Monday, September 26, 2011

Value Opportunities in Stocks

I reiterate that now is a good opportunity to shift from cash reserves to stocks (assuming that cash is currently a substantial portion of overall assets).  In short, stocks are likely to have at least a recovery bounce from an oversold condition; market sentiment measures reflect extraordinary pessimism; and, the valuations of many leading companies are reasonable.

But for those who are unwilling to make a significant net shift into equities, I suggest taking advantage of situations where some stocks in a sector have substantially outperformed similar companies in the same sector.  Such situations provide opportunities to sell the large gainers and reinvest in the laggards.

There are numerous examples.  Take, for instance, Avon Products (AVP) and Colgate (CL), two internationally-focused consumer companies.  So far this year, CL stock is up 13%, has a p/e on 2011 earnings of 18, and a forecast long-term earnings growth rate of 9%.  AVP, however, has a ytd return of -31%, a p/e of 10, and a 12% growth rate.

Similarly, Costco (COST) has a ytd return of 16%, a p/e of 27, and a 13% growth rate.  Target, on the other hand, has a ytd return of -16%, a p/e of 12, and a 12% growth rate.

Those are just two examples within sectors.  Going outside of the same sectors, I'd suggest rotating out of big winners this year and into laggards of high-quality companies.  As I noted recently, electric utilities, for example, generally hold little appeal at current prices, even for income-oriented investors.

Some leading companies whose stocks have become quite depressed are Emerson Electric (EMR), which has a ytd return of -24%; FedEx (FDX), -25% ytd; and Schlumberger (SLB), -25% ytd.  The first two companies are somewhat more sensitive to global economic output, but the below-average valuations relative to long-term prospects reflect that, in my view.  I'll repeat it again.  Always keep some cash reserves for unanticipated buying opportunities.  But if your portfolio allocation to stocks is currently below your long-term target allocation, now is a good time to add to them.

Steve Lehman

S & P 500:  1163

Friday, September 23, 2011

Emerging Market Update

On August 1st I wrote a cautionary note on emerging market investments--their stocks, bonds, and currencies.  It wasn't that I thought the long-term prospects were poor.  It simply seemed to me that the positive long-term case based on superior economic growth, lower debt, and favorable demographics was already well reflected in market prices.  

Brazil, for example, has vast water resources and surplus arable land, which will be two increasingly valuable resources in the years to come.  But so many investors had been attracted to Brazil that its currency had soared in the past two years, and demand for the high interest rates on its bonds led the government to impose a fee on foreign capital inflows.

This is an example of the importance of being able to distinguish between long-term, strategic investment positions and shorter term, tactical considerations.  One must not be complacent about any investment holding these days, as amazing market volatility has unnerved even professional investment veterans.  

To continue with the Brazil example, in the last month its currency--the Real--has fallen 16% versus the U.S. dollar.  That's a drop in a dollar-based investor's Brazilian holdings of 16% in a month just due to currency fluctuations!  As an aside, I'd recently wondered whether despite the obvious troubles of the U.S., the U.S. dollar was forming a technical double bottom on a longer-term basis and could favorably surprise market participants (as U.S. Treasury securities have).  That also was a reason for my recent caution toward gold, since the dollar and gold in recent years often have moved in opposite directions.

So not only have Brazilian investments for U.S. investors fallen 16% in the last month because of currency changes, on a broader basis emerging market bonds have fallen more than 8% this month.  Again, remember the strategic versus the tactical.  And remember that when something is obvious to seemingly everybody, it often makes sense to head the other way.

Steve Lehman

Wednesday, September 21, 2011

For Those With Significant Cash, Buy Stocks

Buying opportunities in the stock market--even if not major bottoms--are naturally associated with bad news or seemingly intractable economic or financial problems.  After all, if there were no worries, wouldn't investors already be fully invested in anticipation of wonderful, profitable opportunities (remember the Internet stock mania of the late 1990's)?

