Thursday, March 31, 2011

Inherent Challenges in Investing in Financial Stocks

I admit to a general reluctance to invest in financial stocks.
I do not have confidence in the financial statements, particularly the balance sheet.  I think that book value (assets minus liabilities) per share is a key valuation measure for most financial firms.  But it is extremely difficult, if not impossible, to ascertain what a financial firm's book value is—specifically the asset component, whether it’s the investments of insurance companies or the loans and other investments made by banks.  

This was true even two decades ago, when most banks were simply banks.  Back then, they derived the bulk of their profits from the spread between what they paid out in interest on deposits and what they received in interest on loans to commercial and consumer borrowers.  Loan quality was crucial, and it helped to have a sense of the conservatism and ethical standards of management in how risky the lending practices were and how much was set aside in anticipation of loans going bad. 

But as the largest banks effectively became hedge funds in the last decade through trading operations and assets held off the balance sheet, ascertaining asset values has become extremely difficult.  And since banks and other financial firms often operate with significant leverage, it is crucial that what is assumed to be an asset is actually worth what the financial statement says it’s worth.  Otherwise, reductions in asset values have a magnified impact on the book value.

Unfortunately, the bursting of the housing bubble and the resulting financial crisis led regulators to loosen the stringency of reporting standards for financial firms.  For many of the assets on the books, firms are allowed to effectively set their own asset values based on financial models estimates, instead of relying on the actual market prices for similar assets.

So for investors in financial firms, there is the risk of a sudden decrease in the value of assets on the balance sheet as a result of writedowns.  Since book value is so important in the valuation of financial firms, I think it is important for investors to conservatively allow for a margin of error in valuing such companies.

The largest financial firms are now considered “too big to fail” because their collapse would jeopardize the entire financial system.  These firms have reported asset values (and book values) that I frankly have no confidence in.  The mindset of the authorities seems to be the same as that in Japan after their bubble burst in the early 1990’s.  That is, look the other way in (not) regulating them and hope that the companies can muddle through over a number of years by  gradually working off the impaired assets.

Smaller financial firms don’t have that luxury.  This week Hudson City Bancorp, the largest U.S. bank to forgo a government bailout, announced a $644 million loss from paying off debt that was underwater, under pressure from regulators.  The bank bought back $12.5 billion of securities that cost it higher rates of interest than the bank was earning on its assets (investments).  The bank still has more than $16 billion remaining of the money-losing securities.

The Hudson City's book value fell by more than 10% and would seem to be vulnerable to a further drop of 12-15%.  The share price dropped more than 20% since March 2, when the bank disclosed that regulators were pressing the bank to reduce risk.  It seems that the pressure on the bank's management of maintaining an exceptional growth rate of ten consecutive years of record profits led to excessive risk taking (as we saw during the housing bubble with many other firms).

I suppose one could simply invest in the biggest financial institutions on the assumption that no matter how much risk they take, the government will prop them up.  But with unknowable asset values, questionable earnings levels (and associated p/e multiples), and generally minimal dividend yields, I tend to favor other sectors for investment.

If, however, a financial firm’s management is skilled, shareholder-oriented, and ethical; and if the tangible book value (removing “goodwill” from the asset list) results in the stock selling at or below that figure; and if there is a solid record of earnings and dividend payments, particularly in a consolidating sector, there may be attractive opportunities.

Steve Lehman

S & P 500:  1325
Russell 2000:  839

Sunday, March 27, 2011

Doing Good Can Lead to a More Sustainable Business

So much of the news is dispiriting, that when there is good news it stands out.  And there was some good news for the environment—and for the long-run sustainability of the business in question—this week.

Scotts Miracle-Gro, the world’s largest marketer of branded consumer lawn and garden products, launched new initiatives involving product changes and consumer education efforts to improve water quality and conservation in the U.S.   Water quality and scarcity is already an urgent problem around the world, and a fertile investment area with few publicly-available vehicles in which to participate. 

Scotts will phase out phosphates from its lawn fertilizers by the end of 2012.  Phosphates lead to algae growth and have been accused of choking lakes and rivers.  Scotts will also focus on more efficient ways to use nitrogen in its products through enhanced science and technology efforts.  Nitrogen is vital for plant growth, but excess nitrogen in the environment, particularly from runoff that ends up in the Gulf of Mexico, has created a vast “dead zone” in the Gulf.  Aquatic and marine dead zones can be caused by an increase in chemical nutrients (particularly nitrogen and phosphorus) and a decrease in oxygen in the water, known as eutrophication

Excessive use of chemicals and fertilizers by homeowners is a significant problem, and Scotts is trying to do something positive about it, along with the contamination and wasteful use of water.  

