Tag Archives: valuation multiples

CenturyLink levelled

It’s been over 6 months since I last posted on the upcoming merger of Level 3 (LVLT) and Centurylink (CTL). Since then, LVLT’s CEO Jeff Storey has been named COO of the combined entity and CEO from January 2019, after a gentle push from activist investor Keith Meister of Corvex Management (here is an article on their latest position), effectively meaning the merger is an operational LVLT takeover of CTL. In June, CTL also got hit by a lawsuit from an ex-employer alleging a high-pressure sales culture which ripped customers off (an avalanche of class action suits followed). And, potentially more damaging, the recent results of CTL continue to point to deteriorating trends in the legacy part of their business and lackluster growth on the strategic part of the business. CTL missed their quarterly estimates again in the most recent quarter, the third miss in a row.

Picking up on my recent telecom industry post, the sector will struggle in the short term to find top line growth before the full impact of new “digital lifestyle” opportunities emerge. The figures below for enterprise, including public sector, and wholesale revenues for some of the biggest US players (which have been adjusted judgmentally for items such as the impact of the XO acquisition on Verizon’s revenues and the ever-changing classifications and reclassifications that telecom’s love) illustrate the current struggle in getting newer IP enabled services to fully compensate for declining legacy revenues.

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These figures imply average quarterly declines since 2014 of -0.3% and -1.2% for enterprise and wholesale business respectively. However, the trend has been getting worse. The average quarterly change was 0.2% and -1.1% for enterprise and wholesale business respectively from 2014 to 2015. Since 2016, the average quarterly change is -0.9% and -1.3% for enterprise and wholesale respectively. Not exactly a cheery trend when contemplating the prospects of a merged CTL/LVLT!

As can be seen below, the share price of LVLT and deal implied price have converged, particularly as CTL’s dividends get paid, albeit with a sharply downward bias in recent weeks over worries about dividend sustainability, valuation, sector trends, lawsuits and uncertainty over the closing date of the merger (a delay by California, the last State approval needed, may mean the end of September deadline is missed).

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My estimates for a standalone LVLT compared to analyst figures and those presented by LVLT management in the S4 (figures presented for merger negotiations are generally on the optimistic side) are below. Even factoring in higher interest rates (about 40% of LVLT’s debt is floating) over the coming years, I am comfortable with a standalone share price around the current mid-50’s, in the unlikely event the merger falls apart.

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To recap on my confidence in the ability of LVLT’s current management team to deliver, the results of the last merger between LVLT and TWTC show that management delivered a 40% uplift in the amount of free cashflow (e.g. EBITDA less capex) on flat revenues from 2014 to 2017 (e.g. combined FCF of both entities in the year prior to the merger to actual H1 results and my estimates for H2 2017). Some of my many previous posts on LVLT are here, here and here. Such a repeat in FCF in the CLT/LVLT merger is not a realistic expectation given the larger scale and different business mix, as the analysis below illustrates. Of course, the flat revenues over the past 3 years is a key concern (but worthy of praise given the industry trends highlighted above) and one of the catalysts for the CLT deal. Also, the health of designate CEO Jeff Storey may also be a factor over the next few years given his heart issues a few year ago.

My knowledge of CTL’s business is not as deep as that of LVLT’s and my confidence in their prospects on a standalone basis is nowhere near as lofty. My projections, split over a conservative base scenario and a more conservative low business scenario, can be seen below. My projections are primarily based upon the more recent trends in their business lines across their legacy and strategic enterprise and consumer businesses. The vast variance in my estimates, based upon recent trends, and those presented by management in the S4 (again, acknowledging that these are generally optimistic) illustrates why the market has lost such confidence in the outgoing management team at CTL, in my opinion.

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In terms of trying to model the merged CTL/LVLT, I have assumed the deal closes by the end of 2017 with 2018 being the first year of the merged entity. I have made a number of judgmental adjustments in my model, including assuming some loss of revenue due to the merger and cost reductions above published target synergies (e.g. $1 billion of operating synergies by end 2020 and $150 million of capex synergies by end 2019, higher than the announced target savings of $850 million and $125 million for opex and capex respectively). I have taken analyst estimates as an optimistic case (in CTL’s case I have taken their EBITDA estimates but still can’t get anywhere near their revenue figures) and called it the high scenario. My two projections above are used for the base and low scenarios. The resulting operating metrics for each scenario is shown below.

