Friday, July 27, 2012

"Sustainable" Investing: Rewards and Challenges

The investment approach has various labels, including "sustainable," "responsible," and "ethical" investing.  Or, it is known as ESG investing, where conventional investment analysis is combined with a company's environmental, social, and governance practices.  Regardless of the label assigned, it means investing with an emphasis on companies with managements that are progressive with respect to making useful products and minimizing the harmful environmental consequences of the business operations, fostering positive employee and community relations, and practicing high ethical standards.  A growing number of pension and endowment funds have embraced sustainable investing.  

It's easy to see why.  First, investing in progressive companies has the effect of reducing risk without sacrificing returns, and it is often consistent with the missions of such funds. Companies that are progressively managed relative to their competitors have less risk of legal or regulatory problems, resource scarcity, and they have greater business opportunities. 

Such companies are simply better managed, and they deserve higher valuations in the stock market.  Their stocks also have produced superior returns to market indexes, and even greater returns compared to their competitors who are rated poorly on ESG measures.  These better-managed companies are more "sustainable," in that they are more likely not only to survive over time, but to excel relative to competitors.

Research firms specializing in ESG investing provide qualitative assessments of the largest publicly traded companies, and quantitative scores and rankings as well.  Various publications and online sources also provide pertinent ESG information and rankings of companies.   

There are, however, challenges in taking a sustainable investing approach.  It is difficult to assign a rating or ranking to large enterprises that operate in various industries with operations around the world.  Some regions or business divisions may have exemplary records, while others within the same company might not.  Many companies, for example, operate in industries that have harmful environmental effects, such as mining or energy.  How much emphasis should be given to managements' good intentions at improvements on ESG measures and how much to the actual effects of the operation of the business?

For these reasons, for the largest global companies, there are varied rankings on ESG measures for the same company, depending on the firm that has done the analysis.  There are, however, a group of companies that tend to appear at the top of global rankings nevertheless (as well as a group of companies at the bottom).

In contrast to approaches from a decade or two ago in which investors would simply avoid entire industries that were major polluters, for example, most sustainable or responsible investment firms now engage company managements to try to alter company practices in a positive way and give credit to companies that try to improve on this score.  That is where the emphasis should be placed, favoring those at the top of global company rankings and avoiding those toward the bottom.  

Two recent examples show the challenges for research firms and investors to fairly assess the conduct of companies.  GlaxoSmithkline for some time has been near the top of most rankings of sustainability.  Yet, the company recently was assessed a fine of the extraordinary amount of $3 billion for improper marketing of some of its drugs.  That was clearly unethical behavior, but does that negate the good the company has done on other measures?  And how does Glaxo compare to other pharmaceutical firms?

Similarly, the U.K. bank HSBC consistently has been near the top of most sustainable investment rankings.  But the bank recently was accused of money laundering for Mexican drug cartels.

While examples such as these are frustrating to analysts and investors who embrace sustainable investing, they don't negate the value of investing this way.  Like other approaches to screening for attractive equity investments, the value of the approach is in emphasizing those at the top and avoiding those at the bottom.  Most investment firms in the ESG area use this "Best in Class" approach by investing in the best companies in each industry using ESG criteria, rather than avoiding entire industries because they might be major polluters, for example.

By favoring companies that rank high on ESG criteria and by avoiding the "bad actors" at the bottom, an investor can still achieve a portfolio that has lower risk and higher returns than by ignoring those factors or by investing in a market index.  For those who prefer to hire a professional money manager, they can employ a sustainable approach using individual stocks or mutual funds that are dedicated to a "sustainable" approach.

Steve Lehman

Thursday, July 26, 2012

Mario Draghi--the New "Maestro"?

Today's surge in stock prices around the world was attributed to comments by the chairman of the European Central Bank, Mario Draghi, who stated that the ECB would do "whatever it takes" to hold the Euro zone together.  Such confidence in the wisdom and power of the central bank and its head.  It almost made me feel nostalgic for Alan Greenspan, the original "Maestro" (not really).

Expectations of a more active policy of intervention in markets by the ECB was a tonic for beleaguered investors, who have endured month after month of the European debt crisis with measures that have thus far been insufficient.  It could be that this time the European authorities really mean business.  I'm skeptical.  But even if they do, I think the problems there present risks to the entire financial system, along with other issues, such as the likelihood of earnings shortfalls in coming quarters.

