Data from China suggests that economic activity could resume after initial containment and not trigger new COVID-19 cases

Summary

- A study was published in early 2020 by Ainslie and colleagues (), suggesting that, after initial containment is achieved, within-city movement (measured through a “Movement Index”) seems to be uncorrelated with new COVID-19 cases.

- Within-city movement is used in the study as a proxy for economic activity.

- Economic activity seems to have successfully resumed within approximately 2 weeks from containment, and approximately 4 weeks from the peak of new cases.

Within-city movement vs. new COVID-19 cases

The graphs below summarize key results from a study published in early 2020 by Ainslie and colleagues (). Dr. Ainslie is in the Faculty of Medicine, School of Public Health, Imperial College London. The study looked at within-city movement, as a proxy for economic activity, and how that movement has influenced the numbers of new cases of COVID-19 in various areas, after initial containment.

As you can see, after initial containment is achieved, within-city movement (measured through a “Movement Index”) seems to be uncorrelated with new COVID-19 cases; or somewhat negatively correlated, as the authors note. This rather surprising and counterintuitive outcome may be due to people becoming much more cautious about social interactions.

Time to resumption of economic activity

Note from the graphs that economic activity seems to resume within approximately 2 weeks from containment, and approximately 4 weeks from the peak of new cases.

Also note that containment has been fairly effective in China. The Chinese government has enforced it through strict lockdowns. Perhaps this is what makes people so cautious about social interactions afterwards, which we speculate might be at the source of the success of their strategy.

From an economic revival perspective, these are good news – particularly if the same approach can be replicated in other countries and regions.

A simulation-based valuation of DXC Technology (DXC): March 2020

Summary

- DXC Technology (DXC) is a technology consulting and services company headquartered in Tysons Corner, Virginia ().

- Launched in April of 2017, DXC was created from the merger of Computer Sciences Corporation (CSC) and the Enterprise Services division of Hewlett Packard Enterprise (HPE).

- In this post we provide a simulation-based (sim-based) valuation () of DXC.

- Our results suggest the following fair values – stock price: $64.12, and price-to-earnings ratio: 9.96.

- DXC currently trades at $15.14, so it appears to be undervalued, with a potential upside of 323.51%.

DXC Technology (DXC)

DXC Technology (DXC) is a technology consulting and services company headquartered in Tysons Corner, Virginia. Launched on April 3, 2017, DXC was created from the merger of Computer Sciences Corporation (CSC) and the Enterprise Services division of Hewlett Packard Enterprise (HPE).

The company operates in more than 70 countries, and counts among its customers several federal and regional government agencies. In many ways DXC is similar to Accenture (ACN). In fact, DXC has a new CEO, Mike Salvino, who previously served as group CEO for Accenture Operations.

Estimating a fair value for the stock

In this post we provide a simulation-based (sim-based) valuation () of DXC.

At the time of this writing the company had a negative net profit margin of -8% and a price-to-sales ratio of 0.26. The company has great growth potential, as long as it transitions from legacy technology services to more modern offerings (e.g., cloud applications). This transition seems to be a major focus of the new CEO.

To be somewhat conservative, we will use recent numbers from Accenture to set our sim-based estimated earnings growth rate for the next 5 years (6.47%) and net profit margin (11.06%). We believe this to be a conservative approach because DXC is much smaller than Accenture; e.g., DXC’s revenues are about half of Accenture’s.

Another reason why we believe the above is a conservative approach is that it is quite possible that we currently are in a recession (yes, already), in which case earnings growth should be much higher than it is now in the near future. Sales are likely to go up, and so should earnings – the latter at a faster pace, leading to higher margins for many of DXC’s services (the same goes for Accenture).

The table below summarize our sim-based results.

Since our sim-based analysis uses a S&P 500 return as a basis, our results summarized on the table above suggest the following fair values – stock price: $64.12, and price-to-earnings ratio: 9.96. DXC currently trades at $15.14, so it appears to be undervalued, with a potential upside of 323.51%. Yes, you read it right. The company seems to be more than simply cheap; it appears to be dramatically undervalued at the moment.

Note that we assumed a positive net profit margin of 11.06% for a company that actually has a net profit margin of -8%. This type of assumption is useful in valuing companies that have a negative profit margin, which is often the case with companies that have been experiencing problems; as well as high-growth companies that have been publicly-traded for only a few years.

Other pluses and minuses

DXC pays an attractive dividend of 5.11%, significantly higher than the average S&P 500 dividend. With DXC’s market capitalization of $5 billion, this translates to roughly $255 million per year given out in dividends. DXC has $2.56 billion in cash, so we think that the dividend currently is relatively safe, and will continue being so for several years to come.