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The high scenario shows revenues flat-lining slightly above $24 billion for 2018 and 2019 with top-line growth returning in 2020 (YoY above 2.5%). EBITDA margins hit 40% by 2019 and remain stable around 40% thereafter. Capex is assumed to hit 15.5% of revenues by 2019 and remain at that percentage thereafter. This scenario assumes that management will be able to generate an approximate 30% uplift in the amount of free cashflow (e.g. EBITDA less capex) from 2017 (e.g. combined FCF of both entities in the year prior to the merger) to FY 2020.

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The base scenario shows revenues flat-lining around $23.5 billion for 2018 through 2020 with top-line growth returning in 2021 (YoY just below 2%). EBITDA margins hit 40% by 2019 and slowly trend down toward 39% thereafter. Capex is again assumed to hit 15.5% of revenues by 2019 and remain at that percentage thereafter. This scenario assumes that management will be able to generate an approximate 22% uplift in the amount of free cashflow (e.g. EBITDA less capex) from 2017 (e.g. combined FCF of both entities in the year prior to the merger) to FY 2020.

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The low scenario shows revenues around $23.5 billion for 2018 and drifting down to $23 billion before slowly hitting $23.5 billion again by 2022. Thereafter revenue growth builds slowly from 1.5% to 2.5% by 2027. EBITDA margins hit 39.5% by 2019 and slowly trend down toward 38.5% thereafter. Capex is again assumed to hit 15.5% of revenues by 2019 and remain at that percentage thereafter. This scenario assumes that management will be able to generate an approximate 18% uplift in the amount of free cashflow (e.g. EBITDA less capex) from 2017 (e.g. combined FCF of both entities in the year prior to the merger) to FY 2020.

I also assume the merged entity will carry $38 billion of debt from the offset (resulting from merger expenses, the cash payout to LVLT shareholders, and existing debts from both firms, after factoring any proceeds from recent CTL divestitures). I estimate that only 30% of this debt load is subject to a floating rate. In all scenarios, I assume the LIBOR rate linked to the floating rate increases incrementally by 275 basis points over the next 3 years (the current 12 month US rate is about 175 basis points). With a net debt to EBITDA ratio of approximately 3.8 at the end of 2018 across all scenarios, I believe that getting that ratio below 3 within 4 years by 2021, at the latest, will be a primary objective of the new management team. That would only be prudent in my view given the likely tightening monetary environment over the next few years which will punish valuations of corporates with high debt levels. Also, management will want to remain flexible if higher capex is needed to compete in new technologies for the IoT and digital lifestyle era (see recent sector post). I haven’t factored in an upside from LVLT’s CFO Sunit Patel proven ability to actively manage debt rates and maturities (his ability is highlighted by the fact that LVLT’s fixed debt costs 5.5% compared to CTL’s admittingly much larger fixed debt costing 6.8%)

That leads to the thorny question of the sustainability of the annual dividend of $2.16 per share (particularly given that share count will double, amounting to $2.3 billion per year). Under the high scenario, maintaining the current dividend and getting the net debt multiple below 3 by 2021 is doable if a little tight (primarily due to the cashflow benefits of LVLT’s NOLs). For both of the base and low scenarios maintaining the current dividend level is not realistic in my view, with a cut in the dividend to $1.30 and $1.00 needed in each scenario respectively (a 40% and a 55% cut). The current dividend yield on CTL is over 10%. Each of the cuts above would reduce that yield to approximately 6% and 5% for the base and low scenarios respectively based upon the current share price. Addressing the uncertainty over the dividend should be one of the priorities of the new management (and may even result in Jeff Storey’s move to the CEO position ahead of the planned January 2019 date).

Finally, before I reveal my per share valuations, I haven’t given any consideration to the financial impact of the current legal cases on alleged aggressive sales tactics as the level of current detail makes any such estimate impossible. Some of the class action cases claim anything from $600 million to $12 billion but these claims are always bloated and the eventual settlement figure, if there even is one, are often for a lot less than that claimed. Nor have I considered the potential impact of a spin-off of the consumer business (that’s for another time!).