I do think that European equities are quite inexpensive on a longer-term basis, but I am cautious on global stock markets at current levels and will generally watch from the sidelines for the time being.  

Steve Lehman

S & P 500:  1363

Tuesday, July 24, 2012

"Beat the Estimate" Grows Old

Companies, securities analysts, and the media are again colluding in a favorite activity, "beat the quarterly earnings consensus estimates."  It's pretty simple.  Corporate managements guide analysts during the quarter to lower their earnings estimates for the company.  Or, if business is better than expected, managements lowball their earnings guidance.  Either way, when the company actually reports its profits for the latest quarter, the results are better than the consensus forecast, and the stock jumps.  Collectively, the media reports on the percentage of companies that "beat" the consensus estimates and typically, it is about two thirds of companies.  "Positive earnings surprises" are indeed looked upon favorably.

A related phenomenon is occurring again this quarter--earnings growth with little or no growth in revenues.  IBM has been a foremost example of this puzzling phenomenon, as it has continued to generate double-digit growth while revenues rise much less.  Several tactics are commonly used to drive earnings per share.  Switching to more lucrative business activities could provide a boost to profit margins and earnings.  Savvy tax strategies can lower the company's corporate tax rate (and increase reported profits).  Or buying in shares to reduce the number of shares outstanding increases earnings per share.  

There must be a limit to such tactics to boost reported earnings.  And since profit margins are at historic high levels, further significant growth in profits will need a comparable growth in revenues.

On this measure, the latest quarter is not encouraging.  Verizon, for example, reported 13% profit growth in its latest quarter while revenues grew only 3.7%.  GE and Microsoft had soft results in both earnings and revenues.  GE  profit and revenues each grew only 2.5%, while Microsoft had a slight decline in earnings while revenues grew 4%.

The media are reporting that the percentage of companies that "beat" the consensus earnings expectations is again running at close to 70%, but the number "beating" revenue expectations is only about 40%.  I remain concerned about earnings risks in the quarters ahead.

Steve Lehman

Sunday, July 22, 2012

Time to Raise Cash (at Least)

In hindsight, it is obvious why particular sectors and individual stocks have risen or declined over the last year.  Amid sluggish economic activity in the U.S., the debt crisis in Europe, and slowing Chinese growth, defensive sectors such as consumer staples and drugs have produced both excellent relative and absolute returns.  Conversely, investment banking, materials and natural gas stocks have been among major losers, along with companies with particular problems, such as Dell, Hewlett-Packard, and Walgreen.

But perhaps it is time at least to take some profits, if not reinvest in some of the laggards.  The performance differential in just the last year in a number of cases is fifty to seventy percentage points.

Note the large gains and losses among prominent companies listed in the following table:


Amgen +43%, Apple +66%, Comcast +34%, CVS +31%, Home Depot +41%, Mastercard +42%, News Corp. +42%, Starbucks +35%, US Bancorp +33%, Verizon +24%, Visa +44%, Wal-Mart +36%, Disney +25%, Wells-Fargo +25%


Baker-Hughes -45%, Caterpillar -25%, Citigroup -28%, Devon Energy -28%, Ford -29%, Freeport-McMoran -40%, Goldman Sachs -24%, Halliburton -44%, Hewlett-Packard -46%, Morgan Stanley -32%, Walgreen -26%

The companies among the gainers are clearly great companies, and the share-price gains over the past year reflect that.  I'd raise some cash from that list.  I haven't bought shares of any companies among the decliners list, but could they really be that bad?

Steve Lehman

Friday, July 20, 2012

Where Is the Value in Many Widely Held U.S. Stocks?

Starting price matters in an investment's subsequent return.  We've heard so much for so long about the virtues of stocks that pay significant dividends (including from me).  But starting price does matter, and new buyers of many U.S. stocks will not be getting a good value.  This will impede their future returns.

Take, for example, one of the most widely held dividend stocks, Verizon.  Not long ago, Verizon's dividend yield was 5.5%, which looked very good against other stocks and fixed-income alternatives.  But it now looks to me that it should be swapped into a better a different stock that offers better value.

