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Economic Value Add

August 5, 2004

The two "formal" techniques used by Stock Market Investment Analysts are:

  • Fundamental Analysis - which seeks to assess the underlying value of quoted shares (Reality)
  • Technical Analysis - which seeks to assess the state of play in the battle between Bulls and Bears (Perception).

An old saying in the field of marketing is that "Perception is Reality" and, to a large extent, this is true. It follows that Technical Analysis will often lead to a more accurate assessment of what the immediate future holds for a share's price than will Fundamental Analysis.

But there is a caveat to this observation, and that is that Technical Analysis can only be relied upon as a useful tool if you are reading the Primary Trend correctly.

Prudent Investors will be ever vigilant in their attempts to validate the conclusions of these two techniques of share price assessment and, unfortunately, it is particularly difficult to determine when the Primary Trend is about to change its direction. To my knowledge, there is only one tried and tested technical method of making such an assessment, and that is based on the work of Charles Dow - who understood in the marrow of his bones that in the long term, price inevitably follows value. Thus, technical sell signals at the bottom of a Bear Market (when prices represent great value) are probably meaningless just as buy signals should prudently be ignored when values are not present.

For this reason, using technical analysis techniques without any reference to fundamental analysis is a very high risk proposition. Quite simply, if share prices get too far out of kilter with underlying values then we have the makings of a Stock Market Crash

Let's turn our attention to Value. What is meant by "Value"?

Professor Joel Stern developed a concept which he called Economic Value Add which focuses on the difference between Return on Assets and Cost of Funds. In laymen's terms, if a business can generate a return on assets that is greater than the cost of funding those assets, then it is creating Value.

More accurately, if a company's Net Operating Profits After Tax but before Interest (NOPAT) as a percentage of its Invested Capital is greater than its Weighted average Cost of Capital (WACC), as expressed in percentage terms, then it is Adding Economic Value, but if its NOPAT as a percentage of Invested Capital is lower than its WACC then that company is actually destroying value. It is not a difficult concept to grasp.

Take the following example of Company XYZ:

  • NOPAT/Invested Capital = 15%
  • WACC = 10%

Conclusion: Company XYZ is adding value at the rate of 5% p.a. on invested capital

Conversely:

  • NOPAT/Invested Capital = 9%
  • WACC = 10%

Conclusion: Company XYZ is destroying invested capital value at the rate of 1% p.a.

Now, what is WACC?

When a company wants to borrow money, its bankers will assess its risk profile and will determine the premium over their base interest rate that they will require to offset this risk of lending to XYZ company. Equity investors go through a similar process of risk assessment to determine the rate of return that they will require to justify an equity investment but, of course, because their investment is unsecured, their risk is higher and they will demand a significantly higher return to compensate.

Given a particular company's debt:equity ratio, and given its calculable cost of debt and equity finance, it is a relatively simple technical task to derive the WACC for any company.

It follows from the above that eps, dps , P/E ratios and Dividend multiples are not really measures of value in the true meaning of the term, and are merely used as proxies for value.

The "correct" answer to the underlying question as to whether a company's current market capitalization represents value is capable of being answered by the following quantified approach:

  1. Calculate the Net Present Value of Economic Value Add in dollar terms, by discounting this stream of Value Add earnings using WACC as the discount factor.
  2. Add 1 above to the Net Tangible Asset Value
  3. If 1 plus 2 above is greater than or equal to current market capitalisation, the shares at current price represent good value.

Now, in an environment where quantified underlying values of companies that are quoted on the stock market are significantly less than their market capitalisation, if interest rates start to rise - leading to an increase in WACC - then the rose coloured view of investors which led to overvaluation will come under the spotlight of a bone jarring "reality check". Investment Analysts who were arguing that the NOPAT/Invested Capital ratio minus WACC percentage of the particular organization would grow into the foreseeable future (thereby justifying an investment at premium to underlying notional value) will be seen to have been talking nonsense. Eventually, as followers of Charles Dow's theory well understand, the market reaches a state of epiphany - which can be likened to a recognition that "The Emperor has no clothes" - when the understanding of reality finally dawns (as evidenced technically by a confirmation of both the Dow Jones and the Transports to lower lows) , there will be a predictable move of investors to the exits. From that point onwards, the market will head South until it reaches a point when prices once again represent great value, and the Bear Market bottoms out.