This is an example of a market-leading company that has decided to use its prominence to  lessen the negative consequences of its products and to help the environment have a fighting chance.  It also is sound business through good publicity and by making it more likely that the company will be around longer. 

This is a concrete illustration of the concept of “sustainability.”  It goes beyond socially-responsible investing, which has an undeserved stigma that investment returns must suffer when businesses do good as well as simply maximize their short-term profits.  It has to do with the products a company sells, the ethical conduct of its managers, and the effects of its operations on the broader society.

More forward-thinking executives—and investors—should orient their thinking along these lines.

Steve Lehman

S & P 500:  1314
Russell 2000:  824

Wednesday, March 23, 2011

The 2008 Financial Crisis? What Financial Crisis?

Americans—and Americans who invest, in particular—have short memories.  They forgot which investment strategists and  economists (and policy makers) drove them off the cliff in the technology-stock bubble a decade ago.  Many of those same actors were back it only half a decade later.  They claimed that nationwide house prices never decline, that derivatives were marvelous for diversifying risk, and that government regulation impeded the operation of the miraculous free market.  I wish more people would watch the movie “Inside Job.”  It MIGHT alter thinking enough so that people would no longer tolerate the crony capitalism that so badly damaged our country.

A Bloomberg news story today noted that the recent Japanese earthquake was on a different fault line than the major one that runs under Tokyo and as a result, some geologists worry that the quake put more stress on the Tokyo fault, making it just a matter of time before The Big One hits Tokyo.  Similarly, I worry that the 2008 global financial crisis didn’t remove stresses in the global financial system and that it remains precarious. 

The financial reform regulation in the U.S. was so watered down that the proposals of Paul Volcker--a true public servant and the epitome of a prudent central banker—were effectively dismissed.  As with a different Japanese crisis two decades ago—the peak of their market bubble—the response by those in charge here seems to try to buy time to muddle through and avoid recognizing the huge losses in the system.   In the meantime, there is money to be made, so why waste the chance?

The President of the Dallas Federal Reserve Bank, Richard Fisher, is the closest thing to a financial conscience this country has had since Mr. Volcker.  Mr. Fisher warned yesterday of “extraordinary speculative activity” in the U.S.  Citing a surge of “covenant-lite” loans (loose lending practices) and a return of private-equity payouts (huge payouts from financial engineering), he noted that “there is an enormous amount of liquidity sloshing around.”  That liquidity is the result of the policies of Ben Bernanke, he of the actors who drove the financial system to the brink. 

This environment might lead to profitable trading opportunities for the fast-money crowd, but the U.S. financial system remains dominated by a handful of firms that are “too big to fail.”  It continues to be a system in which profits are for private, well-connected interests and losses are for the taxpaying public.

Ask yourself whether your portfolio can again withstand something similar to what happened in 2008.  If not, this is an ideal time  to make needed adjustments.

Steve Lehman

S & P 500:  1295
Russell 2000:  809

Tuesday, March 22, 2011

Systemic Bullish Bias Returns in Short Order

There were signs last week of it returning.  A prominent market strategist appeared on Bloomberg TV and stated that U.S. stocks were attractively priced at only 13 times forward operating earnings.  He went on to state that they were especially attractive when compared to U.S. Treasury notes, which were trading at 30 times. I wondered at the time, “Thirty times what?  Earnings of the U.S. Government?” 

U.S. Treasuries pay interest—guaranteed—by the U.S. Government.  A common stock represents in today’s dollars the future stream of cash generated by the underlying business.  On average today, a stock’s current cash payout in dividends to investors is only 1.9% (using the Standard & Poor’s 500 Index).

The strategist’s comparison of earnings on stocks to interest on bonds is known as the “Fed Model” because it was reportedly one of Alan Greenspan’s favorite measures of the stock market.  (You remember him, don’t you?  The former head of the U.S. central bank, called the “Maestro” by author Bob Woodward for his purported mastery of the economy and markets.  I prefer “Mr. Bubble,” because he never met a bubble he didn’t like.)  By taking the inverse of the stock market’s p/e (in this case 1/13, or 7.6%), this gives the “yield” on the stock market’s earnings.  This is then compared to the yield on bonds, typically the 10-year U.S. Treasury Note (now only 3.3%).
This makes stocks look like an outstanding investment, at least when compared with the usual alternative, bonds.