After the 24% rise in the stock in the last year, the dividend yield on Verizon is now 4.4%.  This still looks good compared to many others stocks, and especially when compared with the 1.5% yield on a 10-year U.S. Treasury note or the 3% on a typcial intermediate-term, investment-grade bond mutual fund.  But the $.50 quarterly dividend comprises 80% of Verizon's estimated earnings per share for 2012.  This is extraordinarily high.  If the payout ratio were closer to 50% of earnings for a mature company such as Verizon, I would be more comfortable.

How is the stock's valuation?  Based on the company's earnings, the valuation is extraordinarily poor.  The stock now sells for 18 times estimated earnings per share for 2012.  Such a high valuation either implies that investors expect a rebound from temporarily depressed earnings or sustainable, significant earnings growth.  Neither seems likely, as Verizon's earnings are only slightly higher than they were three years ago.  I would much prefer buying a stock like this at a price/earnings ratio between 10 and 13.

How is the financial condition?  It, too, is poor.  The ratio of debt to shareholders' equity is 120%, which is high but manageable.  However, the company's pension fund is underfunded by an estimated $32 billion.  When this is added to the debt, the adjusted ratio of debt to equity is 218%.  Furthermore, though the company has a positive net worth of assets minus liabilities when including goodwill and other intangible assets, its tangible net worth is much worse.  When deducting the intangible assets, the tangible net worth (book value) of the company is negative.  The (intangible) Verizon brand name surely has considerable value, but is it worth nearly three times the tangible net assets of the company? 

Verizon isn't unusual in its lack of value.  Similarly, Coca-Cola reported roughly flat earnings growth for its latest quarter, but the stock sells for 19 times estimated 2012 earnings.  Its dividend yield is 2.6%.  Another market leader, Home Depot, not long ago offered good value at about 12 times earnings with a dividend yield of 3%.  But the stock has risen 41% over the last year, and it now sells for more than 17 times earnings and yields 2.3%.  I see little value at its current level.

Again, starting price matters in an investment's subsequent return.

With valuations of many of the most widely held stock now at 15-20 times earnings and their share prices up 20% or more over the past year, I advise general caution toward U.S. stocks.  Cash, which so many investors disdain, provides the means with which to take advantage of better buys in the stock market in the days ahead.

Steve Lehman

S & P 500:  1377

Wednesday, July 18, 2012

Reduce U.S. Stock Holdings

As a highly price-sensitive investor, I am taking profits as the S & P 500 has risen 7% in less than two months.  A number of stocks that I had identified as potential buys have rebounded 10-20% during this time, and I refuse to chase them.  If this summer rally continues, I will generally watch it and enjoy tennis and other summer activities.

There are exceptions.  Today I bought a stock that has fallen 21% this month in a sector that has excellent long-term prospects (agriculture).  There are a handful of other stocks of quality companies that are still reasonably priced.  

But with the VIX index at 16, the lowest level in a year, a more cautious approach is appropriate.  The VXX exchange-traded note based on the VIX is worth accumulating over the next several weeks.  After all, stocks have rebounded, complacency seems widespread, and the historically negative market months of September and October are not far off.

One equity market remains historically quite undervalued--Europe.  But with the possibility of a sharp decline in the Euro versus the U.S. dollar, the currency risk of European equities is significant for U.S.-based investors.  If the Euro does fall sharply, the competitiveness of European companies would be much better, and they would likely then represent outstanding long-term values.

But for now, greater caution toward the U.S. equity market is appropriate.

Steve Lehman

S & P 500:  1375

Tuesday, July 17, 2012

Is the Stock Market a Fair Game Any More?

Individual investors generally fled the stock market after the 2008 financial crisis and have not returned.  Instead, they have shifted money from stock funds to bond funds, in massive amounts and for many months.  There is no sign of this shifting.  The early explanations centered on the volatility of markets and the aversion of individuals to subject their portfolios to such wide swings.  I think a growing reason is that the stock market is no longer considered a fair shot for the average investor.

The lack of prosecution of key heads of financial firms after the 2008 financial collapse and the government bailouts that followed, shook the confidence of the average investor.  But it doesn't seem any better today.  

Recent news reports of rigged interest rates by Barclay's bank in the U.K., and the NY Times report that hedge funds have been getting previews of Wall Street analysts' reports and recommendations give no reason for average investors to return to the stock market.

