Vol. 2, No. 9
On the cost of capital. Regional equity valuations. The Fed is going to tank the housing market. Corporate shuffleboard. Credit creation, cause & effects. Value in generic pharmaceuticals.
Valuabl is an independent, value-oriented journal of financial markets. Delivered fortnightly, Valuabl helps contrarians pop bubbles, buy low, and sell high.
In today’s issue
Cartoon: Billionaires’ game night
The cost of capital (4 minutes)
A global stocktake (4 minutes)
As safe as houses (7 minutes)
Corporate shuffleboard (4 minutes)
Credit creation, cause & effects (5 minutes)
Investment ideas (16 minutes)
Cartoon: Billionaires’ game night
The cost of capital
Interest rates and capital costs are the most consequential yet misunderstood prices in capitalism, connecting the future to the present.
•••
U.S. stock prices fell again last fortnight. The S&P500, an index of large U.S. companies, was down 6.0% to 4,180. The index is now down 12.3% from the start of the year, testing its previous March lows, and is now flat over the last 12-months.
The price of 10-year U.S. Treasury notes dropped again as yields rose. Yields peaked at 2.93% on April 19, their highest point since 2018, before falling to 2.84%, seven basis points (bp) higher than last fortnight. While Treasury yields were climbing, the 10-year breakeven inflation rate rose slightly to 2.88%. These are still historically high levels of expected inflation and about the highest levels since the Federal Reserve began reporting this data in 2003. Investors are now losing just 0.04% of their purchasing power per year by investing in Treasuries. We are almost back into positive real rate territory for the first time since the COVID-19 crisis began. Is financial normality knocking on the door?
The equity risk premium (ERP), an estimate of the extra return investors demand for investing in stocks over government bonds, rose by 25bp. The current ERP, 5.21%, is still down from its recent high of 5.29% in March, when investor fear was multiplying, but remains much higher than it has been historically. The cost of equity, and the implied return for U.S. stocks, have also increased to 8.04%. While U.S. dollar risk-free rates are still historically low, in the 19th percentile of data going back to 1960, equity risk premiums are far above average, in the 80th percentile. Equity investors are again becoming increasingly fearful.
Spreads on U.S. corporate debt rose, too. The average spread of corporate bonds over 10-year Treasury bonds rose by 11bp. Spreads at the riskier end of the curve rose more than the safe end, except those rated ‘B’. In most monetary and credit contraction cycles, creditors likely believe rising interest rates will stress uncreditworthy borrowers and defaults will rise.
There are some signs that rising rates and expanding spreads are already affecting debt financing. A note from the Wall Street Journal detailed how Carvana Co. (NYSE: CVNA), “once a market darling,” failed to get away a $2.3bn junk bond issuance at a 10.5% yield. That is until Apollo Global Management, Inc. (NYSE: APO), an investment firm already invested in Carvana’s equity and debt, stepped in to restructure the offering and buy $1.6bn worth of the bonds at a 10.25% yield. Moody’s Investors Service downgraded Carvana’s long-term bond rating from B3, already highly speculative, to Caa1, in line with the issuance.
Using the average ERP of the last five years, the current 10-year T.bill yield, analysts’ consensus earnings estimates, and a stable payout ratio based on the S&P500’s average return on equity over the last decade, I value the index at 4,205 compared to its level of 4,180.
This valuation suggests the S&P500 index is now 0.6% undervalued compared to 8% overvalued at the start of the year and 27% 12-months ago.
READY FOR MORE?
This is the end of the free portion of Valuabl. To access all issues and support independent research, consider becoming a paid subscriber.
A global stocktake
An aggregate look at valuations of regional stock markets to help us find suitable ponds in which to fish for value.
•••
Over the last 12-months, public companies worldwide have used $52.8trn of equity to produce $6.1trn of after-tax net income. These companies made a total return on equity (ROE) of 11.65% compared to the current global cost of equity, in U.S. dollars, of 9.37%.
