital.
As we navigate through this period, we have looked carefully at our profit preservation and stop-loss strategies. Attached is a thorough review of these strategies as they are currently being applied. We expect to meet personally with each of our clients, either in person or on the phone, in the next few weeks. In the meantime, please ask any questions that come to mind about the scenarios we have outlined.
To Our Investors:
The U.S. economy still appears to be in the trough of the recession, which began nearly a year ago, and the timing of the recovery remains uncertain. While the optimism of the consumer continues to be a bright light, there is still very little visibility on capital spending plans for 2002, which, among other things, dampens expectations for a significant recovery in corporate profits this year. On that basis alone, despite consumer confidence, the equity markets appear to be overvalued. Nonetheless, we hasten to add that we believe this market anomaly will be resolved during 2002, and that we will be well positioned to reinvest our cash in undervalued EVA companies.
Statistically, the price/earnings (P/E) ratio of the S&P 500 index is at a near-historic high of 39.4, based on trailing 12-month earnings. Based on earnings estimates for the S&P index in 2002, the P/E ratio is still well above normal. This unprecedented enthusiasm is discounting a very strong recovery from the current recession, which, as described above, is nearly invisible. This would seem to be an indication that the “bubble” mentality that has affected market pricing over several years is still with us. These statistics are clearly born out by our EVA modeling work and, consequently, we are resisting making new commitments at this time, and have sold some positions to conserve capital.
Beyond statistics, the Enron bankruptcy and the apparently fraudulent actions of management committed under the supposed supervision of Arthur Andersen, one of the largest audit firms in the world, are weighing heavily on the equity markets. We believe that more stringent application of accounting principles by the large audit firms during the next several months will result in more highly publicized problems with large, well-known companies. Not surprisingly, the SEC is also making more inquiries into corporate accounting and public disclosure policies. While this may seem to be negative in the short term, the result of more accurate disclosure should be a long-term positive, especially for those of us who do in-depth financial analysis.
As carefully as we analyze our investment decisions, we have not been immune from these issues. Calpine, which has been one of our core holdings, was immediately affected by the Enron bankruptcy, even though there appeared to be few similarities between the companies. As the stock fell, we intensified our analytical work, gathering projected cash flow numbers, both from several key analysts and directly from the company. Our work shows that the company is significantly undervalued, with a P/E ratio of only about 5.0, based on expected 2002 earnings. With that in mind, we moved to average down our holdings at the end of January, when the company provided 2002 operating cash flow projections, which corresponded well with our previous analysis. Just a few days later, we were very surprised to learn that the SEC was making inquiries about Calpine’s accounting for transactions with Enron, as well as launching an inquiry into potential selective disclosure of earnings projections to analysts. In the current environment, these inquiries are the proverbial “kiss of death,” regardless of the company’s apparent strengths, and we felt compelled to take action immediately to conserve capital. We are currently looking closely at our other holdings to try and anticipate further effects of the current environment.
The inflated market valuations we are experiencing affirm for us that our EVA modeling process is quite accurate. Fortunately, we do not need many opportunities to make our investment process effective and we believe that, as market valuations become more realistic, the astute long-term deployment of our cash in EVA companies will significantly outweigh the short-term transactions we have undertaken to conserve capital.
As we navigate through this period, we have looked carefully at our profit preservation and stop-loss strategies. Attached is a thorough review of these strategies as they are currently being applied. We expect to meet personally with each of our clients, either in person or on the phone, in the next few weeks. In the meantime, please ask any questions that come to mind about the scenarios we have outlined.
Wednesday, September 12, 2001
Thoughts - 9/12/01
Thoughts for Clients Sept. 12, 2001
We expect markets to be closed for a couple of days, perhaps until next week…A good thing.
There will probably be some selling when the markets do open, primarily from mutual fund redemptions. We don’t think this will continue, although it will take stocks lower for the time being.
We do not believe it would be wise to sell stocks at this time, even if there is a decline. If there should be some reason to accumulate cash in the near future it would be advisable to wait a few days in any event.
In the absence of further terrorist developments at this time (and it now appears that this was a one-time attack rather than a coordinated series of attacks) the economy should not be drastically affected overall. It is possible that consumer confidence will decline temporarily, but if nothing else develops, that decline should not be drastic. However, it is possible that a lethargy in consumer spending could result for a period of time which would precipitate the recession which continued consumer confidence has been delaying for the last few months.
