Tuesday, January 31, 2012

Income Ideas

With interest rates offered by banks near zero and rates on U.S. Government securities not much higher than that, where can investors generate investment income?

I previously have recommended stocks with high dividend yields and dividend growth prospects.  The current era is quite extraordinary, as dividend yields on the S & P 500 exceeds the yield on U.S. government notes for the first time since the 1950's.  With the 20% rebound in the S & P 500 since October, however, I'd recommend waiting for a correction before buying many stocks.

But there are two alternatives that I currently like.  I still think that high-yield bonds are attractive, and yields of 7-8% are available.  Unfortunately, the interest is taxed at ordinary income rates, so they are most appropriate for tax-deferred accounts (unless the investor is in a low tax bracket).

In addition, there are selective opportunities in preferred stocks, which typically are issued by banks.  While I am cautious about common stocks of banks, dividend yields of 7-8% are available on straight preferred shares.  Some preferred dividends are tax at 15%, others are not and are taxed at ordinary income rates, so one should choose carefully.

This week I bought two preferreds with yields of almost 8% and which have qualifying dividends (taxed at 15%).  If economic conditions deteriorate significantly, banks would likely cut common dividends first, giving the preferreds one level of safety.  

In addition to the tax rate on the dividends of preferred stock, another consideration is the call provision.  Most preferred stock can be called in by the issuing company after a specified date, and the call price often is below the current market price, so a holder could face a capital loss.  The two stocks that I bought this week do not face an imminent risk of being called on unfavorable terms.

Those are two ways of generating high investment income at a time of low interest rates, and if the stock market declines--which I think is increasingly probable--there will be a number of common shares with good dividend yields.  

Steve Lehman

Monday, January 30, 2012

Investing in Bank Stocks? Buyer Beware!

I have long had a bias against investing in bank stocks (and I suppose insurance stocks as well) because of an inability to ascertain the quality of the assets on the balance sheet.  Unlike a non-financial business that generates cash from operating assets, traditional banks generate money from financial assets, usually loans.  But the quality of the loan and the underlying collateral is effectively impossible for an individual investor (and, I suggest for securities analysts as well) to assess.

The task became even more difficult as large banks moved into trading operations that more resemble hedge funds than a financial entity that earns a profit on the spread between the cost of funds (usually deposits) and the interest rate received on investments (or loans).

I recently have been looking for small banks to invest in, particularly in farming areas that are flourishing.  I came across one (not in the Midwest farm belt) that illustrates the risks of relying on banks’ financial statements.

I long have been skeptical of valuation arguments in support of banks that are based on the stock price selling at a discount to reported book value (i.e., assets minus liabilities).  Many banks—especially the largest—have grown through acquiring other banks.  Quite often, a large bank became large by making dozens of acquisitions over a number of years.  Acquisitions typically require a premium over the target company’s stock price, and the difference between the price paid and the net accounting assets of the acquired bank go on the books as “goodwill.”

For a company like Coca-Cola that has an invaluable brand name, “goodwill” probably has a substantial real value.  But for a bank that has effectively undifferentiated products and services, “goodwill” is a dubious asset.  So a conservative first step in analyzing bank stocks is to remove goodwill from the assets, which produces “tangible book value” (assets minus goodwill minus liabilities).

But even this might not be enough.  If a significant portion of the bank’s assets is made up of loans (or other investments) with shaky collateral, the assets need to be discounted further, reducing tangible book value even more.

The small bank that I was looking at gives a concrete example of such risks.  On the surface, the stock seemed cheap, selling at only 0.5 times tangible book value.  But an alarming deterioration in the loan portfolio backed by commercial real estate makes this apparent cheapness misleading.