North American businesses performed the best, producing a 15.3% ROE compared to the current cost of 8.04%. These companies created 7.3% of economic value. In contrast, Asian, Caribbean, Central American, South American, and Eastern European businesses destroyed value. The firms of the Caribbean performed the worst. They took in equity that cost 14.68% and only produced returns of 4.67%, killing more than 10% in value.
Central & South American businesses are paying out the most significant proportion of their income, while Caribbean companies are raising more capital than returning. Based on their fundamental growth rates, the return on equity multiplied by the ratio of that capital retained, African companies are set to grow the fastest, and Caribbean ones the slowest.
Valuing the 46,000 companies in my sample using the fundamental growth rate, a five-year dividend discount model, and a stable payout ratio based on the cost of equity reveals that the public stock of companies is worth $70.6trn. However, it would currently cost you $110.6trn to buy it all, suggesting that investors are overvaluing stocks by about 36%.
Applying this methodology to each region reveals that investors have overpriced North American stocks by about 38%. Reconciling this with the valuation of the S&P500 above suggests that smaller companies, and those outside the S&P500, are likely overvalued. Based on this, the only market that appears undervalued is the Eastern European market. However, I expect that the returns on equity seen there over the last 12-months will not continue as the economic ramifications of the Russian invasion of Ukraine tear companies in this area apart.
The companies of Eastern Europe will be my main hunting ground for the next few weeks as I screen and value them. The complexities of the economic and political situation make for challenging work, but value could be found.
“If only one word is to be used to describe what Baupost does, that word should be: 'Mispricing'. We look for mispricing due to over-reaction.”
–Seth Klarman
As safe as houses
The Fed is walking an impossibly thin tightrope between controlling inflation and collapsing the housing market.
•••
Last month, the Federal Reserve Bank of Dallas sounded the alarm on the housing market. “There is growing concern that U.S. house prices are again becoming unhinged from fundamentals,” wrote their economists in a piece called Real-Time Market Monitoring Finds Signs of Brewing U.S. Housing Bubble. They are right, if not a bit late to the party. Over the last 18 months, your author has penned nine pieces on the growing housing bubbles worldwide, analysing everything from what is causing them to how big they are.
During the Federal Open Market Committee’s (FOMC) March meeting, Fed officials suggested it “would be appropriate” to consider selling mortgage-backed securities (MBS) to combat rising inflation and cool the housing market in the U.S. They said that in the context of rising mortgage rates and shrinking refinancing volumes, getting these securities off their balance sheet made sense but that any decision “would be announced well in advance.” This announcement was enough to get markets moving. The 30-year fixed-rate mortgage, which had already climbed from 2.77% in August last year to 3.85% before the March meeting, has risen to above 5%, the highest rate since 2011.
In the U.S., mortgage securitisation, and the Federal Reserve’s interest rate suppression agenda, have distorted financing costs. By pooling risk, removing it from the banking sector, and putting it into the hands of private investors, the financial system has been made more robust. But the market has become so big, and the Federal Reserve such a large part of it, that any reversal would crush the housing market. According to the Securities Industry and Financial Markets Association (SIFMA), as of Q4 2021, the total U.S. MBS market was worth about $12.2trn. The MBS market has grown to 21% of the total value of all U.S. housing stock and 68% of the entire mortgage market. Securitisation has run rampant.
Since the global financial crisis (GFC) in 2008, particularly during the pandemic, the Fed has been a considerable buyer of these securities. According to their latest H.4.1 release, they currently hold $2.7trn worth. The goal of buying these assets was to suppress interest rates on mortgages, particularly long-term ones. It worked. The more involved the Fed got in the MBS market, the lower real mortgage costs, the difference between the 30-year fixed-rate mortgage and 30-year break-even inflation, dropped. By the start of this year, the Fed held 22% of all mortgage-backed securities, and real mortgage costs were 0.5%.
