Thursday, 16 January 2014

Where are we now in the Stock Market Cycle?

And Unilever PLC

Astrologer casting a horoscope, 1617, Robert Fludd, courtesy Wikipedia.
It is the time of year when financial journalists, stockbrokers and anyone vaguely interested in the stock market offers an opinion on what the stock market will do this year. They have the power of prediction of the astrologers of yore. 
Howard Marks of Oaktree Capital Management is a self-styled contrarian investor. To understand where we are in a market cycle, Marks sets out a simple checklist that he calls "The poor man's guide to market assessment". For each consideration he has set up a pair of answers. Check one of the two for each consideration. "And", he writes, "If you find that most of your checkmarks are in the left-hand column, hold on to your wallet." Oaktree Capital Management applies Marks's principles to the $71 billion debt, property and equity investments the company manages. Mr Marks has a personal fortune of $1.5 billion. 
Capital Markets
Interest rates
Eager to buy
Uninterested in buying
Asset Owners
Happy to hold
Rushing for the exits
Starved for attention
Hard to gain entry
Open to anyone
New ones daily
Only the best can raise money
Recent performance
Asset prices
Prospective returns
Popular qualities
Caution and discipline
Popular qualities
Broad reach
From The Most Important Thing: Uncommon Sense for the Thoughtful Investor by Howard Marks
It is likely most people will check the left column more frequently than the right.
James Mackintosh, of the Financial Times Short View column (8 January 2014), points out that UK investment trust discounts are at an historical low. In the past low discounts have always been followed by a period of stock market underperformance over the following 12 months.
Shiller's graph for the Cyclically Adjusted Price Earnings ratio (CAPE - the current price of the S & P 500 share price divided by a rolling average of 10-year earnings) is commonly used as a measure of where we are in the stock market cycle. This is because a 10-year rolling average for earnings is a more reliable indicator than taking a single year. Here he compares it to long-term interest rates. As one might expect, CAPE ratios are higher when long-term interest rates are lower. In my valuation model this is reflected in the discount rate, which depends on long-term interest rates.

Courtesy Robert Shiller's Yale website, click to enlarge
Depending upon your reading of these tea leaves, stock markets in the US and the UK (the FTSE All Share is closely correlated to the S&P 500) are either midway towards a bubble or they are nearing the top of its regular cycle. Goldman Sachs, in its Monday telecast, is now predicting a 'correction', but that the FTSE 100 will end 2014 10% up on 2013.
What to do? It is at these moments when rule-based investing comes to the aid of the party. Stick to a tested methodology to value individual stocks and other assets that has worked for you in the past.

Unilever PLC

Ad for Lux soap from the 1920s, courtesy Wikipedia
Unilever was reviewed at this blog in April 2013 (see  To resume:
The present management has staged a remarkable turnaround since 2005. Marketing is concentrated on 14 brands each with sales exceeding €1 billion, and emerging markets now account for 55% of the company's sales.
Financial results are strong.
1. Earnings per share have increased by 11% pa from 2001-3 to 2010-12 and the dividend per share has increased by 18% pa from 2001-2012.
3. Return on equity averages 31% on an historical basis, but this has fallen to 15% on retained earnings. Equity per share has increased by 7% pa since 2001.
4. Free cash flow of €27 billion in the past 5 years has paid for capital expenditure and the dividend with €6 billion to spare.  This was used to reduce debt.
5. Net debt is down from €26 billion in 2000 to €7.6 billion in 2012. Unilever has a long-term credit rating of A+. 
Yet the price of Unilever shares (in blue) is back where it was at the beginning of 2013 while the FTSE 100 (in green), of which it is a component, has increased by 12%.
Graph courtesy Barclays Stockbrokers, click to enlarge
What has happened?
1. Analysts have reduced earnings expectations for 2013 to 3%. The reduced earnings expectations for 2013 are the result of adverse currency movements against the Euro of the US dollar and many other currencies. And Unilever sold Skippy for $0.8 billion. Once revenues are corrected for currency fluctuations and Skippy, they are up by around 5%, compared to 6.9% in 2012 (excluding acquisitions and favourable currency movements in that year).
2. Net debt jumped by €4.2 billion in the first half of 2013. This was almost entirely the result of placing €3.8 billion into an escrow account to buy out the minority shareholders in Unilever's Indian subsidiary. In the end, Unilever paid €2.5 billion for a smaller number of shares and the difference will go back into cash at the 2013 year end. And future attributable profit deductions for minorities will be considerably lower, though Unilever does not inform us by how much.
Some of Unilever's brands, including Lux soap, go back to the 19th century. The company's brands span all markets and many of the top 14 are either the largest or second largest in their respective markets. Revenues from emerging markets grew by 9% in the first 9 months of 2013, and it was Europe and North America where sales stagnated. But both markets should resume their growth with the economic recovery.
Management is reducing regional and local marketing staff by 12% with the purpose of reducing costs and the duplication of functions. This follows other global consumer companies that have either done something similar or have announced it. Unilever is aiming, in addition, to save $400 million on global advertising by forcing down rates rather than less exposure.
At the current price of 2406p, Unilever shares trade on an estimated 2013 PE ratio of 18 and yield 3.7%. Including the expected 2013 results in my valuation model, the shares are good value.* Preliminary results for 2013 are due on 21 January.
*Eps growth of 9% p.a., average PE of 18, 15% return on equity, dividend payout ratio of 67% of earnings, discounted by 10.8% (3.8% SLXX +  2% operating risk + 5% margin of safety) for the years 2014-2018.
Cautious investors will note:
1. Emerging markets growth is in decline and there is no guarantee that it will recover its former vitality.
2. The competition is intense from the likes of Heinz, Colgate, Nestlé, Procter & Gamble and Reckitt Benckiser, and local producers in places like China and India.
3. The growth in Unilever's earnings per share has declined in recent years.
4. Management has a large number of 'soft' objectives on social and environmental issues that might distract them from profit making and cash generation.


  1. hi,

    would you please tell me where can I get some more info about your evaluation model and how its calculated please ?

  2. Hi Kaveh M, you can find it at