To illustrate how heavily leveraged banks are, if this bank’s “troubled” loans are uncollectible to various degrees, this seemingly cheap bank stock will look extraordinarily over valued.  If 40% of the troubled loans default, the price to tangible book value (P/TBV) ratio goes to 1.0.  Not bad.  But if 2/3 of the troubled loans default, the P/TBV ratio goes to 2.6.  And if 80% of the troubled loans default, the P/TBV ratio goes to 13!.  And this assumes no further deterioration in the regional economy and the commercial real estate market.

Bank stocks can be good investments, especially if they are small banks that are acquired at large premia by large banks.  But be careful!

Steve Lehman

Thursday, January 26, 2012

Earnings Shortfalls Likely to Restrain Equity Gains

With major U.S. equity indexes near their post-2009 highs (only 2-3% from the high on the S & P 500), I've urged investors to raise some cash.  

I have been particularly concerned about high profit expectations for 2012.  I think it's probable that individual stocks especially are at risk of earnings shortfalls.  Though some companies (McDonald's and Apple, e.g.) reported strong results, others across various sectors (banking, drugs, industrials) revealed disturbing trends, particularly late in the quarter.  I still think two of the main risks are difficult comparisons and reduced currency translations from a stronger U.S. dollar.

Raising cash still is the most compelling immediate investment move, in my opinion.

Steve Lehman

S & P 500:  1317

Sunday, January 22, 2012

Europe Looks Better...For Now at Least

Developments relating to the European financial crisis have been the most important macro factor affecting global markets for many months.  For now, things seem to be looking up.

Last month, the European Central Bank (ECB) ended many weeks of indecision and halting measures by extending $630 billion to banks at a rate of only 1%.  The banks will repay the ECB in three years.  In the meantime, it is expected that the banks will use the money to buy bonds issued by European governments in the weeks to come.  Governments will need to issue approximately $1 trillion of bonds this year, to replace maturing bonds and to cover budget deficits.  This will provide support for the European bond market and provide an attractive "carry," or interest-rate spread to banks of about 5%.

So far it seems to be working.  This week, yields at bond auctions were significantly lower than at prior auctions.  The action of the ECB buys time for the banks, whose financial conditions are much worse than those in the U.S., and provides them with a source of profits to offset at least part of the diminished profitability resulting from shrinking their balance sheets by curtailing credit outstanding (and shoring up their capital positions).

This action by the ECB has the added appeal of not imposing further direct costs on (German) taxpayers or of making large direct purchases of government bonds.  As a result, the ECB has substantial capacity remaining for further measures if they are needed.

So far, the ECB has bought bonds in an amount equivalent to only about 2% of European GDP.  The U.S. Federal Reserve's intervention of bond buying has been about 11% of GDP, and in the U.K., purchases by the Bank of England amount to 13% of GDP.

With new governments in Italy and Greece, the ECB apparently relented and provided the substantial help that political leaders had been clamoring for.  But Europe is not past its problems.  Long term demographics are worse than in the U.S., and the debt consequences are grim.  In addition to the large existing debt obligations of the Eurozone, pension obligations amount to an estimated $39 trillion, which is five times the amount of gross outstanding debt.

Though conditions in the U.S. are on the upswing, banks in the U.S. and elsewhere still have considerable exposure to the European credit crisis, which is why I continue to be wary of investing in major bank stocks.  Small, regional banks (particularly in farm states) seem to be a better area of investigation.

Steve Lehman

Saturday, January 21, 2012

Earnings Season--A Time For Caution

The latest quarterly earnings reports have begun to be issued in the U.S.  With U.S. stock prices up 20% from the low three months ago and at a six-month high, it seems prudent to realize gains and reduce exposure.  Momentum measures are still positive, so if that is your method of participating in markets, hang on but look for an exit.

Typical of periods of rising stock prices, there has been favorable news to support the rise in stock markets.  Economic news in the U.S. has been getting better, and Europe is showing signs of stability in its financial system.  I suggest not getting carried away.