Once the Fed gets out of the MBS check-out line, only private investors like pension and insurance funds will be left shopping. With high levels of household debt to income–I estimate it to be 186%–and inflation expectations picking up, these investors will demand higher returns as compensation for these risks. Markets have already priced in the Fed’s check-out-line sidestep. Investors’ expectations that the Fed won’t be an active buyer of MBSs anymore is why mortgage rates have increased dramatically over the past few weeks. Using the 2014 to 2018 period as a proxy for when the Fed maintains but doesn’t expand its MBS position, the average long-term real mortgage rate was 2.5%. With long-term break-even inflation at 2.5%, a 30-year fixed-rate mortgage should cost about 5%, which is where it currently sits according to the Federal Reserve Bank of St. Louis.
If inflation moves higher and the Fed starts actively trimming its MBS position, real rates will rise again and crush both sides of the market. Financing will dry up for builders looking for construction loans and home buyers looking for mortgages.
The housing market has always been cyclical but has become hooked on low and declining interest rates. In this fight, the central bank has been their friend, stepping in to lower rates with new money whenever needed. But the Fed is walking an impossibly thin tightrope between controlling inflation and crushing the housing market. Unless they pull off something never-before achieved, the “don’t fight the Fed” adage might have a new, negative meaning for house prices.
Corporate shuffleboard
A smattering of headlines from the world of corporate shuffleboard. Pushing discs won’t create value, but it can springboard its revelation.
•••
Initial public offerings
Malaysian company, Top Glove Corp Bhd, said that its application for an IPO in Hong Kong lapsed. This is the second time in a year it’s listing plans have stalled.
Chinese company, Full Truck Alliance Co Ltd., has paused its $1bn Hong Kong IPO as Chinese cybersecurity regulators are about to announce a probe into the company.
International institutional investors have registered concerns about Life Insurance Corporation’s IPO in India. It isn’t known what their concerns are.
The Egyptian president has ordered the government to list army-owned enterprises on the Egyptian stock market before the end of the year.
Hunan Airbluer Environmental Protection Technology’s shares began trading on the Shenzhen stock exchange on Tuesday.
Shares in Chinese company, Zhihu Inc., fell 24% on their opening day on the Hong Kong stock exchange.
Global Blockchain Acquisition Corp. filed with the SEC for an IPO worth up to $150m.
Mergers & acquisitions
Elon Musk is planning to take Twitter, Inc. private in a deal worth $44bn.
Crypto Blockchain Industries signed an agreement to buy Xave World, a metaverse devoted to music for $2m in cash and shares.
Divestitures & spin-offs
The British government is planning to sell Channel 4, a publicly owned broadcaster.
OTP Bank Nyrt., a Hungarian bank, is under pressure from the Ukrainian government to sell its Russian business.
Polish clothing retailer LPP SA will sell its business in Russia.
Finnish daiy company, Valio, sold its Russian businesses to GK Velkom after Russian authorities threated to nationalise its business there.
Schneider Electric S.E. will sell its Russian assets to local management.
Anheuser-Busch InBev SA/NV will exit Russia, too, by selling its interest in a joint venture.
Share repurchases & buybacks
TotalEnergies SE, a French oil and gas company, will ramp up buybacks as high oil prices fuel earnings.
Standard Chartered PLC, a British bank focused on Asia, has completed 80% of a $750m buyback plan.
Food Empire Holdings Limited has halted its share buyback program. The company expects profits from operations to decrease in 2022.
SPREAD THE WORD
Help make Valuabl an indispensable part of your friends’ and associates’ fortnightly routines. Click the button below to spread the word.
Credit creation, cause & effect
The Federal Reserve buys and sells securities and sets interest rates to influence: borrowing costs, lending activity, inflation and employment; to varying effects.