While certainly leveraged, DXC has a reasonably attractive balance sheet, with EBITDA in the neighborhood of $3.26 billion. This, added to its cash position of $2.56 billion mentioned above, is actually lower than half of its $10.49 billion dollar debt. So, DXC is leveraged, but much less so than many other companies with much higher valuations.

Is DXC a value trap?

Why does DXC look so undervalued? The reason is a combination of what appears to have been a period of disorganized growth, bad management decisions, somewhat disappointing guidance, the resignation of the former CEO in late 2019; and now, to cap all of this, we have the coronavirus pandemic.

Given the new CEO’s caliber, it is reasonable to expect better stewardship of resources. The coronavirus pandemic is prompting major actions from the US government, including interest rate cuts that should make it easier for DXC to service its debt.

The US government is also promising “as much liquidity as needed”, to avoid layoffs. This means essentially unlimited credit to companies, so that unemployment remains low; this promised by the entity that can print unlimited amounts of it is own currency, the US dollar.

The mighty Office of the US President is fully committed. And we are in an election year. Note that it is not a recession that creates re-election problems for an incumbent US President. Those problems are actually caused by the significant rise in unemployment that usually accompanies a recession. And there can be a recession without unemployment, at least in theory, as long as the country is willing to get into debt up to its ears.

It does not seem like DXC is a value trap; at least not at the current levels. DXC is currently trading at prices not seen since 2012. It has reached a high in the mid-$90s quite recently, in late 2018. If anything, it looks like a big opportunity for investors, as long as the US government keeps its promises of liquidity to address coronavirus-induced sales losses.

Disclosure

The author owns DXC shares at the time of this writing.

A simulation-based valuation of Conn's, Inc. (CONN): February 2020

Summary

- CONN is an American furniture, mattress, electronics and appliance store chain headquartered in The Woodlands, Texas ().

- In this post we provide a simulation-based (sim-based) valuation () of CONN.

- At the time of this writing, the company had a rather low trailing twelve months price-to-earnings ratio of 3.62.

- According to our sim-based analysis, the fair price-to-earnings ratio should be 5.46, leading to a current fair value of $13.81.

- CONN currently trades at $9.16, so it appears to be undervalued, with a potential upside of 50.76%.

- The above conservatively assumes a negative earnings growth rate. Let us say that the company manages to simply have no growth (i.e., 0% growth) in earnings for the next 5 years, instead of negative growth. In this case, our sim-based analysis suggests that the fair price-to-earnings ratio should be 7.19, leading to a current fair value of $18.20. This would mean a potential upside of 98.69%.

Conn's, Inc. (CONN)

CONN is an American furniture, mattress, electronics and appliance store chain headquartered in The Woodlands, Texas (). The company caters to credit-challenged customers, and also operates in the lease-to-own space. It has been around for a long time. It was founded in 1890 as Eastham Plumbing and Heating Company, having been renamed as Conn's in 1934.

Estimating a fair value for the stock

In this post we provide a simulation-based (sim-based) valuation of CONN. The foundation of this approach is explained in a previous post ().

At the time of this writing, the company had a rather low trailing twelve months price-to-earnings ratio of 3.62. The expected growth in earnings for the next 5 years is uncertain. Based on the most recent earnings report, when the company beat estimates, the expectation is that earnings will drop by approximately 5.55% in the near future. To be conservative, we will consider this value, of -5.55%, to be the sim-based earnings growth rate for the next 5 years.

Is the low price-to-earnings ratio of 3.62 suggestive of actual undervaluation? As you can see in the table below, the answer to this question seems to be “yes”. Since our sim-based analysis uses a S&P 500 return as a basis, the fair price-to-earnings ratio should be 5.46, leading to a current fair value of $13.81. CONN currently trades at $9.16, so it appears to be undervalued, with a potential upside of 50.76%.

Keep in mind that the above assumes a negative growth rate. Let us say that the company manages to simply have no growth (i.e., 0% growth) in earnings for the next 5 years, instead of negative growth. In this case, our sim-based analysis suggests that the fair price-to-earnings ratio should be 7.19, leading to a current fair value of $18.20. This would mean a potential upside of 98.69%.

Other pluses and minuses

The business in which CONN operates is less likely to be affected by what has been called the Amazon-driven “retail apocalypse”. Moreover, CONN can be seen as a somewhat defensive stock in the case of an economic downturn, since it primarily caters to credit-challenged customers. When the economy slows down, the number of credit-challenged individuals usually goes up.

