To be a great equity investor means being a knowledgeable credit investor as well. Today’s FA Alpha Daily will focus on a changing trend in the credit markets and how to leverage it for your portfolio”
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Credit markets, compared to the stock market, don’t typically see a lot of dramatic shifts.
Changes tend to occur slowly and over extended periods of time. And to add to the lack of excitement, most equity investors mistakenly think changes in the credit market don’t impact them.
By taking a long-term view, we can see that the U.S. credit markets have seen a significant change over the past 40 years.
The safest credit rating, AAA, has slowly been disappearing. These credits are considered the gold standard, as rating agencies think they have a slim 0.09% chance of defaulting over the next five years.
Although credit rating agencies dropped the ball on mortgage-backed securities, they tend to have a higher batting average with corporate credit ratings, as this is where they spend a majority of their time.
This higher visibility is the reason why the trend in AAA companies over the past 40 years is so telling. It tells us that corporate credit has steadily become riskier over the past four decades.
In 1980, there were 60 companies with a AAA rating.
By 2011, after this pool of companies suffered business issues, leveraged buyouts, and just increased comfort with higher leverage with lower interest rates, only four AAA companies remained.
These four companies were ADP, Inc (ADP), Johnson & Johnson (JNJ), Microsoft (MSFT), and Exxon Mobil (XOM).
By 2016, this number dropped further to just Microsoft and Johnson & Johnson. ExxonMobil was hamstrung after it overinvested and over-leveraged during the shale boom, and ADP has taken on increased leverage.
Moody’s became the first agency in several years to award a new AAA rating, as it did for Apple (AAPL) in late 2021. It joins Johnson & Johnson (JNJ) and Microsoft (MSFT) as the only three companies with a AAA rating from and of the Big 3, and in our opinion, it’s the only company that actually deserves it.
Just as the Big 3 have their AAA club, we have a club that is virtually as exclusive with only four names getting the rating, including Apple.
We don’t rate Microsoft or Johnson & Johnson as AAA names. Our Credit Cash Flow Prime (CCFP) analysis has shown them to be riskier than the rating agencies have determined.
On the other hand, our analysis reacts faster to corporate fundamentals, which allows us to detect new AAA-worthy companies faster. Among our four perfectly rated firms is Nvidia (NVDA).
As demand for its chip business has skyrocketed, NVIDIA has built an impressive economic moat around its business. Furthermore, its ability to stay at the forefront of new developments such as VR/AR, artificial intelligence, and crypto has led them to become both a $600 billion market cap business and the largest semiconductor maker.
Using our CCFP framework, we can understand Nvidia’s true fundamental credit risk and why we give it our highest rating.
In the chart below, the stacked bars represent the firm’s obligations each year for the next seven years. These obligations are then compared to the firm’s cash flow (blue line) as well as the cash on hand available at the beginning of each period (blue dots) and available cash and undrawn revolver (blue triangles).
As you can see, as Nvidia has cash flows that are forecasted to consistently be in excess of two times its obligations. Alongside prodigious cash on hand, it has virtually no risk of a liquidity crunch.
Also worth noting is that regulators have made it clear Nvidia is going to have a challenging time making any acquisitions, which should help it avoid mismanaging its war chest of cash on a poor investment.
That’s why we rate NVIDIA as having a much lower risk, with a golden IG1 rating.
Yet its pessimistic A- rating from the Big 3 seems to miss all of this risk mitigation.
Using Uniform Accounting, we can see through the distortions of as-reported numbers to get to the true fundamental credit picture for companies as strong as NVIDIA.
To see Credit Cash Flow Prime ratings for thousands of other companies we cover, click here to learn more about the various subscription options now available for the full Valens Database.
SUMMARY and NVIDIA Corporation Tearsheet
As the Uniform Accounting tearsheet for NVIDIA Corporation (NVDA:USA) highlights, the Uniform P/E trades at 51.6x, which is above the global corporate average of 24.0x and its historical P/E of 35.8x.
High P/Es require high EPS growth to sustain them. That said, in the case of NVIDIA, the company has recently shown 79% Uniform EPS growth.
Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.
We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, NVIDIA’s Wall Street analyst-driven forecast is for a 51% EPS decline in 2022 and 14% EPS growth in 2023, respectively.
Based on the current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify NVIDIA’s $243 stock price. These are often referred to as market embedded expectations.
The company is currently being valued as if Uniform earnings were to grow by 40% over the next three years. What Wall Street analysts expect for NVIDIA’s earnings growth is below what the current stock market valuation requires in 2022, but above the requirement in 2023.
Meanwhile, the company’s earning power in 2021 is 5x the long-run corporate average. Also, cash flows and cash on hand are well above its total obligations. Additionally, intrinsic credit risk is 10bps above the risk-free rate. All in all, this signals a low credit and dividend risk.
Lastly, NVIDIA’s Uniform earnings growth is below peer averages and the company is trading above its peer average valuations.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research
Today’s highlight, NVIDIA Corporation (NVDA:USA) is one of the top stock picks from FA Alpha 50 this month. To see more stock picks like this subscribe to FA Alpha!