•••
The Federal Reserve buys & sells securities
The U.S. Federal Reserve continued to expand its balance sheet last fortnight by adding $2bn net of Treasury securities, $10.5bn net of mortgage-backed securities and $1.3bn net of loans. The central bank trimmed its other asset holdings by $1.7bn net, while the total amount of Reserve Bank credit increased by $12.1bn net. Despite the increase in holdings in absolute terms, the bank continues to taper its expansion. Monthly, Reserve Bank credit is only expanding at 2.5% compared to 28.4% on a 12-month basis. However, at the current trajectory, total bank assets will top out at $9trn in August. There’s nothing special about this number other than how large it is.
And sets interest rates
Based on interest rate futures prices, the market expects the federal funds rate to reach a target range of 275 to 300bp by the end of the year. While this expectation hasn’t increased since last fortnight, the expected pace of rate hikes has. The market expects a 50bp hike at the May meeting, a 75bp hike at the June meeting, a 50bp hike at the July meeting, and 25bp hikes in September, November and December.
To influence: borrowing costs
Treasury security yields continued to march higher last fortnight. The 10-year yield, a critical measure for valuing financial assets, is up 12bp to 2.82%, while the two-year yield rose by 21bp to 2.58%. If inflation remains high and the labour market robust as the Fed finishes tapering, these rises will not slow down soon. The five and 10-year yields inverted slightly last week, but this has reversed.
If the historical spread between long bond rates and the federal funds rate holds up, I expect the 10-year Treasury yield to rise to between 3.50 and 5.00% over the next six months.
Lending activity
With commercial and consumer loan activity accelerating, the monetary supply is expanding to support this. The monetary base, the amount of money that the central bank creates, continues to grow at a blistering speed, up 20.5% last month on an annualised basis. Similarly, the M1 supply, the total amount of currency and deposits, is expanding rapidly. Rising interest rates will cool borrowing over the coming months, and this will slow monetary expansion in turn.
Inflation & employment
Real GDP, both on an aggregate and per person basis, dropped in the first quarter of this year as the rising cost of living and ongoing supply chain problems cut into spending. Astute readers have noted that this puts pressure on the Fed’s expected rate hike trajectory. But as long as the labour market remains strong and inflation remains high, the Fed will hike. The alternatives are to let inflation run away and destroy the currency and the economy with it or hike rates into an inflationary recession to get inflation under control. Both are economically painful, but only one saves the currency and aligns with the Federal Reserve’s dual mandate.
PPI, CPI, and energy commodity prices all continue to rise quickly. However, wages are not keeping up with increases in house prices, commodities, and consumer prices. No wonder consumers are feeling the pinch.
To varying effects
Give the gift of Valuabl
Click the button below to give Valuabl as a gift to a colleague, mentee, friend, or family member—they’ll think you’re a genius.
Investment ideas
To help readers buy low and sell high, these are the best investment ideas, mostly long but sometimes short, I have found in the last fortnight. To forecast is to err and the only prudent path is to operate with a margin of safety. When the gap between price and value is vast, pleasing returns should follow.
•••
Summary
Stock: Krka, d. d. (WSE: KRK) common equity
Market cap: €2.80bn
Rating: Buy
Price: €89.80
Target: €126.59
•••
Setting the stage
Krka, d. d., founded in 1954, is a Slovenian generic pharmaceutical manufacturer. The company makes money by developing, producing, marketing, and selling prescription and non-prescription generic drugs in Europe, mainly Eastern Europe.
The company’s prescription drugs include medicines for treating cardiovascular diseases, the gastrointestinal tract, the central nervous system, pain relief, anti-infectives, blood, blood-forming organs, the urological system, diabetes, and oncology. These products make up 83% of sales. Its non-prescription drugs include medicines for oral cavities and the pharynx, cough and cold treatment, analgesics, nasal products, vitamins and minerals, cerebral and peripheral circulation, the digestive tract, and others. These products make up 9% of sales. The company also has animal health products, making up 5% of sales, and health resorts and health tourism services, making up the final 3% of sales.