So, based upon the analysis outlined in this post and using a discount rate of 8.5%, my valuation estimates for each of the three scenarios are below.

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The market’s current valuation of CTL around $20 indicates scenario 3 as the current expectation. This emphasizes the need to address the uncertainty over future dividend levels and the validity of the legal cases. Uncertainty over the closing date of the deal is overblown, in my view, and a few months of delay will not prove material. I do think the current valuation is harsh, given the potential upsides from the deal and longer-term industry trends. Interestingly, my base scenario valuation of £31 is not too far off the value of $34.75 by BofA Merrill Lynch and Morgan Stanley in the S4 (see this post on the S4). The base scenario is the one I would have the most confidence in, based upon my current knowledge, rather than the high scenario of $43 which does look too optimistic to me given current market trends.

I was never going to reinvest the cash component of the deal for LVLT shareholders given my current reservations about market valuations and move to cash across my portfolio. The analysis presented in this post indicates to me that the CTL shares due from the deal for LVLT shareholders are worth holding from a valuation perspective. For now.

For new investors, I’d wait to see how some of the uncertainties play out, particularly the dividend issue.

Farewell, dissonant 2016.

Many things will be written about the events of 2016.

The populist victories in the US election and the UK Brexit vote will no doubt have some of the biggest impacts amongst the developed world. Dissatisfaction amongst the middle class across the developed world at their declining fortunes and prospects, aligned with the usual disparate minorities of malcontent, has forced a radical shift in support away from the perceived wisdom of the elite on issues such as globalisation. The strength of the political and institutional systems in the US and the UK will surely adapt to the 2016 rebuff over time.

The more fundamental worry for 2017 is that the European institutions are not strong enough to withstand any populist curveball, particularly the Euro. With 2017 European elections due in France, Germany, Netherlands and maybe in Italy, the possibility of further populist upset remains, albeit unlikely (isn’t that what we said about Trump or Brexit 12 months ago!).

The 5% rise in the S&P 500 since Trump’s election, accounting for approx half of the overall increase in 2016, has made the market even more expensive with the S&P 500 currently over 60% of its historical average based upon the 12 month trailing PE and the Shiller CAPE (cyclically adjusted price to earnings ratio, also referred to as the PE10). A recent paper by Valentin Dimitrov and Prem C. Jain argues that stocks outperform 10-year U.S. Treasuries regardless of CAPE except when CAPE is very high (the current CAPE is just above the “very high” reference point of 27.6 in the paper) and that a high CAPE is an indicator of future stock market volatility. Bears argue that the President elect’s tax and expansionary fiscal policies will likely lead to higher interest rates and inflation in 2017 which will further strengthen the dollar, both of which will pressure corporate earnings.

Critics of historical PE measures like CAPE, such as Jeremy Siegel in this paper (previous posts on this topic are here and here), highlight the failings of using GAAP earnings and point to alternative metrics such as NIPA (national income and product account) after-tax corporate profits which indicate current valuations are more reasonable, albeit still elevated above the long term average by 20%-30%. The graph below from a Yardeni report illustrates the difference in the earnings metrics.

click to enlargenipa-vrs-sp500-earnings

Bulls further point to strong earnings growth in 2017 complemented by economic stimulus and corporate tax giveaways under President Trump. Goldman Sachs expects corporations to repatriate approx $200 billion of overseas cash and to spend a lot of it buying back stock rather than making capital expenditures (see graph below) although the political pressure to invest in the US may impact the balance.

click to enlargesp500-use-of-cash-2000-to-2017

The consensus amongst analysts predict EPS growth in 2017 in the high single digits, with many highlighting further upside depending upon the extent of the corporate tax cuts that Trump can get past the Republican congress. Bulls argue that the resulting forward PE ratio for the S&P 500 of approx 17 only represents a 20% premium to the longer term average. Predictions for the S&P 500 for 2017 by a selection of analysts can be seen below (the prize for best 2016 prediction goes to Deutsche Bank and UBS). It is interesting that the average prediction is for a 4% rise in the S&P500 by YE 2017, hardly a stellar year given their EPS growth projections!

click to enlargesp500-predictions-2017

My best guess is that the market optimism resulting from Trump’s victory continues into 2017 until such time as the realities of governing and the limitations of Trump’s brusque approach becomes apparent. Volatility is likely to be ever present and actual earnings growth will be key to the market story in 2017 and maintaining high valuation multiples. After all, a low or high PE ratio doesn’t mean much if the earnings outlook weakens; they simply indicate how far the market could fall!