There surely is much to ponder--even fear--today.  But key measures of investor sentiment that I follow suggest that current stock prices generally reflect considerable anxiety already.  Conditions are not as depressed as they were in the spring of 2009 (before stock prices roughly doubled over the next two years).  They don't have to be.  There can still be a significant rebound.  It is difficult, if not impossible, to identify a plausible catalyst for higher stock prices.  There just needs to be something that is less bad than expected.

With depressed sentiment and the shares some of the world's leading companies selling for 10-11 times current-year earnings, dividend yields of 3-5%, and strong cash generation by the underlying businesses, I'd be buying.

I'd be buying, that is, on the condition that one has significant cash reserves.  One of my strongest investment principles is not to be fully invested so there will always be available cash in case what initially seemed like excellent values fall in price and become even more attractive.

Steve Lehman

S & P 500:  1167 

Monday, September 19, 2011

Large Mutual Fund Redemptions--A Reliable Buy Signal?

The investment decisions by mutual fund investors have been a reliable buy or sell indicator in the past.  Are they still?

The investment results of investors in mutual funds have been dismal.  Human nature has repeatedly caused poor decision making by individual investors.  The herding behavior tends to cause individual investors in mutual funds to react to trends in stock prices after the fact, buying after large gains have already occurred (and news is good) and selling after large declines in stock prices (and news is bad).  As a result of these poor timing decisions, the average returns by investors in mutual funds have substantially trailed the returns of the funds themselves.  And since most fund returns after expenses have trailed those of major stock-market indexes, the results of individuals have been even worse.

What have mutual fund investors done during the past three years, and what might this indicate for prospects for the stock market from today's starting point?

During the financial crisis in the fall of 2008 as stock prices collapsed, mutual fund investors responded by redeeming approximately $75 billion from equity mutual funds in the five months following the collapse of Lehman Brothers.  The stock market bottomed soon after, in March 2009, which was a great buying opportunity before stock prices nearly doubled in the following two years.

More recently, after the S & P 500 stock index fell 16% last spring and early summer, mutual fund investors redeemed more than $40 billion in the four months through August 2010, another bottom in the stock market.  The S & P 500 index then gained 13% in the next three months.

Mutual fund investors again have redeemed $75 billion from equity mutual funds during the last four months.  This news, combined with other measures of depressed investor sentiment and reasonable valuations of stocks, persuade me that it is a good time to buy stocks.  Bad news (now the fears over European solvency in particular) alone doesn't mean that one should buy stocks.

But shares of some of the top companies in the world are selling at relatively low valuations of earnings and cash flow while being in superb financial condition.  Their dividend yields range from 3-6%, with excellent prospects for income growth.  In contrast, interest rates offered by banks and money market funds are near zero, and government debt yields only a few percent.  While I continue to exhort investors to always maintain cash reserves for unanticipated buying opportunities, the risk/return prospects for leading stocks is now quite satisfactory in my opinion.

Steve Lehman

S & P 500:  1196

Sunday, September 18, 2011

Oops!--The Truth Slips Out

It has been well known for some time that European banks were in shakier condition than U.S. banks after the financial crisis of 2008.  Even though U.S. banks have succeeded in weakening proposed regulations that were intended to prevent a similar crisis, the U.S. bank bailout kept major U.S. banks viable.  In Europe, however, banks have had a much smaller financial cushion against losses, and regulators have been slow to require the shoring up of capital positions.  That has been part of the recurring concern over the European financial system.

Christine Lagarde, the new president of the International Monetary Fund, recently slipped a rare bit of candor into the discussion.  An IMF report indicated that European banks had a huge capital shortfall--an estimated $273 billion.  She quickly retracted the estimate and said the report was still in the draft stages, while the IMF worked with European governments on the matter of adequate capital levels.

It would be enormously dilutive to reported bank earnings for the banks to issue billions of euros of new stock to raise capital levels enough to likely avert risks to the entire European financial system.  As in the U.S., the political strength of the banks might again put in jeopardy the entire financial system.

As for Ms. Largarde's candor, I'd urge her to persevere and keep in mind the great U.S. central banker, Paul Volcker, whose integrity and determination were largely responsible roughly thirty years ago for gaining the confidence of market participants and launching years of prosperity.