Having said that, an economic downturn could lead to an increase in defaults, potentially hurting CONN’s ability to collect from its customers. One way to address this challenge would be to increase CONN’s participation in the lease-to-own space, but in a way that would allow it to operate more as a renter of its products. This seems to be a direction that CONN’s management is looking at carefully in recent quarters.

In the last two quarters, the company bought almost $100 million of its own stock, which makes sense given that the stock price has gone down so much. It has also been retiring debt at a very healthy pace, although it is still very leveraged. Last quarter, however, it issued about $8 million in debt, in part to buy its own shares – about $58 million worth of shares were purchased.

Short sellers may be interpreting the above share purchases as an attempt to prop up the stock price. The current short interest as a percentage of float is a frightening 65.96%. Still, it is hard to question the logic of buying your own shares when they are so cheap, especially given that interest rates are at their lowest point in years. If the company were to re-issue its shares at the more conservative fair value we estimated in this post, it could make a significant profit, which it could use to reduce its debt further.

There is no evidence that the company is anything but conservative in its future earnings growth  projections. It has beaten earnings expectations in at least the last 10 quarters, often by a large margin.

Disclosure

The author owns CONN shares at the time of this writing.

A simulation-based valuation of Aaron's, Inc. (AAN): January 2020

Summary

- AAN is a lease-to-own retailer headquartered in Atlanta, Georgia ().

- At the time of this writing the company had a trailing twelve months price-to-earnings ratio of 21.

- Our simulation-based valuation suggests a fair price-to-earnings ratio of 23.93, leading to a current fair value of $70.18.

- AAN currently trades at $61.58, so it appears to be undervalued, with a potential upside of 13.97%.

- If the growth in earnings is what analysts are currently expecting, namely around 30%, our potential upside may be significantly underestimated. In that case, the fair value of the stock would be $94.96.

Aaron's, Inc. (AAN)

AAN is a lease-to-own retailer headquartered in Atlanta, Georgia (). It focuses on leases and retail sales of furniture, electronics, appliances, and computers. Its acquisition of Progressive Finance in 2014 positioned AAN as the leader in the rent-to-own (RTO) industry, which helps credit-challenged customers gain access to goods they would have otherwise been unable to afford.

Estimating a fair value for the stock

In this post we provide a simulation-based (sim-based) valuation () of AAN.

At the time of this writing the company had a trailing twelve months price-to-earnings ratio of 21. The expected growth in earnings for the next 5 years is a high 21.50%. Even though it is high, this growth number may be an underestimation given the current spread in estimates for trailing and forward price-to-earnings ratios: 21 and 14.3. To be more consistent with this spread, we will consider the value of 23.89% to be the sim-based earnings growth rate for the next 5 years.

Is the price-to-earnings ratio of 21 suggestive of undervaluation? As you can see in the table below, the answer to this question seems to be “yes”. Since our sim-based analysis uses a S&P 500 return as a basis, the fair price-to-earnings ratio should be 23.93, leading to a current fair value of $70.18. AAN currently trades at $61.58, so it appears to be undervalued, with a potential upside of 13.97%.

Is the fair price-to-earnings ratio of 23.93 too high?

Could the fair price-to-earnings ratio estimated above, of 23.93, be too high? Arguably the answer is “no”, because of the expected growth in AAN’s earnings (see: ). In fact, if the growth in earnings is what analysts are currently expecting, namely around 30%, our potential upside may be significantly underestimated. In that case, the fair value of the stock would be $94.96.

Other pluses and minuses

AAN is not leveraged. The sum of its cash (and equivalents) and its EBITDA (earnings before interest, taxes, depreciation, and amortization) is higher than the company’s debt. Its dividend is not very attractive at the moment, at 0.26%, but the current payout ratio is a low 4.81%. This means that the dividend could be easily raised. In the meantime, the company seems to be using its available cash for other purposes that have a positive impact on earnings, including share buybacks – justified base on AAN’s current relatively low valuation.

The business in which AAN operates is less likely to be affected by what has been called the Amazon-driven “retail apocalypse”. Moreover, AAN can be seen as a somewhat defensive stock in the case of an economic downturn, since it primarily caters to credit-challenged customers. When the economy slows down, the number of credit-challenged individuals usually goes up.

Disclosure

The author owns AAN shares at the time of this writing.

A simulation-based valuation of American Eagle Outfitters (AEO): December 2019

Summary

- AEO is a clothing and accessories retailer based in Pittsburgh, Pennsylvania ().

- At the time of this writing the company had a trailing twelve months price-to-earnings ratio of 9.95.

- A simulation-based (sim-based) valuation () suggests that the fair price-to-earnings ratio is 16.73, leading to a fair share value of $23.62.