Absent any significant event in the early days of Trump’s presidency (eh, hello, Mr Trump’s skeleton cupboard), the investing adage about going away in May sounds like a potentially pertinent one today. Initial indications of Trump’s reign, based upon his cabinet selections, indicate sensible enough domestic economy policies (relatively) compared with an erratic foreign policy agenda. I suspect Trump first big foreign climb down will come at the hands of the Chinese, although his bromance with Putin also looks doomed to failure.

How Brexit develops in 2017 looks to be much more worrying prospect. After watching her actions carefully, I am fast coming to the conclusion that Theresa May is clueless about how to minimise the financial damage from Brexit. Article 50 will be triggered in early 2017 and a hard Brexit now seems inevitable, absent a political shock in Europe which results in an existential threat to the EU and/or the Euro.

The economic realities of Brexit will only become apparent to the UK and its people, in my view, after Article 50 is triggered and chunks of industry begin the slow process of moving substantial parts of their operation to the continent. This post illustrates the point in relation to London’s insurance market. The sugar high provided by the sterling devaluation after Brexit is fading and the real challenge of extracting the UK from the institutions of the EU are becoming ever apparent.

Prime Minister May should be leading her people by arguing for the need for a sensible transition period to ensure a Brexit logistical tangle resulting in unnecessary economic damage is avoided. Instead, she acts like a rabbit stuck in the headlights. Political turmoil seems inevitable as the year develops given the current state of the UK’s fractured political system and lack of sensible leadership. The failure of a coherent pro-Europe political alternative to emerge in the UK following the Brexit vote, as speculated upon in this post, is increasingly looking like a tragedy for the UK.

Of course, Trump and Brexit are not the only issues facing the world in 2017. China, the Middle East, Russia, climate change, terrorism and cyber risks are just but a few of the issues that seem ever present in any end of year review and all will likely be listed as such in 12 months time. For me, further instability in Europe in 2017 is the most frightening potential addition to the list.

As one ages, it becoming increasingly understandable why people think their generation has the best icons. That said, the loss of genuine icons like Muhammad Ali and David Bowie (eh, sorry George Michael fans) does put the reality of the ageing (as highlighted in posts here and here) of the baby boomer generation in focus. On a personal note, 2016 will always be remembered by me for the loss of an icon in my life and emphasizes the need to appreciate the present including all of those we love.

So on that note, I’d like to wish all of my readers a prosperous, happy and healthy 2017. It looks like there will be plenty to write about in 2017…..

A gaggle of bankers

How many investment bankers does it take to change a lightbulb? Well there are numerous jokes on that. Here’s one: two – one to take out the bulb and drop it and another one to sell it before it crashes!

In the case of the Level 3 (LVLT) and Centurylink (CTL) proposed merger (see previous post), it took no less than five investment banking firms according to the recent S4 filing to get a deal agreed. Centurylink had Bank of America Merrill Lynch and Morgan Stanley as its main advisors with Evercore added for another fairness opinion. Level 3 had Citi as its main advisor with Lazard for another fairness opinion.