There are several problems with this line of reasoning, which essentially is that when interest rates are low, it is a good time to buy stocks.  Most pragmatically, it doesn’t work.  Or at least it hasn’t stood the test of time.  (Refer to the work of James Montier and John Hussman for a thorough discussion of the theoretical flaws of this approach.)  This approach, e.g., would have supported aggressive purchases of Japanese stocks for much of the last two decades because interest rates on government notes averaged 1% or less.  But Japanese stocks are down about 70% in price over that time.  The approach also would have argued in favor of buying U.S. stocks right before the 1929 market crash.

Instead of this widespread view that money has to go somewhere other than a money fund that yields 0.2%, history shows that bull markets have tended to begin when interest rates were HIGH, not low, and they fell over time.  Long-term bear markets have tended to occur when rates started low and rose over time.  Given the huge borrowing requirements of the U.S. government, unprecedented monetary stimulus, and rising commodity prices that could well cause a surge of inflation in the years to come, along with erosion of the value of the U.S. dollar, rising interest rates over time seems likely.  The world’s currency regime seems unsustainable, and a currency crisis is probably in the shadows.

But that’s evidently not a worry now.  Today’s Bloomberg headline, “All Clear Signal Sounded as Global Markets Shrug Off Multiple Black Swans,” reveals the powerful systemic bias for cheerleading the stock market (and economy), as policy makers, institutional investors, and individuals desperately try to make the crisis of 2008 a distant memory (despite a lack of meaningful reforms to prevent something similar).

S & P 500:  1296
Russell 2000:  812

Wednesday, March 16, 2011

Price Appreciation, Retirement, and Income (Cont.)

Last time I cited the rising pressure on portfolio performance.  The absence of house-price appreciation removes a crucial source of retirement resources, and demographic factors make further house-price depreciation likely over the next several years.  In addition, American workers are, on average, far short of the necessary resources for their retirements as the Baby Boomer generation is just beginning to move into retirement.  According to the Employee Benefit Retirement Institute, more than half (56%) of workers surveyed had less than $25,000 in savings and investments.  They have a long way to go.

For those investing for future and present retirement, where can they find opportunities to build a portfolio, generate income, and protect the portfolio and its income from unexpected inflation?  As a broad theme, emerging-market equities and currencies seem likely to offer above-average returns relative to developed markets in the years to come.  The countries generally have superior economic growth rates, low national debt levels, and favorable demographics.  Many also have natural resources that will be increasingly scarce.  However, after the more than doubling in most stock markets over the past two years, I suggest waiting for a correction.

Gold, as mentioned in the last post, offers inflation protection and protection against further declines in the U.S. Dollar, but it does not produce income.  And with capital gains even more unpredictable than in the past--or at least when compared to periods with attractive starting valuations--current income seems of critical importance.  After all, dividends historically provided nearly half of the total return from the stock market.  It's time once again to favor stocks with high current and sustainable dividends, as well as stocks with moderate dividends and prospects for dividend growth.

Besides large, multinational stocks, there are three other potential sources of income, income growth, and inflation protection.  First are master limited partnerships (MLPs).  They offer high income payouts, generally stable underlying cash flows, and exposure to tangible assets like energy pipelines.  Current distribution yields are about 5%.  The tax aspects are mixed.  The businesses are exempt from corporate tax.  On the other hand, the partnership taxation means that investors are taxed not on the cash distributions received each year, but on partnership tax computations, which add complexity and inconvenience to an individual's tax return.  I favor simplicity and would prefer to avoid the tax complexity.  Furthermore, share prices have risen sharply over the past two years and valuations based on cash-flow multiples are stretched. 

Another area is real estate.  Though residential house prices in the U.S. seem likely to fall further and a rebound looks well off into the future, commercial real estate has long-term appeal.  According to a recent Bloomberg report, the average “cap rate” on commercial real estate—that is, net income dividend by the market price—is about 7%.  If inflation rises in the years to come, both rents and property values should rise in turn.  Though I think the office and retail sectors face ongoing pressure, the unfavorable single-family home demographics are actually quite attractive for the apartment sector.  

The most accessible form of real estate is real estate investment trusts (REITs).  Unfortunately for new investors, REITs have rebounded sharply.  Apartment REITs, for example, typically had dividend yields of 7% or more a decade ago.  Now, they yield 3-3.5%, as the stock prices have risen on improved prospects for apartments (rents were up 4% on average over the past 12 months).  Until a price correction provides a better entry point for apartment REITs, health-care REITs that own senior housing or medical office buildings seem more attractive.  Health care REITs offer high dividend yields of 5-7% and prospects for moderate dividend and capital growth.  Foreign real estate stocks, particularly in Asia, would seem to have even better long-term prospects and would further diversify holdings of U.S. investors.