- AEO currently trades at $14.05, so it appears to be undervalued, with a potential upside of 68.11%.

American Eagle Outfitters (AEO)

AEO is a clothing and accessories retailer based in Pittsburgh, Pennsylvania (). It focuses on casual apparel, accessories, and footwear for men and women aged 15–25 years. Notably, it sells intimates, apparel, and personal care products for women under the Aerie brand; this is a major growth engine for the company.

AEO does not own or operate any manufacturing facility. As such, it depends on third-party manufacturers for all of its merchandise. The company’s operations may be negatively affected by import disruptions. Trade-related unpredictability is not good for this company. On the other hand,  such unpredictability also regularly offers attractive entry points for investors.

Estimating a fair value for the stock

In this post we provide a simulation-based (sim-based) valuation () of AEO.

At the time of this writing the company had a trailing twelve months price-to-earnings ratio of 9.95. The growth in earnings for the past 5 years has been on average 27.87%, but has recently (trailing twelve months) gone down to 5.56%. To be conservative, we will consider the mid-point between these two numbers, or 16.76%, to be the sim-based earnings growth rate for the next 5 years.

Is the price-to-earnings ratio of 9.95 suggestive of undervaluation? As you can see in the table below, the answer to this question seems to be “yes”. Since our sim-based analysis uses a S&P 500 return as a basis, the fair price-to-earnings ratio should be 16.73, leading to a current fair value of $23.62. AEO currently trades at $14.05, so it appears to be undervalued, with a potential upside of 68.11%.

Is the fair price-to-earnings ratio of 16.73 too high?

Could the fair price-to-earnings ratio estimated above, of 16.73, be too high? Arguably the answer is “no”, because AEO’s price-to-earnings ratio for the past 5 years has been on average 19.80. In fact, given this, our potential upside may be underestimated.

Other pluses and minuses

AEO pays an attractive dividend of 3.64%, significantly higher than the average S&P 500 dividend, and with a comfortable payout ratio of 36.47%. It has an attractive balance sheet, with $317 million in cash, and no debt – unlike other retailers being affected by what has been called the Amazon-driven “retail apocalypse”.

Also, AEO has been steadily buying back its shares, and it has not been issuing any new debt to finance this.

Recently the stock has lost about 7% of its value in one single day, after it provided “soft” Q4 guidance in an earnings report. The forward guidance was below what analysts expected, but consistent with the conservative approach to guidance usually adopted by AEO.

Still, even with the soft guidance, AEO reported earnings (bottom line) in line with analyst expectations, and revenues (top line) that beat expectations.

Disclosure

The author owns AEO shares at the time of this writing.

The initial jobless claims data may be very misleading: What really matters is the trend of the “second derivative”

Summary

- Initial jobless claims seems to be going down sequentially as of late.

- But the year-over-year rate of change is clearly going up, and fast.

- Recently the popular business media have been largely reporting the initial jobless claims measure as evidence that the job market is strengthening.

- The reality is that it is weakening, based on this measure, at an alarming rate.

Initial jobless claims

In the US data on initial jobless claims is released by the Department of Labor every week. The measure tracks the number of people who filed initial claims for unemployment benefits in the previous week. This measure is closely followed by the financial markets.

Since the measure is “noisy”, usually the 4-week moving average is followed. As you can see from the graph below, from the FRED (), it seems to go up prior to recessions. The latest data is circled on the right, and it looks like it is going down.

What really matters is the trend of the “second derivative”

The above trend is misleading because, as with most leading indicators of economic slowdowns (including recessions), what really matters is the trend of the change in the rate of change. This trend is frequently referred to as the trend of the “second derivative” of the underlying measure.

Look at the graph below, also from the FRED, which is the percentage change in initial jobless claims compared to the same period in the previous year. It is important to consider the year-over-year rate of change, as we do here, because of the seasonal nature of initial jobless claims.

As you can see on the right, this rate of change (the "second derivative") has been increasing steeply in recent months. This essentially means that the year-over-year rate of change in initial jobless claims has been increasing at a fast rate more recently.

The job market is weakening at an alarming rate

This is an unusual situation because the measure itself, initial jobless claims, seems to be going down sequentially as of late. But its year-over-year rate of change is clearly going up. This tends to precede recessions.

Recently the popular business media have been largely reporting the initial jobless claims measure as evidence that the job market is strengthening. The reality is that it is weakening, based on this measure, at an alarming rate.

A simple analogy

Imagine that you are driving from Houston to Austin. Where you are, at any given time, is the measure. The first derivative is the speed at which you are traveling. The second derivative is the acceleration.

