Reality Check

Reality check.  Flying high markets took a break from their ascent yesterday as a dose of reality was served up by the IMF, China, and trade negotiators.  Equity markets have been on somewhat of a tear since hitting lows in late December as the Fed backed off its aggressive rate hiking stance and US-Chinese trade negotiations appeared to be heading in a positive direction.  Behind the headlines, markets were oversold, P/E multiples were looking cheap, and investors were eager to get back into the market after having a difficult 2018.  The buying that ensued was fairly aggressive with investors even ignoring some of the headlines and indicators that would typically prompt a more defensive stance.  As of this morning we are 33 days into what is the longest government shutdown in US history, domestic economic indicators have shown some signs of slowing (though still positive), and China, the world’s second largest economy, has been producing miss after miss in its economic indicators.  As I mentioned in yesterday’s note, the market has at this point most likely factored in a positive outcome to the trade war and any signs of a deterioration would cause volatility.  That is exactly what ensued yesterday.  China announced yesterday that its 4Q GDP growth slowed down making it the 3rd quarter in a row of deceleration.  China’s +6.6% GDP growth for 2018 is the slowest pace since 1990.  In Davos, where international finance elites are meeting, the IMF announced that it revised its global GDP forecast downward for 2019 and 2020. Trade talks between the US and China appeared to be stalling a bit as the President sent out what appeared to be a negative tweet on the matter.  These were enough to cause traders to pull back a bit in the morning session.  Later in the session, a report hit the tape that a meeting of Chinese and US delegates was being cancelled due to lack of progress. The report caused markets to sell off rather quickly with the Dow being lower by around 460 points, at its session lows.  All of the indexes except for the Russell 2000 retreated below their 50 moving averages at the lows of the session. Closes below the moving averages would have been viewed as negative from a technical perspective.   Then came the Plunge Protection Team (PPT), which is a group of administration officials who seem to show up and make positive leaks and interviews when things are looking grim for markets. Yesterday right before the close, Larry Kudlow, one of the most prominent PPT members, came on the air to say that the meeting with the Chinese wasn’t canceled, causing markets to make a quick recovery, though they still closed down for the day.  The net result included the S&P500 slipping by -1.42%, the Dow Jones Industrials pulling back by -1.22%, the Russell 2000 dropping by -1.69%, and the NASDAQ 100 falling by -2.03%.  Bonds advanced slightly in yesterday’s session leaving 10 year yields lower at 2.74%. The real news this week is about earnings releases.  With 50 S&P 500 companies releasing, analysts and investors will be looking over financials carefully to determine whether the cheap multiples are justified (companies are underperforming) or if they represent value.  With a growing number of economists starting to believe that recession is within 18-24 month’s out, analyzing corporate health is more important than ever.  One of the many things that analysts look at is a company’s ability to survive a pullback in revenues. Put simply can a company continue to pay its employees and service its debt if sales slow down?  The best place to look for corporate health is in a company’s cash flow statement, and because it is geek-out Wednesday and we are in a pivotal earnings season, I will go a bit more into cash flow.

When I was in graduate school… many years ago… I took a financial analysis class and the list of books included some of the usual suspects.  Of course there would be Graham and Dodd’s “Security Analysis” (made famous by Benjamin Graham’s esteemed student Warren Buffet) and Harry Markowitz’s (the Father of Modern Portfolio Theory) “Portfolio Selection”.  Almost every class in finance includes those books in required reading.  But in this particular class, there was a new one called “Financial Statement Analysis” by Martin Fridson.  It was not the typical 4-inches-thick full-of-calculations kind of book that we were used to.  But this one would change everything.  In his book, Fridson laid out his case for “cash is king” as a way of analyzing corporate health.  After all… cash IS king.  When coming up with and reporting earnings, companies can do many perfectly legal things in order to smooth earnings or even mask threats.  There is very little a company can do to mask their cash flow.  You either have it or you don’t, and if you do, how did you get it?  So let’s start with what is cash flow.  It is defined as the cash and cash-equivalents that is flowing in and out of a business.  Cash comes in through sales of products and it goes out when companies pay expenses.  Nothing ground breaking yet.  Sounds like you can get all of this by looking at a companies income statement, right?  Not really. Just because a company makes a sale doesn’t mean that they actually received cash.  When customers actually pay, the sale adds to cash, so accounts receivable would actually diminish cash.  On expenses, when a company makes a purchase of an asset like machinery it must pay the vendor in cash.  Typically when a company accounts for the purchase, they would depreciate the asset over its useful life and spread out its cost.  That means that even though the company may have laid out cash in year 1, it would only list a portion of the cost as an expense on its income statement in that year.  In other words, depreciation is not a real cash expense, therefore it would actually increase cash. Wow, now its starts to get complicated right?  It’s not as bad as it may look.  The Financial Accounting Standards Board issued a statement in 1987 called Statement 95 (AKA FASB 95), which established a standard for companies to report cash flows to be included along with an income statement and balance sheet.  Because it is a standard, you can find it in any public company 10Q or 10K and they will appear the same regardless of industry or size.  The cash flow statement is broken down into four main sections:

