September 2018 – Sale of Flower’s Foods, Inc. (FLO)
Over the past couple of weeks I have spent time checking on the health of my active equity portfolio. This included a review of my asset allocation to see if it warranted any rebalancing, as well as individually scrutinizing each of my holdings. While this will not be a post that delves into my overall strategic asset allocation decisions, it is a review of why I made some recent tactical moves. I recognized that my cash position was a bit light given the current valuation of equities and at roughly 5% of my portfolio I did not feel as though I had enough fire power to take advantage of a sell off.
I have no interest in timing the market and realize that it is a sucker’s game for most. I do not believe I have the time, nor resources at my disposal to do the type of due diligence necessary to make informed “market-timing” decisions. Even then, it would most likely be a horrendous attempt. I do, however, pay attention to the macro-environment that I am investing in and make tactical adjustments in an attempt to manage risk. After a decade long bull-market I have noticed that it is becoming harder to find value in today’s equity market.
The economic indicator first made famous by Warrant Buffet that is used consistently by value investors, known as the “Buffet Indicator”, or total market cap (TMC) relative to gross national product (GNP), is pointing to a stretched US equity market. At the time of writing, the Wilshire 5000 Total Market Index sits at 30,091.3 billion, or 150% of the latest report on US GNP. That is the highest that the ratio has ever been dating back to 1971, reaching only 141% just prior to the bursting of the tech bubble in 2000. There are reasons one could allude to in an attempt to explain why the equity markets are at these levels. Analysts point to strong earnings growth, low unemployment and tax cuts, and, while speaking out of both sides of their mouth, remind us of trade wars and geopolitical risks that could derail the economy. Meanwhile, the schiller ratio for the S&P 500 sits at 33.1x, much closer to the 43x it hit just before the tech bubble burst than the 7x level seen in the early 1980’s. In my opinion, US equities seem rich and prices could revert if there is a significant shock to the economy. I can’t say for certain what will happen when a significant amount of liquidity is pulled out of the market by the Federal Reserve unwinding their balance sheet. What would be the impact of a rise in interest rates have on the portfolio? Investments compete for investor money and if rates rise, other assets will adjust accordingly. At 2.9%, the 10yr yield has been bumping up against 3% for some time now. What if the yield curve were to adjust and rates move to 5%? 7%? Should we be worried about inflation? What would hyper-inflation, or even stagflation do to the equity markets? Quite frankly we don’t know which direction equity markets or interest rates will go, but I’m seeing that there is a lot more room to the downside and I want to be prepared to put money to work at more favorable implied returns.
As such, I have decided to take some chips off the table and increase my cash holding. I sold all my shares in Flowers Foods, Inc. (FLO), netting a solid 17% annualized return since I purchased the stock in Late 2016. This will almost double my cash position to roughly 10% of the portfolio giving me a decent war chest, relatively speaking. I only held FLO for about 2 years and was sitting on a 35% total gain. Typically, I don’t like to sell my holdings at the first sign of trouble or overvaluation because I believe that letting the winner’s run has worked for several successful investors. It’s simple, good company’s continue to produce quality earnings that fuel growth.
But the decision was two-fold. The first consideration being my desire to increase cash and the second being the fundamentals of the company. The company has now been moved to my watchlist and I’ll continue to check back on it from time to time. Here are some of the main drivers that lead me to believe the company’s growth may be tepid moving forward:
· Revenues have been pretty flat over the last 3 years
· Operating margin has declined roughly 2.6% annually over the last 5 years
· Net Margin has fallen to its lowest point since 2005
· Dividend payout ratio has steadily climbed and is currently greater than 100%
· FCF as a percent of revenues has declined over 200 bps, falling to 4.5% on TTM basis
· ROE & ROA have steadily declined over the past couple of years
· P/E and P/FCF ratios are stretched on a historical basis at 30x and 23x respectively
This was not what I had anticipated when I bought FLO. Essentially, growth has slowed, margins are being compressed and this is having a negative impact on free cash flow. The dividend isn’t as sustainable as I had originally thought and could potentially be frozen. Without much growth in the business or the dividend, my returns are susceptible to a compression in multiples, which are on the higher end of the company’s averages from the last decade and tend to revert over time. I’m comfortable taking profits here to de-risk and not to chase other investments.
One last piece to note is that I do intend to hold roughly a 10% cash position for the foreseeable future. This means that new purchases will need to come from fresh capital that I save or that is provided through my dividend income. I will have an updated portfolio displayed in the author’s section.
Thoughts? Questions? What does your cash position look like? How do you decide when is a good time to sell?