Importantly, if the difference between Market Capitalisation and Underlying Value as calculated using the above methodology is large (ie Market Capitalization is significantly higher than underlying Value) then the move to the exits will likely turn into a stampede, and we will be faced with an extraordinarily high probability of a Stock Market Crash.

One needs to be cautious on BOTH the upside and the downside here. There are straws in the wind on both sides of the argument.

For example, I recently saw a reference to the fact that the ratio of Market Capitalization to Book is currently around 5X when it was only 4.3X in 1929.

It has also recently come to my attention that there is an organization in Sweden that calculates the value of Intellectual Property, and that this organization concluded that whilst around 20 - 30 years ago Tangible Assets made up around 60% of a company's worth, nowadays this ratio has fallen to around 10%. Therefore, given that intangible assets like Intellectual Property are typically not even reflected on the Balance Sheet, this ratio of 5X is likely to be significantly overstated.

But one can't have one's cake and eat it. If one moves to capitalise IP on the Balance Sheet then the ratio of NOPAT/Invested Capital will fall - which will only serve to exacerbate the situation.

Let us turn our attention in another direction for the moment:

There has been a very important clue that businesses are preparing themselves for tough times, and that clue is evidenced by the fact that they have been repaying debt.

One needs to understand what repayment of debt means in financial terms

Interest on debt is a Profit and Loss Account entry that relates to expenses, but "debt" itself is a Balance Sheet entry. Debt is part of the "capital" that is required to finance expansion - either of debtors and inventories, or of underlying fixed assets.

When a company moves to repay its debt it is signalling to the market that it will not be needing that capital to finance expansion.

By doing this, it is also implicitly saying to the market that "Our NOPAT/Invested capital ratio cannot be expected to rise relative to WACC"

Why is this so?

Because when you reduce your debt, you increase your reliance on equity; and when you increase your reliance on equity, you increase your WACC

Unfortunately, if you increase your WACC in an environment of rising interest rates you get a double whammy hit because rising interest rate will probably also lead to stagnating (and possibly falling) sales.

And if you have stagnating or falling sales you can take poison on the virtual certainty that NOPAT/Invested Capital is likely to stagnate at best, and fall at worst.

Thus, in an environment where market capitalisations are already out of kilter with (significantly greater than) underlying Values, and you have the added burden of stagnating or contracting Economic Value Add and you have rising WACC, you have the witches brew that will very likely lead to a market crash.

The question is one of timing, and this brings us to the critical importance of technical analysis. There are indeed some technical clues that WACC is likely (at best) to stop falling and, at worst, to start rising.

The blue lines drawn in above represent a "Diamond Reversal" pattern in the chart of the Long Bond prices. It is not necessary to go into the theory here. Suffice it to say when you have falling bottoms followed by falling tops, and a break down from the rising trendline, that is an indication that the Diamond is indeed a "reversal" pattern - and that the Primary Direction in movement of Bond Prices (and yields) is about to change.

So, in the above chart we have our first tangible evidence that WACC is about to stop falling (as it has been doing over the past few years) and, possibly, start to rise.

But even if it only stops falling, this will indicate an imminent stabilisation/contraction of Economic Value Add and, in turn, this will make a mockery of the current Price:Earnings ratios which are factoring in continuing strong growth. At best, that growth will not materialise, and at worst it will start to contract and maybe even turn negative.

There is a paradox that is very difficult to explain in rational terms, and that is that the chart below (the monthly chart of the US Dollar) also looks like it is bottoming. Note how oversold the PMO has become.

Yes, if interest rates rise and the dollar rises, then the capital losses on bonds might very well be offset (from a foreigner's perspective) by the gain in foreign exchange differentials. This is a logical possibility.

Unfortunately, it is very difficult to reconcile a rising dollar and a falling stock market; and in terms of the above fundamental analysis logic, there is a very high probability that the equity markets will be falling if not collapsing.

And, as always, this brings us to focus on the ultimate barometer of investor emotions - the gold price.