Steve Lehman

Thursday, September 15, 2011

Gold Update

Gold has been an outstanding investment over the last decade.  I remember 2000, when the price of gold was about $250 and the Dow Jones Industrial Average roughly 10,000 (or 40 times the price of an ounce of gold).  I said at that point I'd much prefer to hold gold than the Dow Jones, which though not nearly as overpriced as the NASDAQ at the peak of the internet stock mania, had just had an 18-year bull market.  

The probability was for poor returns from the stock market in the coming decade, based on its historic overvaluation and its strong past returns.  After all, when gold last peaked in 1980, the ratio of the Dow Jones to an ounce of gold was roughly 1:1.  I argued in 2000 that the ratio wouldn't necessarily reach 1:1 again, but it was highly likely to move in that direction.   And it has.  Today, the Dow Jones to the price of gold is about 6:1  So might gold rise much more before its bull market is over (or the Dow fall sharply), or is that stretching a historical coincidence too far?

It also seemed that gold was likely to be a good investment, for two perhaps cynical reasons.  Alan Greenspan, who at the time was revered by many, was running a reckless monetary policy (and undermining the value of paper money).  Also, Gordon Brown and the UK government sold its entire gold holding at about $250 per ounce.  (I was not impressed by the savvy of government officials and thought one should go contrary to their financial actions.)

Gold has indeed been an outstanding investment over the past decade (11 years, actually) rising from $250 in 2000 to a recent high of over $1,900.  This sevenfold gain in gold (roughly 20% annualized) over the last 11 years occurred when the U.S. stock market was roughly flat (plus about 2% per year on dividend income).

Throughout the last decade, the policies of Greenspan and Ben Bernanke have been extraordinarily positive for gold.  Gold has historically performed well when real short-term interest rates have been negative (that is, short-term interest rates minus the rate of inflation).  Rates have continued to be negative, and recent upticks in inflation measures in the U.S. and the U.K. solidify this positive indicator for gold.  So for this and other reasons, I think that gold remains in a bull market and that most portfolios warrant even a modest allocation to gold.  I'd suggest a core allocation of 5-10%, with a potential range of 3-20%.

I hesitate to place too much emphasis on seasonal trends or averages, but gold's bull market has, like many bull markets, had periods when the price rise became too sharp and led to a significant pullback.  As gold had risen nearly 50% over the past year and 30% this year, a pullback seemed likely (as I wrote on 8/10 and 8/25).  During previous episodes, the gold price pulled back to close to its 200-day moving average.  In the autumn of 2009, gold rose to about 20% above its 200-day moving average before declining about 15%.  In the autumn of 2010, gold rose to about 15% above its 200-day moving average before declining 10%.  This year, gold recently rose to nearly 30% above its 200-day moving average.  A return to close to the 200-day moving average would result in a decline of about 20% from its recent peak (without necessarily ending its bull market).  The gold price has declined about 6% already, so the odds favor a further pullback of perhaps 10-15%.

For those with more than 20% of their assets in gold, I suggest reducing positions even at current levels.  For those with modest or no positions, I'd wait for a further pullback and make meaningful purchases when the price has fallen further and sentiment measures fall to extraordinarily low levels.

Steve Lehman

Gold:  1777

Tuesday, September 13, 2011

Be Careful in Investing in REITs Today

I probably was spoiled when I was aggressively buying real estate investment trusts (REITs) a decade ago. They offered dividend yields on average of 7% and sold at sharp discounts from their estimated underlying real estate value.  So it's hard for me to be enthusiastic about REITs today with average dividend yields of 3.7%.  I realize that with interest rates at historic lows, there is less competition for yield--except from blue-chip equities.

Many investors disagree with me, as REIT mutual funds and exchange-traded funds (ETFs) have recently had the most inflows from since 2006.  Assets are at record levels.  The long-term conceptual case for REITs is compelling, as I also favor investing in tangible assets.  I think, however, that appeal is already well reflected in REIT share prices.  Apartment REITs have benefited from problems in the home ownership market.  The stocks of the largest apartment REITs (Avalon Bay and Equity Residential) have risen 19% and 16% this year, and their dividend yields are now only 2.7% and 2.3%.