The other alternative is foreign bonds, particularly those of emerging countries.   Though the yield spread over U.S. Treasuries is now historically low, yields are still attractive (typically between 4.75-6% after expenses, using mutual funds or ETFs).  And for funds that hold bonds denominated in local (foreign) currencies, there are prospects for currency gains from appreciation relative to the U.S. dollar.  The dominant global currency role for the dollar is eroding, and prospects for emerging economies are excellent.  Emerging economies now comprise nearly half of global economic output, yet their stocks and bonds are significantly underrepresented in portfolios in developed countries, especially the U.S.  The long-term prospects for emerging market investments seem excellent; timing an entry point is the question.  This sector seems well suited for a dollar-cost averaging approach to building a sizable stake over time.  As with the other areas cited, gaining exposure to foreign currencies on a correction would be preferred as, for example, the Brazilian real has risen nearly 25% versus the U.S. dollar over the past year.  

These areas—high-yielding stocks, MLPs, REITs, and emerging market bonds–along with some gold (ETFs) for protecting against the consequences of monetary debasement--are areas to consider at a time of low (or no) yields and rising demands on current income and “real” capital protection.  But at the moment, I favor cash with some selective exceptions.

For those who can't bear holding cash at 0.2% these days, I consider emerging-market bonds and high-yielding stocks to be the most attractive asset classes based on both short-term and long-term considerations.

Steve Lehman

S & P 500:  1274
Russell 2000: 789

Friday, March 11, 2011

Price Appreciation, Retirement, and Income

“Don’t worry if the stock market is down, prices always recover.”  That widespread sentiment reflects the traditional emphasis on stocks—and stock-price appreciation—to provide the bulk of a portfolio’s returns to build assets for retirement.  Bonds provided stability and steady income.

But while stock prices may indeed always recover, they can take an inconveniently long time to do so.  If before stock prices recover retirement or a financial emergency occurs, for example, that can be a major problem.  And the odds of stock prices taking an inconveniently long time to recover are high when the entry point is high.  From the mid 1960’s to the early 1980’s, major stock indexes produced no gain in price.  Dividends were the only source of return.  Similarly, despite the doubling of stock prices over the last two years, the price appreciation on stocks during the last decade was only about 1% annualized.

So as the huge Baby Boomer cohort moves into retirement, private pensions are eliminated and government pensions are curtailed, there is even greater pressure on portfolio returns and steady investment income than in previous decades.  In addition, since house prices are generally no longer providing substantial appreciation—and instead will likely decline further—investment portfolios cannot provide extended periods of no price appreciation (unless there is high investment income). 

There are two investment sources to provide retirement resources—capital gains from price appreciation, and current income.  Considering the two traditional portfolio asset classes—stocks and bonds—conventional prospects are daunting.  Substantial, widespread capital gains seem unreliable from this point, despite the flat decade just passed.  Stock valuations are quite high on any basis except current-year earnings, which is no reasonable basis when profit margins are at historic highs (from unprecedented cost cutting and government stimulus measures).  On a cyclically-adjusted basis, valuations are quite high, as they are on a book value or dividend yield basis.  Bonds generally have completed a 30-year bull market, so further price appreciation prospects are similarly questionable.

That leaves current investment income to pick up the slack.  However, the dividend yield on stocks is only 1.8% on the S & P 500 Index, the 10-year U.S. Treasury note yield is about 3.4%, and the yield on cash is close to 0.2%.

With those paltry income returns, where can investors turn for sufficient income, growth of income, and protection of their asset base?  Fortunately for stock investors, the highest-yielding stocks are generally the most attractive segment of the market at current prices.  A number of health-care and communications services (particularly foreign) have substantial dividend yields and prospects for dividend growth to keep up with inflation.

Is it necessary to be concerned about future inflation, since inflation has not been a problem for some time?  Unfortunately, the wild experiment in monetary policy (especially in the U.S.), and probable further large increases in energy and agricultural prices, make protecting the “real” value of income and principal investments crucial.

Gold is a venerable form of money and inflation protection whose decade-long bull market seems intact.  But it is not an investment.  It is a form of money whose price has no investment basis.  Investments are based on the cash that is generated over time, which in the case of stocks provides resources for business expansion and the payment of dividends to owners.  Gold generates no cash flow, so a prudent portfolio that has at least a modest gold component will need to generate reliable cash from other sources.

One of the best sources of cash generation for investors is dividends and growth in dividends.  I’ve covered income-producing stocks in recent comments, such as high-yielding stocks and moderately-yielding stocks that have prospects for dividend growth (such as Abbott Labs—ABT).  In the bond market, inflation-protected government bonds might have some appeal for principal protection.  High-yield bonds, another potential source of high-current income, have recovered so sharply from the 2008 financial crisis plunge that their yield premium over U.S. Treasuries is now relatively modest.