The S4 also reveals that there was no auction process. Although both sides have no doubt talked to many potential partners about deals (both telecom firms have extensive M&A experience) in the recent past, this merger proposal really got started after discussions with the CEOs in May, initially about a LVLT purchase of CTL’s business segment and a tracking stock on the consumer business. The tracking stock idea quickly got dumped with the cash and share purchase of LVLT by CTL discussed in principle in September with the details agreed in October. Given the breakup fee is only around $2 a share for any alternative bidder, LVLT decided it was best to nail down the deal with CenturyLink rather than look for other deals. The S4 stated the following:

In light of the premium being proposed by CenturyLink, Level 3 management’s view of the relatively low likelihood of any potential alternate bidder being willing to make a superior proposal within a short time frame and the risk of potential leaks raised by pursuing such a pre-signing market check, coupled with the ability of any potential interested bidder to submit a competing offer following the signing of a definitive agreement with CenturyLink and the ability of Level 3 to terminate any definitive agreement with CenturyLink post-signing to accept a superior proposal from another bidder, the Level 3 Board determined at that time to continue pursuing the transaction proposed by CenturyLink without approaching other parties.

Relying on investment bankers to give fairness opinions could be viewed with scepticism by anybody with a memory and a sense of humour. However, in this case, I believe that the strategy is a sensible one for shareholders. The business segment of CTL and LVLT clearly makes sense as a match up with the possibility of significant synergies (more I think than has been assumed). The consumer side of the merged entity can always be offloaded at an opportune time in the future. Also, any other potential bidders of LVLT, such as Comcast or a technology firm like Goggle or Microsoft, will be forced now to act if they want the unique assets of the firm. My sense is that the possibility of another bidder emerging over the coming months remains low.

The financial projections, shown below, from management of each firm on a standalone basis are presented in the S4 and make for interesting reading.

click to enlargecenturylink-level3-projections

The projections for LVLT show higher capex figures for 2016 and 2017 than analyst estimates. From 2017 onwards, LVLT’s estimates of revenue are higher than analyst estimates whilst the resulting EBITDA is lower. This suggests a slower progression in EBITDA margins than analysts’ expectations with a figure closer to 35% and stable over the medium term. For CTL, the longer term revenue growth figures from the firm are more aggressive than analysts with EBITDA margins drifting down to the 35% level and below over the medium term.

It is unclear how many adjustments have been made by advisors to the figures provided by management of both firms. I am not that familiar with CTL’s figures but the LVLT figures look reasonable enough. The fairness opinions generally state that they reviewed the figures provided and the assumptions behind them without actually coming up with their own figures. The valuations of a standalone LVLT in an M&A context, and the assumptions behind the methods used, outlined in the S4 are shown below.

click to enlargelevel-3-valuations-from-s4-december-2016

The valuations are generally consistent around a $60 per share level, varying from $50 to $70. Most include the value of the NOLs with Citi estimating their value separately at approximately $7 per share. A number of the bankers also valued the targeted synergies of the deal assuming 100% of these were assigned to LVLT shareholders. These estimates and the valuations of a standalone CTL are shown below.

click to enlargelvlt-and-ctl-valuations-from-s4-december-2016

Comparing the average LVLT standalone valuations and those including the synergies shows a value of $25 per share (i.e. $84-$59), assuming shareholders get 100% of the synergies. That assumption is clearly unrealistic. If 50% of the synergies were assigned to LVLT shareholders (who will get 49% of the combined entity), than a reasonable expectation in the longer run would be a value equivalent to $72 per share. As can be seen below, this is equivalent to a share price of $32 per share for CTL under the merger terms. BofA Merrill Lynch and Morgan Stanley in the S4 calculated a proforma value of CTL after the merger (with the synergies realised) of $34.75 which would put the value of the deal to LVLT shareholders around $76 per share, as below.

click to enlargecenturylink-level-3-merger-deal-2

With CTL’s stock still trading just over $24, there is obviously a lot that can happen before this proposed merger closes. And even more time before the deal synergies are realised. One thing is for sure through, the investment bankers are making out well as the exhibit on their fees below shows. $25 million alone for a few week’s work to provide the fairness opinions is outrageous.

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The amount of such fees investment bankers get away with charging always boggles the mind and shows what a closed shop the business still is. Whatever happens to LVLT and CTL shareholders, these masters of the universe always make out like bandits.

So….2016

As the first week of January progressed and markets tumbled, I was thinking about this post and couldn’t get away from the thought that 2016 feels very like 2015. The issues that were prominent in 2015 are those that will be so again in 2016 plus a few new ones. The UK vote on the EU and a US presidential race are just two new issues to go with China economic and political uncertainty, Middle East turmoil, Russian trouble making, a political crisis in Brazil, the insidious spread of terrorism, a move towards political extremes in developed countries and the on-going fault lines in Europe and the Euro. All of these macro factors together with earnings and the impact of rising interest rates are going to dominate 2016.