I've noted previously that earnings expectations in the U.S. had been at historically high levels, which has been associated with poor subsequent equity returns.  Estimates admittedly have come down, but they still reflect a 10% increase in 2012.  By a recent count, 96 companies in the S & P 500 had revised their fourth-quarter estimates downward, which is the most since 2001. Perhaps coincidentally, the S & P 500 declined 22% the following year, 2002.

I am not suggesting an imminent drop of more than 20% in stock prices.  I am, however, reminding that profit margins are at historic high levels, and year-over-year profit comparisons will soon face a significant headwind.   The typical S & P 500 company derives more than 40% of revenues from abroad.  The strength in the U.S. dollar last year means that over the next several quarters, foreign revenues at U.S. companies will have to be converted into more-expensive U.S. dollars than a year ago.  This will reduce revenues and earnings reported in U.S. dollar terms (all else equal).

It makes sense to me to raise some cash from U.S. equities.

Steve Lehman

S & P 500: 1315

Monday, January 16, 2012

Gold Still Warrants a Place in One's Portfolio

During my endorsement of gold going back to 2000, a key rationale has been that investors would lose confidence in central bankers (notably Alan Greenspan--remember him?) and paper money.  That continues to be the case.

As savers in the U.S. continue to be penalized by negative "real" interest rates after inflation, a primary basis for higher gold prices persists.  Negative real yields on U.S. Treasury bills historically have coincided with rising gold prices.  There is no indication of higher rates in the U.S. or other developed countries, and even central bankers in developing countries are cutting interest rates to try to promote economic growth.  In essence, there is no opportunity cost to holding gold rather that cash that yields nothing.  Of course, if the 20-year bull market in gold ends, cash will look good.

The recent 19% decline in the price of gold bullion has been followed by a 6% rebound.  Last week, reports indicated a sharp increase in Chinese imports of gold from Hong Kong.  That buying, plus a likely end to major selling has supported the price of bullion.  Why did bullion fall 19% in price?  The near 30% year-to-date gain in bullion had left it vulnerable to profit taking, particularly in a year where many hedge funds had large losses elsewhere.

I think it is too soon to eliminate gold from one's portfolio.  Sentiment measures are depressed, commercial market participants (the "smart money") are buying, and real interest rates remain negative.  In addition, gold equities are quite depressed, despite an ongoing profit surge.  That is one sector that, in a slow-growth economy, has large profit gains ahead.  But as we saw in 2008, if stock prices fall sharply, gold stocks will behave like the equities that they are.

Steve Lehman

Sunday, January 15, 2012

Earnings Expectations Remain Incongruously High

I've noted that one significant impediment to higher stock prices in the U.S. has been the high expectations for profit growth in 2012.  Though the consensus forecast for S & P 500 earnings has been trending lower, 2012 profits are still expected to be more than 10% above 2011 levels.  This seems to be a stretch given that Europe is in recession, China and other developing economies are slowing, and profit margins in the U.S. are at historically high levels.

Even more surprising is the consensus estimate of 9% profit growth in Europe this year.  With the continent in recession and headline risk extraordinarily high, one would expect greater caution among analysts.  Valuations of European equities are quite depressed, but a major shortfall in profits would impede gains in share prices.  There are, however, a number of European companies that are global leaders and whose shares are increasingly attractive.  

I think a major surprise in 2012 could be gains in the Euro and European stock prices.  If Greece and other weak members are forced out, the Euro would become stronger and more like the Deutsche Mark.  That assumes that the banking system survives.

Contrarians take note.  The percentage of bulls on the Euro in the latest Consensus Inc. poll was only about 15%.  In addition, long positions in the U.S. dollar were among the highest in the last five years.  A lot of bad news is priced into the market.  

But before acting on either of those contrarian trades, I want to see more realistic profit estimates in Europe, and further declines in the Euro, first.

Steve Lehman

S & P 500:  1295

Thursday, January 12, 2012

Raise Some Cash

In recent weeks, I've been neutral on stocks.   That is, one should have had a "normal" portfolio allocation to equities that is consistent with one's long-term strategic equity allocation.