In addition to income-oriented common stocks, there are three alternative sources of returns that deserve a prominent place in portfolios for the years ahead.  I'll comment more on those in my next posting.

Steve Lehman

S & P 500:  1301
Russell 2000:  802

Monday, March 7, 2011

Front-Page News

There are various approaches to successful investing in the stock market.  Some market participants identify stocks whose prices are rising at an unusually rapid rate (price momentum), or they combine that with identifying companies whose revenues and/or earnings are also rising at exceptionally rapid rates (fundamental momentum).  They then ride that success and try to be alert enough to tell when the trends are changing.  

Others may use the approach that famed Fidelity fund manager Peter Lynch espoused by urging investors to look in their backyards and invest in companies whose products they use and are familiar with.  Some institutional investors who have substantial computing and quantitative staff resources use elaborate modeling techniques that may entail rapid trading and portfolio turnover.  Whatever approach you use, my view is that if it works for you, stick with it.  Above all, know yourself as an investor.

For me, that means combining contrarian psychology with identifying undervalued stocks.  I supplement those considerations with a company’s financial strength, earnings momentum and surprise, and management quality.  The essence, though, is a contrarian approach to markets.

While I utilize a screening approach that includes a number of factors, I believe that a skeptical and contrarian mind that pays attention to developments around the world is critically important.  It isn’t necessary for one to have access to the highly complex asset-allocation models that many institutional investors have in order to succeed. 

An individual investor who pays attention, particularly to what is reported in the news, can do well.  Cover stories have been outstanding contrarian examples over the years.  By the time a topic reaches the front page of a weekly magazine or daily newspaper, the subject’s market price already likely reflects the theme.  Developments, if not yet the market price, may already be moving in another direction.  Numerous examples over the last few years exist, with bullish stories on the Indian and Chinese stock markets, the housing bubble, and bearish talk about the U.S. dollar.  The front-page topics appeared in publications ranging in investment sophistication from The Economist and Barron's to Newsweek and Time.  

Today may provide another contrary example.  The New York Times has a page one story, “Patent Woes Threatening Drug Firms.”  It cites in particular the patent expiration later this year of Lipitor, Pfizer’s blockbuster drug.  It explains that the Pfizer example is just the most extreme case of problems that the entire industry faces from patent expirations, pressures from governments in Europe and the U.S. to reduce drug prices, and the inability to discover new compounds that are meaningful advances over existing products.  

Industry analysts, portfolio managers, and even casual investors have known about these issues for years, which is why Pfizer, Lilly and Merck, for example, sell for only eight times 2011 earnings estimates on average (versus 13 for the overall stock market).  While I don’t endorse massive buying of drug stocks now, they do seem to represent one of the few areas of undervaluation in today’s stock market.  

Abbott, a diversified health-care company with significant drug revenues, sells for 10 times 2011 earnings estimates, has a dividend yield of 4%, generates excess cash flow from operations, and has raised its dividend for 39 straight years.  And unlike some of the pure drug companies who might have flat or declining earnings over the next two or three years, Abbott is expected to produce earnings growth of nearly 10% annually.  (Disclosure:  I own shares of Abbott.)  As for the others, closer analysis is needed, but when a stock such as Lilly or Astra Zeneca has no net buy recommendations among several dozen analysts who cover the stock, it may be time for contrarians to look more closely.

Steve Lehman

S & P 500:  1308
Russell 2000:  810

Wednesday, March 2, 2011

Stock Market Decline Likely (cont.)

There are two more reasons why a significant decline in stock prices is likely. First, in the context of complacency by investors, is the current ratio of put option volume to call option volume. The put/call ratio is currently at a relatively low level. This indicates that participants in the options market are more concerned with participating in rising stock prices than they are with protecting against falling stock prices. The current level of this ratio is about where it was last April, before the 15-20% decline in major stock market indexes.

Second, corporate insiders are selling stocks at an unusually high level relative to their stock purchases. The current ratio of sales to purchases (nearly 40:1) is well above the level that is normally a level (20:1) that warrants caution. As with the put/call ratio, the current insider sell/buy ratio is at the level of last April, before the sharp drop in stock prices.

These are two more reasons not to be complacent about stock prices in the days ahead. The appropriate strategy is to hedge by raising cash or buying index put options, or more aggressively, to be net short using put options.

Steve Lehman

S & P 500: 1308
Russell 2000: 811