2015 joins two other years, 2011 and 1994, in being a -1% year for the S&P500 in recent times, as the graph below shows. In fact, the movements of the S&P500 in 2015 show remarkable similarity with 2011. However, there the similarities end. 2011 was the year of the Euro crisis, the Arab spring and the Japan quake. Interest rates were falling, earnings stable, and PE multiples were around 15. 1994 was even more different than 2015. In 1994, the economy was taking off and the Fed was aggressively raising rates, earnings were stable and PE multiples fell to around 15. Interesting the next 5 years after 1994 on the stock market were each 20%+ years! With 2015 around a 20 PE and earnings falling, the comparisons are not favourable and may even suggest we got off lightly with just a -1% fall.

click to enlargeS&P500 Years Down -1%

A recent article in the FT does point to the influence of a limited number of stocks on the 2015 performance with the top 10 stocks in the S&P500 up 14% in 2015 and the remaining 490 stocks down 5.8% collectively. The performance of the so-called nifty nine is shown below. The article highlights that “dominance by a few big companies – or a “narrowing” market – is a symptom of the end of a bull run, as it was in the early 1970s (dominated by the “Nifty Fifty”) or the late 1990s (dominated by the dot-coms).”

click to enlargeS&P500 vrs Nifty Nine

Bears have long questioned valuations. The impact of continuing falls in oil prices on energy earnings and a fall off in operating margins are signalling a renewed focus on valuations, as the events of this past week dramatically illustrate. A graph of the PE10 (aka Shiller CAPE) as at year end from the ever insightful Doug Short shows one measure of overvaluation (after this week’s fall the overvaluation on a PE10 basis is approx 30%).

click to enlargeS&P500 Valuation PE10 Doug Short

One of the longstanding bears, John Hussman, had an article out this week called “The Next Big Short”, in honour of the movie on the last big short. Hussman again cites his favourite metrics of the ratio of nonfinancial market capitalization to corporate gross value added (GVA) and the ratio of nonfinancial corporate debt to corporate GVA (right scale) as proof that “the financial markets are presently at a speculative extreme”.

click to enlargeHussman Market Cap to GVA

Many commentators are predicting a flat year for 2016 with some highlighting the likelihood of a meaningful correction. Whether the first week in January is the beginning of such a correction or just a blip along the path of a continually nervous market has yet to be seen. Analysts and their predictions for 2016 have been predictably un-inspiring as the graph below shows (particularly when compared to their 2015 targets).

click to enlarge2016 S&P500 Analyst Targets

Some, such as Goldman Sachs, have already started to reduce their EPS estimates, particularly for energy stocks given the increasingly negative opinions on oil prices through 2016. The 12 month forward PEs by sector, according to Factset Earning Insight dated the 8th of January as reproduced below, show the different multiples explicit in current estimates with the overall S&P500 at 15.7.

click to enlargeS&P500 Sector Forward PE Factset 08012016

Current earnings estimates for 2016 as per the latest Yardeni report (EPS growth graph is reproduced below), look to me to be too optimistic compared to the trends in 2015 and given the overall global economic outlook. Future downward revisions will further challenge multiples, particularly for sectors where earnings margins are stagnating or even decreasing.

click to enlargeS&P500 Earnings Growth 2016 Yardeni

To further illustrate the experts’ views on EPS estimates, using S&P data this time, I looked at the evolution in actual operating EPS figures and the 2015 and 2016 estimates by sector, as per the graph below.

click to enlargeS&P500 Operating EPS by sector

With US interest rates rising (albeit only marginally off generational lows), the dollar will likely continue its strength and higher borrowing costs will influence the environment for corporate profits. Pent up labour costs as slack in the US economy reduces may also start to impact corporate profits. In this context, the EPS estimates above look aggressive to me (whilst accepting that I do not have detailed knowledge on the reasoning behind the EPS increases in individual sectors such as health care or materials), particularly when global macro issues such as China are added into the mix.