With stock prices now at their highest level in several months, the mood among investors has also climbed. My key measures of investor sentiment now reflect more optimism than is favorable for future gains in stock prices.  The market's technical condition indicates that prices have become somewhat elevated as well, warranting caution about significant new purchases at current levels.  I also think that earnings expectations are still too optimistic for 2012.

Though expectations for European economic growth, its currency, and corporate profits are depressed, headline risk is still considerable.  European governments will need to issue $1 trillion in new bonds this year (to replace maturing debt and cover deficit spending), with almost 1/3 of that to be issued by Italy.  Valuations among European equities are quite depressed relative to historical norms, but I am willing to miss opportunities there.  Now if share prices fall even further.....

I am loath to forecast much of anything, but I think it is unlikely that U.S. stock prices will reach new highs (above 1350 on the S & P 500) anytime soon.  I'd raise cash levels by trimming stock allocations here.

Steve Lehman

S & P 500:  1295

Tuesday, January 10, 2012

Investment Discipline Needed Now More Than Ever (cont.)

Thanks to those who have shared their views by completing the recent (brief) survey.  To those I haven't heard from, please take a few moments to complete the survey:


It is important feedback as I consider potential changes for 2012.


Now for today's comment......

Investing in financial markets has never been easy, but today's global interconnectedness, massive investment pools geared to hair-trigger shifts in positions, and a precariousness of sovereign credit conditions and the global financial system test the skills and mettle of those who dare to participate in markets.  It's no wonder that many individuals have given up on investing in stock markets.

But with savers continuing to be penalized by receiving a negative return after taxes and inflation, individuals are forced into fending for themselves in financial markets (unless they want to invest directly in a business or real estate, e.g.).  And most institutional investors have long since had the option of holding cash reserves while awaiting better investment opportunities taken away by consultants and impatient asset owners.

So what is a prudent investor to do?  Though institutional investors have a decided information advantage over individuals, individuals are free from the short-term performance pressures of the institutional investor.  And with so much information now available through on-line brokerage firms and the Internet in general, individuals can do just fine if, as Warren Buffett has said, they have the right temperament (not necessarily a brilliant investment mind).  As Buffett has said, an individual investor can be like a baseball player who can wait for a good pitch to hit without worrying about strikes being called.

That's all well and good, but what constitutes a good pitch?  For an investor, as opposed to a speculator, I'd suggest the following.  When overall market conditions are favorable--that is, when valuations are reasonable and the mood of market participants is depressed, or when expectations--for economic and earnings growth--are low, that is a good time to invest.  Trying to forecast the economy or company earnings, especially for years from now with supposed precision--is futile.  It is much better to find situations where others are looking for opportunities elsewhere.

For individual companies, I favor the following as a general practice:  stocks that have lagged the market, are undervalued based on the income statement (price to earnings), balance sheet (price to book value), or the cash flow statement (price to cash flow after subtracting capital spending and dividends); earnings strength (surprise and trend); financial strength; management skill and honesty (and conservative accounting practices); and earnings and dividend growth history and prospects.  For sustainable business and earnings growth situations, I use a variant of the PEG ratio where the sum of the dividend yield plus likely long-term earnings growth is divided by the p/e using current-year earnings estimates.

I always like to maintain cash reserves for opportunities that arise, and--especially with current market volatility--use the great John Templeton's approach of using limit orders to set purchase prices and patiently wait.  Patience, however, is not easy to sustain with the clutter of noisy market information and sharp swings in market prices.  But it is worth a concerted effort.

Steve Lehman

Wednesday, January 4, 2012

Please Share Your Thoughts

As I consider potential changes to make in 2012, I'd like input from readers of the blog.

Please take a few moments to complete this brief survey:


Thanks, and best wishes for 2012!

Steve Lehman