The TINA trade is breaking

Once upon a time, you had no choice – equities or nothing. This was referred to as TINA – there is no alternative. Bonds yielded you close to zero. (I’m rounding 0.2% to zero).

Today, two-year US government debt is now yielding 2.7%, which is still less than reported headline inflation, but at least it is something.

This is going to suck up liquidity from the market, and it is pretty obvious this has had a significant effect on broad market equities. Suddenly, instead of investing in bond-proxy equities like Microsoft or Apple, you can instead put the capital into everything-but-inflation risk-free government debt and earn your 2.7% yield this way. High-multiple stocks with promises to pay out in the distant future suddenly no longer look as good simply because there is an alternative.

We have a huge wall of worry ahead of us – the US Federal Reserve on May 5th will be raising interest rates and perhaps initiating quantitative tightening, we have China that is now making famous people in the white-bunny with blue stripe plastic suits enforcing Covid rules, we have the Russia/Ukraine dynamic and the threat of nuclear war, etc.

This is reflected in a high price for protection – the volatility index is once again has creeped upwards – paying for those put options is expensive!

With disaster always comes opportunity. I am sounding like a one-tune band, but those companies earning large near-term cash flows will be making their shareholders a fortune by the reinvestment in their own stock (assuming they have the liquidity to do so!). In some cases, the numbers appear to be extreme – if you could reinvest in yourself at 30% returns, would you? I sure as hell would. Some things are trading like as if everybody forgot how to read financial statements and perform the most cursory of forward projections.

In a rising rate environment, cash flow talks – ARCH’s payout phase

“How much should I pay for the equity” is an easy question to ask, but computing all of the variables to come up with a range of prices is not so easy.

One of the components is the rate of interest. As interest rates rise, you want your cash flows today instead of tomorrow.

For instance, if your high tech company will give out a billion dollars in cash 10 years from today, the rate of interest has a significant effect on today’s capitalized value.

At 1% your billion dollars of cash 10 years out translates into $905 million.

However, at 3%, that same billion dollars turns into $744 million, or about an 18% difference from the above.

This is one reason why long term government debt has been decimated as of late. For instance, the TLT ETF (with an average term to maturity of 26 years) from the local peak at the beginning of December to present has rendered investors a 21% loss. The higher the long-term yield goes, the more damage that gets priced into the capital value. This is only mildly tempered by the 2.47% coupon and 3.01% yield to maturity – in other words, all things being equal, you would have to wait 7 years to recover the loss.

The converse is true for entities that will give out cash today instead of tomorrow.

Arch Resources reported their first quarter results today. There is a lot of details to digest, but the obvious headline is the declaration of a $8.11/share dividend, which is the result of their capital allocation policy to give out half of their free cash flow in dividends, while retaining the other half for other general purposes.

With the price of coal, both metallurgical and thermal, being sky-high as a result of a huge confluence of events (chronic under-investment, ESG, Russia/Ukraine, Australia/China, and overall demand for steel production), Arch and other coal producers that are still able to produce (this is the key – they need to have functional mines and not promises to build them) are making a fortune in free cash flow.

This quarter alone, operating cash flow minus capex was $271 million. This number was smaller than it otherwise would have been due to logistical constraints on the railway that serves the company.

In Q2, this number will be increasing because they will be able to further restore rail capacity, coupled with the average realized price to likely be higher.

My rough estimate for Q2’s dividend will be about $11.60/share, but this depends on certain variables being achieved. Barring a complete and total collapse of the commodity market, it will be around that figure.

However, to be “conservative”, let’s use the previous number – $8.11/share. Multiple this by four times and you get $32.44/share annualized. At Monday’s closing price of $131.32, that represents a yield of 24.7%.

Realize that the dividend represents half of the free cash flow available to the company before a reclamation (asset retirement obligation) reserve.

Obviously the stock market is going to find a 24.7% annualized yield to be very difficult to resist, no matter how vilified the sector of the company is. Pension funds, with both broad exposure in an equity market that is down about 12% year to date and a long bond market that is down 16%, have gotten murdered this year. They need an avenue for returns. The temptation is going to be too much for them to avoid.

Not surprisingly the stock market has decided it was too much to resist and Arch is up about 20% as I write this post. The yield at the implied $32.44/year dividend is now down to 20%.

The question is how much temptation there will continue to be going forward. Will yields compress to 18%? 15%? 10%? This really depends on how desperate the market is for a return, coupled with their impression on how durable the coal market is.

At the current pricing of coal, however, Arch will pay back its entire enterprise value to investors (either through dividends or share buybacks) in a couple years. Needless to say, this beats Microsoft equity which has a total return of 4%, based off of analyst estimates on their upcoming fiscal year ended June 2023.

Going back to my original topic of interest rates and cash flows – in a rising rate environment, present cash flows talk bigger than the promise of cash in the future. Arch (and other fossil fuel companies) is going to be a demonstration why.

A happy problem is to decide how to re-invest the cash flows. Internally for Arch, after building up a sufficient cash reserve, they will likely engage in some sort of equity buyback which will further juice up the stock price. So they are already making part of the decision for you with their cash flow, although there is a diminishing returns aspect to this decision (inevitably they will buy back too many shares at too high a price, like they did in 2019). It doesn’t mean that you have to re-invest your dividend into them – indeed, it would probably be a better time than to be stockpiling the cash for stormier days.