So, as I stated at the start of this post, the outlook for 2016 is looking much like 2015. And perhaps even a tad worse.

Goodbye 2014, Hello 2015!

So, after the (im)piety of the Christmas break, its time to reflect on 2014 and look to the new year. As is always the case, the world we live in is faced with many issues and challenges. How will China’s economy perform in 2015? What about Putin and Russia? How strong may the dollar get? Two other issues which are currently on traders’ minds as the year closes are oil and Greece.

The drop in the price of oil, driven by supply/demand imbalances and geo-political factors in the Middle East, was generally unforeseen and astonishing swift, as the graph of European Brent below shows.

click to enlargeEuropean Brent Spot Price 2004 to 2014

Over the short term, the drop will be generally beneficial to the global economy, acting like a tax cut. At a political level, the reduction may even put manners on oil dependent states such as Iran and Russia. Over the medium to long term however, it’s irrational for a finite resource to be priced at such levels, even with the increased supply generated by new technologies like fracking (the longer term environmental impacts of which remain untested). The impact of a low oil price over the medium term would also have negative environmental impacts upon the need to address our carbon based economies as highlighted in 2014 by the excellent IPCC reports. I posted on such topics with a post on climate models in March, a post on risk and uncertainty in the IPCC findings in April, and another post on the IPCC synthesis reports in November.

The prospect of another round of structural stresses on the Euro has arisen by the calling of an election in late January in Greece and the possible success of the anti-austerity Syriza party. Although a Greek exit from the Euro seems unlikely in 2015, pressure is likely to be exerted for relief on their unsustainable debt load through write offs. Although banking union has been a positive development for Europe in 2014, a post in May on an article from Oxford Professor Kevin O’Rourke outlining the ultimate need to mutualise European commitments by way of a federal Europe to ensure the long term survival of the Euro. Recent commentary, including this article in the Economist, on the politics behind enacting any meaningful French economic reforms highlights how far Europe has to go. I still doubt that the German public can be convinced to back-stop the commitments of others across Europe, despite the competitive advantage that the relatively weak Euro bestows on Germany’s exporting prowess.

Perpetually, or so it seems, commentators debate the possible movements in interest rates over the coming 12 months, particularly in the US. A post in September on the findings of a fascinating report, called “Deleveraging, What Deleveraging?”, showed the high level of overall debt in the US and the rapid increase in the Chinese debt load. Although European debt levels were shown to have stabilised over the past 5 years, the impact of an aggressive round of quantitative easing in Europe on already high debt levels is another factor limiting action by the ECB. The impact of a move towards the normalisation of interest rates in the US on its economy and on the global economy remains one of the great uncertainties of our time. In 2015, we may just begin to see how the next chapter will play out.

Low interest rates have long been cited as a factor behind the rise in stock market valuations and any increase in interest rates remains a significant risk to equity markets. As the graph below attests, 2014 has been a solid if unspectacular year for nearly all equity indices (with the exception of the FTSE100), albeit with a few wobbles along the way, as highlighted in this October post.

click to enlarge2014 Stock Indices Performance

The debate on market valuations has been an ever-present theme of many of my posts throughout 2014. In a March post, I continued to highlight the differing views on the widely used cyclically adjusted PE (CAPE) metric. Another post in May highlighted Martin Wolf’s concerns on governments promoting cheap risk premia over an extended period as a rational long term policy. Another post in June, called Reluctant Bulls, on valuations summarized Buttonwood’s assertion that many in the market were reluctant bulls in the absence of attractive yields in other asset classes. More recently a post in September and a post in December further details the opposing views of such commentators as Jim Paulsen, Jeremy Siegel, Andrew Lapthorne, Albert Edwards, John Hussman, Philosophical Economics, and Buttonwood. The debate continues and will likely be another feature of my posts in 2015.

By way of a quick update, CAPE or the snappily named P/E10 ratio as used by Doug Short in a recent article on his excellent website shows the current S&P500 at a premium of 30% to 40% above the historical average. In his latest newsletter, John Hussman commented as follows:

“What repeatedly distinguishes bubbles from the crashes is the pairing of severely overvalued, overbought, overbullish conditions with a subtle but measurable deterioration in market internals or credit spreads that conveys a shift from risk-seeking to risk-aversion.”