Impacts on particular holdings:
Citigroup… Travelers Insurance, short term negative, long-term neutral
Technology, computers, telecommunications, probably benefit in longer term, neutral short term
Pharmaceuticals and medical technology, neutral to positive short term, positive long term.
Bottom line for us: Be calm, study, watch, wait, look for opportunities.
We expect markets to be closed for a couple of days, perhaps until next week…A good thing.
There will probably be some selling when the markets do open, primarily from mutual fund redemptions. We don’t think this will continue, although it will take stocks lower for the time being.
We do not believe it would be wise to sell stocks at this time, even if there is a decline. If there should be some reason to accumulate cash in the near future it would be advisable to wait a few days in any event.
In the absence of further terrorist developments at this time (and it now appears that this was a one-time attack rather than a coordinated series of attacks) the economy should not be drastically affected overall. It is possible that consumer confidence will decline temporarily, but if nothing else develops, that decline should not be drastic. However, it is possible that a lethargy in consumer spending could result for a period of time which would precipitate the recession which continued consumer confidence has been delaying for the last few months.
Impacts on particular holdings:
Citigroup… Travelers Insurance, short term negative, long-term neutral
Technology, computers, telecommunications, probably benefit in longer term, neutral short term
Pharmaceuticals and medical technology, neutral to positive short term, positive long term.
Bottom line for us: Be calm, study, watch, wait, look for opportunities.
Tuesday, February 01, 2000
Investment Strategy
Investment Strategy
Identify and invest in companies that consistently create “economic value added” (EVA) for their shareholders. EVA is measured by determining a company’s cost of capital and comparing it with annual return on investment (ROI) generated by the company’s net operating profit.
Value-creating companies frequently also have high market valuations. Therefore, we also perform intrinsic value analysis on the companies we follow to determine which are the best investments.
We do this by studying long-term earnings expectations and projecting cash requirements (for capital expenditures, working capital etc.) to determine likely free cash flows over time.
We then calculate the present value of these free cash flows to determine the intrinsic value of each company.
Strategy is to seek out and invest in economic value-creating companies that are reasonably priced relative to their intrinsic values.
- Quality and Consistency are the watchwords of successful long-term investing.
- Own EVA stocks consistently.
Saturday, January 01, 2000
Meet Jack and Peter Falker
Professional Qualifications
- Primary research and investment officer of FalkerInvestments Inc.
- Securities market experience includes:
Farallon Fixed Income Associates (now Bracebridge Capital), Boston, Mass.
Mitchell Hutchins Asset Management, a unit of Paine Webber Inc., New York, N.Y.
Internship positions with U.S. Bank Piper Jaffray and Dain Rauscher Wessels Inc.
- Graduate of the University of St. Thomas with a BA in Economics, 1995.
- Graduate of St. Thomas Academy, 1991.
- Has earned the right to use the Chartered Financial Analyst designation.
* EVA is a registered trademark of Stern Stewart & Co.
John R. (Jack) Falker
- Primary operating officer of FalkerInvestments Inc.
- Active in the practice and teaching of corporate finance for more than 40 years.
- Formed FalkerInvestments after leaving Swenson/Falker Associates, the financial relations firm he co-founded in 1987.
- Corporate treasurer in two Fortune 500 companies.
- Taught applied cost of capital theory and shareholder value maximization to finance majors at the graduate level for many years.
- Advocate of the concepts set forth in the “Quest for Value,” Bennett Stewart’s book which revitalized applied cost of capital theory and set in motion the current attention being paid by corporate managers to the EVA* concept.
- Graduate of the University of Michigan and the University of Detroit with an MBA in Corporate Finance and a BA in English Language & Literature.
- Primary operating officer of FalkerInvestments Inc.
- Active in the practice and teaching of corporate finance for more than 40 years.
- Formed FalkerInvestments after leaving Swenson/Falker Associates, the financial relations firm he co-founded in 1987.
- Corporate treasurer in two Fortune 500 companies.
- Taught applied cost of capital theory and shareholder value maximization to finance majors at the graduate level for many years.
- Advocate of the concepts set forth in the “Quest for Value,” Bennett Stewart’s book which revitalized applied cost of capital theory and set in motion the current attention being paid by corporate managers to the EVA* concept.
- Graduate of the University of Michigan and the University of Detroit with an MBA in Corporate Finance and a BA in English Language & Literature.
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