Atlantic Power – after the buyout

It’s always interesting to see what happens to companies after they get bought out. It makes you wonder whether the price you are receiving is well-deserved or not.

In the case of Atlantic Power, they were bought out for approximately US$270 million plus the assumption of debt (not a trivial amount, roughly US$560 million).

I was just doing some checking up and noticed that Innergex bought the Curtis Palmer hydroelectric project. They paid US$318 million, which implies an EBITDA multiple of about 7.5x.

This was the gem of Atlantic Power.

I also notice they inked a deal with New Jersey to decommission their only coal plant (a 40% economic interest) at Chambers effective May 2022, where they would have received a capitalized value of the remaining power purchase agreement. This PPA was set to expire in 2024. I’m not sure exactly how much the payout was, but I would estimate it would have been around US$80-90 million.

This leaves 19 projects remaining, consisting of biomass, natural gas and hydro generators.

Atlantic Power was a very interesting company to analyze, and run by top-grade management that I would follow in a heartbeat if they decided to manage another public company.

Size of Bank of Canada Quantitative Tightening

The Bank of Canada, effective April 25, will now let its portfolio of government treasury debt mature.

Over the next two years we have the following maturities, in billions rounded to the nearest $100 million (MBS = mortgage-backed securities):

2022 – total 56.9 (+1.3 MBS)
May – 12.6
June – 3.1 (+0.3 MBS)
August – 16.8
September – 6.8
November – 17.6
December – 0.0 (+1.0 MBS)

2023 – total 88.5 (+1.3 MBS)
February – 17.4
March – 10.8
May – 16.9
June – 6.0
August – 9.1
September – 23.9 (+0.6 MBS)
November – 4.6
December – 0.0 (+0.8 MBS)

Total portfolio – 423.2 (+2.6 MBS)

Observations

Below is the chart of the cash the Government of Canada (their asset) has at the Bank of Canada (their liability):

There is around $98 billion for them, which suggests that liquidity will not be a concern with maturing government debt.

We examine Budget 2022, Table A1.7:

Note the $85 billion cash requirement (despite the $53 billion accounting headline deficit), which the government will have to raise through the fiscal year in addition to the rolling over of near-term debt.

How much will the government raise in gross debt in 2022-2023? Around $212 billion according to this projection:

What a coincidence – May, August and November correspond with when the major components of the QT maturities are arriving this year. Instead of the primary issuers buying the debt and then the Bank of Canada immediately scooping them up, now those institutions will have to actually purchase the government debt with the knowledge that the BoC will not be backstopping it.

How much can the treasury market take before it starts to vomit? We will see!

What’s a good earnings multiple?

The traditional financial metric has the P/E ratio being some amount over the risk-free rate.

For example, if the long-term government bond yield is 5%, then the equity valuation would be a premium over this, say 8%. The spread is the risk you take for an equity investment compared to a guaranteed payout on government debt.

The above example means you’d pay 1/8% = $12.50 for each dollar of cash flow, or also a price/earnings of 12.5.

This is a gross approximation, and does not take into a myriad of factors, especially future earnings growth/decline over time and the balance sheet condition (leverage distorts the above calculations).

As a most trivial example, Microsoft, which can be reasonably anticipated to be around for the indefinite future, is estimated to earn $10.66 in their fiscal year ended June 2023. If this extrapolates forever, at the current $300 share price, you are getting a 3.6% return, or 28 times earnings.

Considering the 30-year government bond is 2.7% at present, this is not much of a premium to take risk. Obviously there is some anticipation of earnings growth at Microsoft (at a minimum, one can expect them to be able to raise prices for inflation).

Either way, investors are accustomed to buying non-high flying companies at reasonable valuations, say 9 to 30 times earnings, depending on the perceived stability and earnings power of the company.

However, in the cyclical industries, the earnings factor over time is very volatile. Nothing exhibits this better than commodities.

Canfor (TSX: CFP) is a good example of this.

We take a look at their historical earnings, which is extremely choppy:

Just on the basis of historical earnings, if you took the past four quarters, Canfor, at $22.69, is trading at 1.87 times earnings, or a 53.6% earnings yield!

Of course, things are not that easy in commodity-land. There was an obvious windfall opportunity in lumber in the aftermath of Covid-19.

Despite that, analysts are projecting a 2023 earnings of $5.08/share, which is still 22%.

The issue is that this is a stale estimate. If raw lumber prices continue to drop, this estimate will surely drop, along with the share price. Indeed, the share price itself is a reasonable signal that this estimate is likely high.

The other factor is the duration of the earnings. Cyclical companies are, by definition, ones that go through boom-bust cycles as investment kicks in and supply starts to flood the market. The lumber market in this respect is a lot quicker than some other resources that require half a decade to open up infrastructure.

If this level of earnings is projected to last further in time, then the current price will rise. Conversely, if the earnings deflate quicker than expected, the share price will drop.

Either way, it is gut-wrenching to sell a company that seemingly is trading at such a low multiple. Sometimes, selling at a low single digit multiple is a correct decision!

However, unlike the much more stable Microsoft, an investor is rewarded much more for getting the earnings picture correct for a cyclical company – correctly projecting the future in an earnings-volatile environment is much more rewarded.

Does this mean that Canfor, at 2x or 4x or whatever, is a better investment than Microsoft because it is so seemingly ‘cheap’?

This brings me to the original question on the title of this post – what is a good earnings multiple?

The answer is there is none.