The modest cash generation of most REITs is such that firms issue large amounts of new stock each year to raise money, and a portion of REIT distributions is often considered for tax purposes a return of capital, so the stated dividend yields can be misleading.  Instead, I favor blue-chip stocks such as G.E., Merck, and Vodafone, which have impressive cash generation from business operations and dividend yields of 4-6%.

The conceptual appeal of REITs as tangible assets that provide inflation protection is understandable, especially with interest rates so low.  But with economic growth likely to be sluggish, that will not be a good fundamental environment for office, shopping center, or industrial real estate.  Health care REITs will likely be a better sector.  But I'd suggest going outside the U.S. in considering Asian property companies, given the likely superior long-term growth in that part of the world.  Or if one prefers to stay in the U.S., in addition to health care facility REITs, I'd consider REIT preferred shares.  The preferred nature of the shares offers greater safety if the economy turns sharply lower, but in exchange for higher initial dividend yields, there will be no dividend growth by preferred shares.

A modest portion of one's portfolio could be allocated to these types of REITs, but in general I think it is NOT the time to add U.S. REITs to one's portfolio.

Steve Lehman

Monday, September 12, 2011

There Are (Selective) Values in Today's Stock Market

Unlike consumer staples and most electric utilities, which have significantly outperformed the broad stock market this year, there are two particular areas of value today.  The first is the pharmaceutical sector.  Unlike the other two sectors, it offers attractive earnings-based valuations, strong balance sheets, and significant net cash flow.  Furthermore, on a growth-plus-dividend-yield to p/e basis, the ratio is about 1.0 for Abbott, Merck, and Novartis (unlike 0.6 or so for leading staples and utilities).  While it is likely that there will be further pressure on drug prices by governments in years to come, there is still long-term demand from aging populations in developed countries and from income growth in developing countries.  The leading companies are consolidating the sector and reducing costs with likely additional cost savings ahead.  Even the companies with patent cliffs ahead, such as Astra-Zeneca, benefit from very low investor expectations, as the patent deadlines are widely known.

The other broad sector that offers value is the industrial sector.  Leading companies such as G.E. and ABB sell for close to 10x 2011 earnings.  It is probable, however, that the relative weakness in share prices in this sector reflects reduced earnings expectations consistent with reduced economic growth prospects and alarm over the Eurozone financial crisis.  That is why I target reasonable valuations on current-year earnings, with a cushion allowed for growth in the next year to improve valuations even further.  But even though strong growth is forecast for many of these companies in 2012, stock prices will face pressure if earnings fall short of estimates.  Forecast earnings gains in 2012 for GE, Union Pacific, and UPS, for example, are 15-20%, which I think is too high.  Despite the trimming of earnings estimates, I still think that purchases with a valuation cushion (or margin for error) will be worthwhile.

Steve Lehman

Friday, September 9, 2011

Avoid Electric Utility Stocks

In addition to leading consumer staples stocks, leading electric utility stocks offer poor value.  They also offer an unimpressive combination of current income and income growth in an era where that will be more important than historically.  

Take two of the largest electrics, Southern Co. and ConEd, for example.  They have outperformed the S & P 500 so far this year by more than 20 percentage points.  As with consumer staples stocks, electrics probably have outperformed because of greater earnings stability--and the plunge in government bond yields as competing investments (and reduced utility borrowing costs).

On the principle of growth + income versus valuation, these stocks are even worse than the staples stocks highlighted yesterday.  With forecast earnings growth of 5% (if that) and dividend yields of only 4.5%, these stocks do not deserve to sell for their current multiple of 16 times 2011 earnings.  Furthermore, the companies carry large debt loads and most important, they generate significantly LESS cash flow than they use for capital spending and dividend payments.

There are, however, stocks where the combination of earnings growth and dividend yield approximates the 1.0 level that I prefer, along with solid balance sheets and excess cash generation.  More on those in the next post.

