The great thing about leverage is that, while it works, it is very profitable and it feels really good.  The bad thing about leverage is that, when it doesn’t work, it can bankrupt you quickly and it feels very bad.

This boom/bust scenario manifested itself in the housing market.  I’m fairly convinced that, given the monetary environment, this same equation and outcome will happen again.

Today, we are re-evaluating some of the high flying stocks we own, like KMB which was highlighted in Joe Calhoun’s column last week.

From 30,000 feet, Kimberly-Clark is a toilet paper, “kleenex” and diaper factory.  A box that takes organic materials in the back door, applies a proprietary process and ships a finished product out the front door to someone else’s warehouse or retail shelf.

One can often make an analogy to something familiar to get a sense of the value being provided by an investment.  What if KMB were just a house or piece of real estate?  Would its price seem a bit excessive?

As a landlord, you receive rental income, the current economic benefit of the housing.  This is akin to operating income, the economic benefit that flows to KMB for providing the world with toilet paper.  As landlord, you then pay a capital charge (interest and taxes) and whatever is left would be profit (net income).

Here is Kimberly-Clark as a “property” at its basic level:

  • The bricks and mortar cost plus all upgrades and accoutrements = $19.87bln (Total Assets).
  • It has a $14.88bln mortgage (Total Liabilities).
  • There is a $5bln down payment (Total Equity).
  • Rent is $2.68bln. (Operating Income)
  • Mortgage, insurance and taxes are $930mln (Capital Costs).
  • profit is $1.75bln (Net Income).

Let’s divide everything by $100,000 to make the numbers more familiar and more similar to real life housing.

  • A $198,700 house
  • A $148,800 mortgage
  • $50,000 equity/down payment
  • Current rent of $26800/yr or $2233/mo
  • Current landlord mortgage payment 775/mo
  • Profit = $1458/mo or $17,500/yr

This KMB house, that cost 198,700 to build, has been kept in sparkling condition and now has a market value of:

Equity equals $99/shr on about 390 million shares; we then divide by 100,000 for our hypothetical.

  • $386,000 equity/down payment
  • $148,800 mortgage

equals

  • $535,000 for the house

In real estate terms this equates to a cap rate of 3.27% ($17,500/$535,000).  A $200,000 house going for $535,000 feels eerily familiar.  This is very expensive relative to history.  At current revenue growth rates, it is just expensive period.  The risk/return equation presented by current valuations is the primary reason we sold KMB this week in our Global Opportunities Portfolio.

In an environment like today’s, risk can be hidden in the financials.  Recent performance, lack of alternatives or even impatience can abet the obscuring of risk.   I don’t personally support what Bernanke is doing; but, we must play the hand he has dealt us.  The Fed has manipulated the cost of debt capital, incentivized leverage and increased risk.  In today’s world, it is prudent to reduce the risk of the overall portfolio to compensate for the increased risk in company balance sheets and in the general economic environment.

As stated above, the fundamentals aren’t as rosy as analysts have been predicting.  Revenue only grew 1% last year and net margins are 8.3%.  For the last decade, revenue growth has averaged 3.7% and margins have averaged 9.6%.  This is much of the reason for rosy “forecasts” in the first place.  I think 1% sales growth this year and continued margin contraction would cause this stock to slide 20%.  Flat revenue is not out of the question, this would be more damaging.  Earnings are coming up and we would like to pare exposure to such negative event.

Pictorially, here is what the extra risk looks like, Price/Book ratios increase.  Notice the increase in the market value of equity but not the book value over the last 2+ years.  This is leverage added at a very low cost of debt.

KMB is a good company, perhaps a great company.  Management has executed exactly as expected given the availability of cheap debt capital.  They have not used debt to finance growth, but to lower capital costs and change their capital structure.  This has provided equity owners with large returns.  But, nothing comes for free.  Having already realized good returns, we feel like we will not be compensated properly going forward for the level of risk.  We are aware that Bernanke may be successful at creating a bigger bubble.  But, at these valuations, we felt compelled to take profits and reduce the risk in the portfolios.

KMB

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“Wealth preservation and accumulation through thoughtful investing.”

For information on Alhambra Investment Partners’ money management services and global portfolio approach, Douglas R. Terry, CFA is reachable at: dterry@4kb.d43.myftpupload.com

Disclaimer: The information, data, analyses and opinions contained herein (1) include the confidential and proprietary information of Alhambra Investment Partners LLC, do not constitute investment advice offered by Alhambra,  are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and are not warranted to be correct, complete or accurate. Except as otherwise required by law, Alhambra shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, this information, data, analyses or opinions or their use.