I argued in my last article that the Central Bankers of the World must logically be throwing everything but the kitchen sink at the markets in order to "manage" the outcome; and I even recognised that they have a small chance of pulling it off given the fact that they have access to a bottomless pit of financial resources.

Unfortunately, I also finally concluded that there was an increasing probability that they would fail in their efforts- which is why I am holding such a high proportion of my net worth in Precious Metals related investments.

The chart above is reproduced from the DecisionPoint.com website, but with some trendlines drawn in manually.

The top chart is a chart of the gold price multiplied by the US Dollar Index (which seeks to eliminate the impact of the US Dollar's movements. It has been divided by 10 to compensate for the large number that results); and the chart below is a weekly chart of the gold price itself.

There are some very important observations that flow from these two charts.

First, I draw your attention to the Goldollar Chart and the blue line A,B that I have drawn in. AB is a resistance line that is highly significant from a technical point of view.

First, it is a horizontal line which, from a technical analyst's perspective implies that there is artificial resistance that creeps in every time that level is reached. It's almost as if there is a conscious decision on the part of the Bears that every time that level is reached, a concerted effort is exerted to artificially prevent a rise beyond that level.

Second, if you allow your eye to scan to point A, and then work your way to the right for a couple of centimetres, you will see a "downside gap" at the exact level at which the line was drawn in; and the line itself was drawn by joining the two tops at the extreme right hand side of the chart and then extended to the extreme left. Ie The gap was not used to determine the positioning of the line - and yet it manifestedexactly at that line. This confirmed for me that this particular resistance line is highly significant.

The second important factor is that there has been a rising trend as evidenced by the line C,D. What this shows is that the Bulls are becoming increasingly robust in their convictions. What we have here is a sort of "right angled ascending triangle" which typically manifests when an increasing momentum towards Bullishness finally reaches culmination at the "Maginot" line of the Bears, and a final resolution must manifest - ie, either the Bulls will be overcome by the Bears or the Bears will be overcome by the Bulls.

But given that the Bulls are showing an increasing momentum, and all the Bears can do is put up a "defence" of the Maginot line, the probabilities favour an eventual upside break.

A similar pattern arose in the Gold Share prices a couple of weeks ago, and the ascending right angled triangle "appeared" to break down. It was this "appearance" that focussed my attention on the high probability that the markets were being managed.

But the clincher in the argument is manifest in the second chart - that of the Gold Price.

There are three successive bullish chart patterns which confirm that the gold price is in a Primary Bull Trend.

  • Which is an "equilateral triangle"
  • Which is also an "equilateral triangle"
  • Which is a "flag"

All three of these are known as "continuation" patterns and, given that the Gold Price is in a confirmed Bull Trend, a "continuation pattern" implies that the Bull Trend will continue. Further, given that the US Dollar appear also to be entering a Bull Trend (or at least leaving a Bear trend) the DollarGold chart appears likely to explode upwards

But why would it explode upwards?

Well, in the context of gold being a barometer of fear, this is another sign that the Equity Markets may be heading for a crash - because under circumstances where the equity market crashes - and yields are no longer falling - bonds will no longer represent an attractive investment to holders of US Dollars. There will be nowhere left to turn for safety. Certainly, the property markets will not be sage in an environment of rising WACC's.

Because I cannot bring myself to think in terms of defeatism, I have been applying my mind to possible outcomes and I have been researching the subject of "chaos theory" and "bifurcation points" - both of which are well know to physicists. Of potentially exciting interest to me is that there is an organization known as the BANNF Research Station which has relatively recently begun to research the subject of bifurcation as it may apply to the subject of Biology. http://www.pims.math.ca/birs/workshops/2003/03w5075/

So, to depart this missive on a note of optimism, whilst the evidence is mounting that we are moving inexorably to what might turn out to be a collapse in equity markets and a compensatory explosion of the gold price, there appears to be objective reason to believe that, out of the ensuing chaos, will arise a "new era".

This is typically what occurs at a bifurcation point, and I will be researching this subject with increasing attention over the coming months.


The Incas thought gold represented the glory of their sun god and referred to the precious metal as “Tears of the Sun.”
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