Hussman points to a recent widening in spreads, as illustrated by a graph from the St Louis Fed’s FRED below, as a possible shift towards risk aversion.

click to enlargeFRED High Yield vrs AAA Spread Graph

The bull arguments are that valuations are not particularly stressed given the rise in earnings driven by changes to the mix of the S&P500 towards more profitable and internationally diverse firms. Critics counter that EPS growth is being flattered by subdued real wage inflation and being engineered by an explosion in share buybacks to the detriment of long term investments. The growth in quarterly S&P500 EPS, as illustrated below, shows the astonishing growth in recent years (and includes increasingly strong quarterly predicted EPS growth for 2015).

click to enlargeS&P500 Quarterly Operating & Reported EPS

A recent market briefing from Yardeni research gives a breakdown of projected forward PEs for each of the S&P500 sectors. Its shows the S&P500 index at a relatively undemanding 16.6 currently. In the graph below, I looked at the recent PE ratios using the trailing twelve month and forward 12 month operating EPS (with my own amended projections for 2015). It also shows the current market at a relatively undemanding level around 16, assuming operating EPS growth of approx 10% for 2015 over 2014.

click to enlargeS&P500 Operating PE Ratios

The focus for 2015 is therefore, as with previous years, on the sustainability of earnings growth. As a March post highlighted, there are concerns on whether the high level of US corporate profits can be maintained. Multiples are high and expectations on interest rates could make investors reconsider the current multiples. That said, I do not see across the board irrational valuations. Indeed, at a micro level, valuations in some sectors seem very rational to me as do those for a few select firms.

The state of the insurance sector made up the most frequent number of my posts throughout 2014. Starting in January with a post summarizing the pricing declines highlighted in the January 2014 renewal broker reports (the 2015 broker reports are due in the next few days). Posts in March and April and November (here, here and here) detailed the on-going pricing pressures throughout the year. Other insurance sector related posts focussed on valuation multiples (here in June and here in December) and sector ROEs (here in January, here in February and here in May). Individual insurance stocks that were the subject of posts included AIG (here in March and here in September) and Lancashire (here in February and here in August). In response to pressures on operating margins, M&A activity picking up steam in late 2014 with the Renaissance/Platinum and XL/Catlin deals the latest examples. When seasoned executives in the industry are prepared to throw in the towel and cash out you know market conditions are bad. 2015 looks to be a fascinating year for this over-capitalised sector.

Another sector that is undergoing an increase in M&A activity is the telecom sector, as a recent post on Europe in November highlighted. Level3 was one of my biggest winners in 2014, up 50%, after another important merger with TW Telecom. I remain very positive on this former basket case given its operational leverage and its excellent management with a strong focus on cash generation & debt reduction (I posted on TWTC in February and on the merger in June and July). Posts on COLT in January and November were less positive on its prospects.

Another sector that caught my attention in 2014, which is undergoing its own disruption, is the European betting and online gambling sector. I posted on that sector in January, March, August and November. I also posted on the fascinating case of Betfair in July. This sector looks like one that will further delight (for the interested observer rather than the investor!) in 2015.

Other various topics that were the subject of posts included the online education sector in February, Apple in May, a dental stock in August, and Trinity Biotech in August and October. Despite the poor timing of the August TRIB call, my view is that the original investment case remains intact and I will update my thoughts on the topic in 2015 with a view to possibly building that position once the selling by a major shareholder subsides and more positive news on their Troponin trials is forthcoming. Finally, I ended the year having a quick look at Chinese internet stocks and concluded that a further look at Google was warranted instead.

So that’s about it for 2014. There was a few other random posts on items as diverse as a mega-tsunami to correlations (here and here)!

I would like to thank everybody who have taken the time to read my ramblings. I did find it increasingly difficult to devote quality time to posting as 2014 progressed and unfortunately 2015 is looking to be similarly busy. Hopefully 2015 will provide more rich topics that force me to find the time!

A very happy and health 2015 to all those who have visited this blog in 2014.