Over the last decade, the European pharmaceutical industry has grown aggregate revenues from €182bn to €239bn at 2.5% per year. Demand for pharmaceuticals, particularly generics, has been driven by burgeoning demand for healthcare, especially in the emerging countries of Eastern Europe. Over-the-counter (OTC) drugs play a minor role within this market compared to the revenue generated by prescription drugs which are, in turn, dominated by original products. OTC products, generics, and biosimilars–drugs biologically similar to original products produced by other companies–play only a minor role and cannot counterbalance the significantly higher prices of originals.
Government efforts to reign in healthcare spending have increased the demand for low-cost generics. Krka has riden this trend. By 2021, the company was producing 16.2bn tablets, up from 10.6bn tablets in 2010. The combination of increased demand and production saw the company’s top line grow at 4.1% per year to reach €1.57bn in 2021. While generic demand and volumes are robust, competition constrains prices. As a result, Krka has a tiny, albeit historically high, share of the regional pharmaceutical market. In 2021, the company took in just 0.66% of drug revenues in Europe, up from 0.55% in 2010.
Manufacturing generic drugs is a challenging business. Cost competition is fierce, and pricing power doesn’t exist—companies lower prices when they reduce expenses. Over the last decade, the company has had an average gross profit margin of 57.9%, almost identical to the average gross margin for the industry of 57.6%. But, because the business is vertically-integrated, using self-produced raw materials and active ingredients, Krka’s gross profitability has fluctuated less than its competitors. The standard deviation of the company’s trailing-12-month (TTM) gross margins over the last decade is 1.8%, compared to the 9.5% average of its competitors.
The company does, however, produce higher than average operating margins. There are three main reasons why: First, thanks to the scale and location of production, fixed costs, as a proportion of total costs, are low. Second, as governments have pushed for generics, the company hasn’t had to spend as much on sales and marketing. Third, as they don’t need to invent blockbuster new drugs, R&D requirements are relatively low. As a result, Krka has enjoyed average EBIT margins of 18.2%, at the 71st percentile of the industry, over the last decade. These margins have expanded over the previous five years, too. They bottomed out at 9.4% in Q1 2017 and have swelled to 22.5% in 2021, at the 86th percentile of the industry, in contrast to the decline registered across the industry.
Russia, Poland and Ukraine are the company’s most important three markets. Given Russia’s invasion of Ukraine and the resulting economic sanctions, the company’s future in these markets is, at a minimum, uncertain. Last year, the company got 21.0% of its revenue from Russia and 6.1% from Ukraine. While the Ukrainian office in Kyiv only does marketing, the Russian business has a marketing office in Moscow and a manufacturing facility in Istra. This facility produces 80% of the products sold in Russia and gives them the status of a domestic manufacturer. The company also manufactures in Slovenia, Poland, Croatia and Germany, with the Notol 2 plant in Slovenia handling 30% of the company’s total production.
•••
Story & valuation
Krka d. d. is a European generic drug producer caught up in the crossfire of the Russia-Ukrainian war. I assume their businesses in these two countries are worthless for this valuation. While economists expect the European generic drug market to grow at 4.3% per year outside the troubled region, most of this new spending will go toward originals rather than generics, and Krka won't be able to take market share. Their production volumes and range will increase as they expand their non-Eastern European businesses. Both margins and reinvestment requirements will suffer over the short term, but the business's low overheads and fixed costs will help margins return to the industry's top quartile.
Baseline: For the baseline, I have assumed that the company walks away from its Russian and Ukrainian segments. These divisions produced €333m and €96m of revenue in 2021, respectively. Combined, they're 27% of the business. Ditching these is a big hit. Any resolution to the conflict or the company's ability to stay in Russia will be a financial upside. However, I'm not prepared to include or pay anything for them. This approach is a significantly more bearish take than the consensus of the three analysts covering the company.
Growth: Economists expect the European generic pharmaceutical market, excluding Russia and Ukraine, to grow at 4.27% per year until 2026. This growth will be driven by increasing healthcare expenditure and a spike in the population of Ukrainians seeking asylum. As the company focuses more on Western Europe and the rest of the world (ROW), it will increase production and its range of products. Pricing will remain competitive, and originals will continue to take the most significant slice of the pie. As a result, I forecast the business to maintain its market share across its non-Russia-Ukrainian markets and model it to grow its baseline business at 4.27% per year.