Steve Lehman

Thursday, September 8, 2011

Look Outside of Consumer Staples for Value Today

I recently have urged the purchase of stocks in cases where investors have substantial cash reserves.  This is not, however, a sweeping endorsement of stocks at current levels.  In general, consumer staples stocks offer poor value, as institutional investors who are compelled to remain fully invested apparently have rotated to this sector for its earnings stability and presumed relative safety if the seasonal tendency for stock market declines in September and October occurs again this year.

I find little appeal in this sector.  Colgate, Coca-Cola, and Heinz, for example, trade at nearly 18 times current, calendar-year earnings.  The estimated long-term earnings growth rate is 7-9%, with dividend yields of 2.5%-3.6%.  I like to compare the sum of a company's sustainable growth rate and its dividend yield to the p/e multiple.  In this case, earnings growth plus dividend yield is about 11%, and the p/e is 18, for a ratio of 0.6.  A ratio of close to 1.0 represents much better value.

The staples companies also generate relatively little free cash flow after capital spending and dividend payments, and their debt/equity ratios are unimpressive.  Yes, they have large international operations and growth prospects in emerging markets, but at 18 times earnings, I'd say that's amply reflected in the price and investors should look elsewhere.

Steve Lehman

Wednesday, September 7, 2011

For Those With Extra Cash, Buy Some Stocks

Though prominent Wall Street strategists featured in Barron's recently nearly unanimously reiterated their optimism about the stock market for the rest of the year, I at least agree about near-term prospects.

One of my favorite contrarian sentiment indicators is the put-call ratio.  It recently surged to a level even higher than it was late last summer, before a rebound of more than 20% in stock prices.  In addition, a third-party sentiment indicator that I follow shows sentiment levels to be depressed, which has historically been followed by rising stock prices.   

I also pay attention to insider buying and selling, especially with individual companies.  In aggregate, insider buying relative to selling recently reached the highest level since the market bottomed a year ago.

These indicators, combined with attractive valuations on leading company stocks, suggest that for those with significant cash reserves, it is a good time to be buying some stocks--despite the historic tendency for market declines in September and October.

Steve Lehman

S & P 500:  1165

Tuesday, September 6, 2011

Conventional Wisdom (cont.)

A supposedly sure bet has been that the U.S. is in inexorable decline, and its bonds and currency should be shorted.  It followed that in times of crisis, or at least unease among market participants, the remaining havens were gold and the Swiss franc.  The franc's rise had been extraordinarily sharp for a major currency, and earlier this summer it had become approximately 25% overvalued on a purchasing-power-equivalent basis relative to the dollar.

But as we've seen in various markets, momentum can overwhelm reason--until something changes.  And today something did change for the franc, as the Swiss government imposed a ceiling on the currency's value.  It has fallen approximately 9% today against other major currencies.  The Swiss franc ETF has now fallen 18% from its recent peak.  Going into today's trading, it had risen 30% over the past three years.

For the U.S. and its currency, however, market expectations could hardly be lower.  The national government seems incapable of dealing with the country's problems, and the economy seems on the verge of an extended period of Japan-like stagnation.  

China, on the other hand, reminds me of Japan in the late 1980's, when it seemed poised to take over the world, as it bought major U.S. assets such as Rockefeller Center and Columbia Pictures.  Savvy people were learning Japanese in anticipation of a sustained period of Japanese dominance.  Today it is China in that position.  

I think a major surprise could be that China has major problems that are not widely expected.  With fixed investment at nearly 50% of Chinese GDP and its export markets way down, a major glut--and bank loan losses--loom.  If China does have major problems, the decline in the standing of the U.S. could be reversed for a while.  

The U.S. dollar could have a countertrend rally, which would pressure the reported earnings of major U.S. multinationals, which earn 50-60% of profits overseas.  That would not be good for stock prices but despite this risk, I still find a number of top-quality U.S. and foreign stocks at attractive valuations.  And when valuations are compelling I advocate buying, as there is much room for things to go right when a stock is cheap (and much to go wrong when a stock is expensive and in vogue).  With the baffling volatility of markets these days, I suggest using limit orders at prices that valuation analysis support.

Steve Lehman