1. Cash flow from Operating Activities.  This section starts with net income which, as I alluded to earlier, can be manipulated in many ways.  In this section, all non-cash items that are included in net income are added back and subtracted. For example accounts receivable is money owed to the company by customers, which means the company did not yet receive the cash.  Any increases in Accounts Receivable are therefore subtracted from operating income.  Conversely, with accounts payable.  An increase in accounts payable means that a company has made a purchase but has not yet paid out the cash.  Any increases in accounts payable are therefore added back to net income.  The end result is cash flow from operations, which represents how much cash the company’s core business generated… or lost.

2. Cash flow from Investment Activities.  This section categorizes the flow of cash as it relates to capital expenditures and long term investments.  When a company makes a purchase of property, plant, or equipment they must pay cash for the purchases, though they may report the cost over many years in depreciation.  For example if a company purchases $100k of computer equipment, they may choose to only expense their cost over a 5 year period which means that the income statement will only show an expense of $20k in that year despite the company having laid out $100k in cash.  Capital expenditure represents a cash outflow and it is therefore subtracted from cash.

3. Cash flow from Finance Activities.  This section details the issuance or repayment of debt or equity instruments used by the company to finance its operations.  If a company sells bonds to the public, the proceeds of the sale increase cash flow and it is therefore added to cash, similarly with equity offerings, which raise capital and are also added to cash flow.  Conversely, if a company pays a dividend or buys back stock, it is a cash outflow and therefore subtracted from cash flow.

4. Cash Balance.  This final section brings everything together to get a true cash balance.  First, the prior three sections are summed up to get cash flow from the period and then added to the opening cash balance to get the closing cash balance.

By now you should be able to see that by using the FASB 95 cash flow statement, you can track how a company stays in business.  Did you ever wonder how a company can lose money and continue to stay in business?  Cash flow statement has the answer.  Think of Tesla, which reported a net loss of $1.9 billion in 2017.  How are they still in business?  If you look at their cash flow statement you would see that once they added back all of the non-cash items in the operating activities, the loss was only about $60 million, which is much better but still bad.  But wait, if you continue down the cash flow statement, you would see that the company spent around $4.4 billion in long term investments, most likely on the buildout of production facilities.  Ok, so now the situation looks bad, right?  They lost $60 million in operations and spent another $4.4 billion on investments for a total cash outflow of $4.46 billion. How could they have done this?  The next 2 sections have the answer.  The company sold bonds, equity, and received additional financing to raise a total of $4.14 billion.  Close enough.  They borrowed money, sold equity, and used cash on hand.  That tells you the whole story about how Tesla operated their business in 2017.  Now that we know this we can see that if for some reason the ability to borrow money from the bond market becomes difficult, Tesla may have a difficult time staying in business.  Of course if sales increase significantly and the company slows down the buildout of its production facilities, it may have to rely less on the capital markets to stay afloat in the future.  Tesla will announce its fourth quarter earnings next week and they are expected to earn $1.93 per share versus the loss of -$3.668 per share for 4Q17.  Things may be turning around for Tesla, but the only way to truly know what is going on… the cash flow statement.

Today is a light day for economic releases, but we have a number of pre-market earnings releases which should help set the mood for the session ahead, as markets traded up overnight following on Kudlow’s comments and an earnings beat with upbeat guidance from IBM, post-close.  This morning’s releases featured a solid surprise by United Technologies and Proctor & Gamble, which helped propel futures up further.  Of the pre-bell announcements only 2 out of the 9 missed projections. There will be no lack of volatility today as the VIX index remains at 20, still above that magical 18 level.

daily chartbook 2019-01-23