Someone that is following only your location would see any movement toward Austin as progress. Positive speed is also seen as progress. However, if acceleration is negative, at some point you may stop and start going back to Houston ...

A final note

This blog discusses, among other things, simulation-based valuations of companies. Those valuations are based on fundamentals (e.g., earnings and revenues), and assume growth rates that are generally different from those seen in steep economic slowdowns or recessions.

If the stock market “sees” a recession coming, expectations about growth change drastically, usually for the worse. As a result, stock prices (and thus valuations) tend to drop precipitously, often regardless of fundamentals.

A simulation-based valuation of Hong Kong (EWH): October 2019

Summary

- Shares of the exchange-traded fund EWH () track the MSCI Hong Kong Index, which consists of stocks of large companies traded primarily on the Stock Exchange of Hong Kong Limited (SEHK).

- The EWH pays a very attractive dividend of 3.15%, which is higher than the average S&P 500 dividend.

- In this post we provide a simulation-based (sim-based) valuation of shares of the EWH.

- Our sim-based analysis suggests a fair price-to-earnings ratio of 15.30 and a fair valuation of $27.23.

- The EWH currently trades at $22.53, so it appears to be undervalued, with a potential upside of 20.86%.

The Hong Kong exchange-traded fund (EWH)

Shares of the iShares MSCI Hong Kong Index Fund (EWH) track the MSCI Hong Kong Index (). This index consists of stocks of large companies traded primarily on the Stock Exchange of Hong Kong Limited (SEHK).

Estimating a fair value for the shares

In this post we provide a simulation-based (sim-based) valuation () of shares of the EWH.

At the time of this writing, the EWH had a price-to-sales ratio of 2.45 and a price-to-earnings ratio of 12.66, which combined suggest an average net profit margin of 19.35%. The sales growth was a high 8.37%. We should note that US corporations had profit growth of around 10% on GDP growth of approximately 3% in 2018. That is over 3 times as much profit growth as sales growth.

We will conservatively estimate the sim-based earnings growth rate for the next 5 years to be 15% for the EWH, which is less than 2 times sales growth. Taking these various numbers, we arrive at a fair price-to-earnings ratio of 15.30 and a fair valuation of $27.23, as you can see in the table below. The EWH currently trades at $22.53, so it appears to be undervalued, with a potential upside of 20.86%.

The current US-China trade war

The US and China are currently embroiled in a trade war, which is marked by the imposition of tariffs on each other’s goods. Even though Hong Kong is part of China, the tariffs that the US has imposed on China do not apply to Hong Kong. Maintaining this status quo is in China’s best interest, as it adds some room for maneuvering around tariffs in the future via transshipments.

Hong Kong trades more goods in value than its gross domestic product, and half of this trade is via transshipments; i.e., goods that simply travel through Hong Kong, as opposed to being manufactured there. If the US-China trade war intensifies, Hong Kong’s share of exports to the US may increase via: transshipments from Asian countries that are not targeted by US tariffs; shipments of goods manufactured in Hong Kong; and “disguised” transshipments from China.

If the US-China trade war eases, Hong Kong’s share of open (not “under the table”) transshipments from China may increase. This is likely to play out better for Hong Kong, which is also a major financial center. Interestingly, Hong Kong's GDP relative to mainland China's peaked at 27% in the early 1990s, and fell to less than 3% in recent years. This is primarily due to the massive cumulative economic growth in mainland China since the early 1990s. And continued growth in China means growth in Hong Kong as well.

The current protests in Hong Kong

Hong Kong has a history of protests, many of which have involved violence. Usually the protests have a negative short-term impact on the economy, and are followed by a strong economic rebound soon afterwards. If history repeats itself, the EWH, which is now undervalued, should rebound quickly as soon as the protests lose steam. In fact, the current protests are a key reason why the EWH is undervalued.

Other pluses and minuses

The EWH pays a very attractive dividend of 3.15%, which is higher than the average S&P 500 dividend. Since Hong Kong is a country, it is very unlikely that it would go “bankrupt” in the sense that a company could. The companies that make up the EWH could go bankrupt, but they would have been removed from the EWH way before that happened and replaced by companies with better performance.

Moreover, Hong Kong prints its own currency, which gives it some flexibility to stimulate its economy, should that be needed. This flexibility is limited by the fact that the Hong Kong dollar is currently pegged to the US dollar, which may change in case dire circumstances emerge. Any effective stimulus would probably move the EWH up, well before the main street economy actually felt the jolt (the EWH is a leading indicator).

Disclosure

The author owns EWH shares at the time of this writing.