Margins: Profitability will take a short term hit as the company pivots away from the most troubled regions. I model the company's baseline margins to drop to the 5th percentile of their historic range as losses in Russia and Ukraine mount. However, thanks to the company's low-cost production, low overheads, and fixed costs, margins will return to the industry's top quartile within a few years. I model margins getting to 19.98% by 2024. This profitability is in line with, but lower than, its historical average.
Reinvestment & taxes: As the company pivots, it will need to reinvest in expanding production capacity and its marketing and distribution efforts. I forecast the company's capital efficiency to drop to the bottom of its historic range as it ploughs money into improving and expanding the current facilities. I also model the company's tax rate to trend from its current effective rate towards the underlying marginal rate of the 40 non-Russian, non-Ukrainian regions the company operates in.
Free cash flows: Based on this, I forecast the company to remain free cash flow generative, albeit much less so than it was historically.
Cost of capital: Krka is a European generic pharmaceutical business with an attractive cost structure. The company's operating leverage ratio, the ratio of fixed to variable costs, is about half that of the industry's at 0.75 compared to the average of 1.47 in my sample. They primarily operate in Eastern Europe and face substantial country risk. For this part of the valuation, I include Russia and Ukraine as the company will still have costs to wind up if they go. Based on the 42 segments they operate in, including Russia and Ukraine, the company's weighted average equity risk premium is 7.26%. The company has a small amount, 0.5% debt-to-equity ratio, of debt. I have assigned the business a Baa3/BBB- synthetic credit rating based on an Altman score of 5.78 and imputed a 5.3% chance of distress within the next decade. I estimate the company's cost of equity to be 5.68%, the after-tax cost of debt to be 2.11%, and the WACC to be 5.68%, in Euros.
Add non-operating assets: Krka has investments worth €109m and €314m of cash and equivalents.
Less debts & other claims: The company owes almost €13m to landlords and creditors, and there are €54m of non-controlling interests.
Each share has an intrinsic value of €126.59, and at the current price, the investment has a 41% upside.
•••
Sensitivity analysis & rating
Monte-Carlo Simulation is used to model uncertainty by assuming that the inputs to the valuation model will come from probability distributions around the estimates.
Buy ••••••• 10th: €91.20
Add ••••••• 30th: €108.22
Hold •••••• 50th: €124.63
Reduce ••• 70th: €147.28
Sell ••••••• 90th: €192.03
The current price for Krka, d. d. (WSE: KRK) common equity is €89.80 and is at the 9th percentile of the Monte Carlo sample of intrinsic values. For this reason, it has a rating of Buy.
However, as the stock is not as undervalued as what I already own and including it doesn’t reduce the riskiness of my portfolio enough for me to add a position. The threshold for these requirements for my portfolio is €77 per share. I have placed a small limit order at this price.
PLEASE, NO COPYING
If you are a reader of Valuabl, you ought to be a subscriber to Valuabl.
Please don’t:
Print or screenshot multiple copies from your computer or phone for others.
Copy and post Valuabl, in whole or in part, on your company’s intranet, a website, or anywhere on the internet.
Please do:
Show others your copy of Valuabl in person.
Form a group to receive special subscription rates.
Ask for free trials for friends, colleagues, and loved ones (I’m happy to oblige you).
Do the right and lawful thing. Subscribe. Questions? Reply to any email from Valuabl or email valuabl@substack.com
Also: Share Valuabl with a click
Simply click the share button below to send Valuabl to a friend, colleague, or client. They’ll thank you, and so do I.
DISCLAIMER
Copyright © 2022 by Valuabl. Reproduction or retransmission in any form, without permission, is prohibited. This publication should not be considered financial or legal advice but instead as independent research.