Until there are actions that change the view that those at the top are protected and have the equivalent of inside information, it's no wonder that individual investors have embraced  bonds (even though the end may be near for the multi-year bond bull market).

Steve Lehman

Where to Go for Yield?

For some time, I (along with many others) have been a proponent of using stocks for income, given record low interest rates.  Stocks such as Merck, which a few months ago yielded 5% and had a current-year price/earnings ratio of 9, represented excellent value.  But Merck, and others like it, have risen significantly.  Merck now sells for nearly 12 times earnings, and its dividend yield has fallen to 3.9%.  This still may look attractive compared to the 1.5% yield on a 10-year U.S. Treasury note, but I am cautious after the rise in many stocks.

Two equity sectors that have been popular among investors who seek yield are utilities and real estate investment trusts (REITs).  I consider them both quite unattractive at current levels.  Though utility yields still are relatively high when compared to government notes, their valuations are poor at mid teens price/earnings multiples (and poor free cash flow generation and high debt levels).  Leading REITs now yield 3% or less, and typically a portion of the dividend yield on a REIT is a return of capital, so the effective yield is less.  I know it was a historic buying opportunity, but I remember when a decade ago REITs commonly yielded 7% and were selling at discounts to their real estate asset values.  I would avoid both groups now.

It is still extraordinary for the major U.S. stock indexes to have dividend yields that are higher than the interest rate on a 10-year government note.  That surely is a plus for stocks.  I am concerned, however, about the risk of earnings disappointments in coming months.

While U.S. Government securities repeatedly have held up well (even rising in price) during periods of market stress, I would avoid them and instead favor corporate bonds.  I have a significant stake in high-yield bonds, despite their popularity.  This is despite their equity-like performance in periods of market stress, such as in 2008, when most high-yield bond funds fell more than 20%.  That is a risk I'm willing to take.

In the meantime, I suggest holding significant cash while researching stocks and compiling a buy list and setting target prices.

Steve Lehman

S & P 500:  1355

Friday, July 13, 2012

Earnings and Europe

Today's rally in stock prices is attributed to relief over China's GDP growth and earnings reported by JP Morgan and Wells-Fargo.

Though the largest bank stocks are admittedly depressed, I still regard them as speculative, given the opacity of financial statements for the largest financial firms.  I have broader concerns about earnings as well.

Consensus earnings estimates for the current quarter are for flat earnings on the S & P 500.  Though consensus earnings estimates have fallen in recent months, making positive surprises more likely than before, I am concerned that estimates for the third and fourth quarters this year are too high.  Estimates for the fourth quarter are for a double-digit increase in earnings compared to the previous year.

For years the decline in the foreign-exchange value of the U.S. dollar provided a lift to reported earnings by U.S. multinational companies, as revenues and earnings from overseas operations were translated into more U.S. dollars (as a result of the rise in foreign currencies versus the U.S. dollar).

But with the strength of the dollar over the past year versus the Euro in particular and against many emerging market currencies, foreign results of U.S. companies are being translated into fewer U.S. dollars given the declines in foreign currencies versus the dollar.

Not only has the European debt crisis led to sluggish economic conditions overall and recessions in several countries, the Euro has fallen significantly in value against the U.S. dollar.  The Euro has fallen 14% against the dollar over the past twelve months.

Today two companies--Ford and Lexmark--announced that their European revenues declined by double-digits in the latest quarter compared to a year ago.  Other companies, including Procter and Gamble, have recently noted the drag on profits caused by their European operations.

This risk of earnings disappointments supports my existing preference for holding considerable cash reserves in addition to significant stock holdings.  Though cash yields almost nothing in the short-term, its value rises dramatically when stock prices fall sharply.

Steve Lehman

Thursday, July 12, 2012

"Operation Barn Door" Strikes Again

One of my peeves with the conventional investment business is the investment recommendations of "sell side" securities analysts.  These analysts work for investment banking firms that have a dual charge of promoting stocks through share issuance and also giving investment recommendations to portfolio managers.

The tendency is to recommend buying stocks, which is why there is usually a preponderance of "buy" or "outperform" ratings on a stock, with comparatively few "hold" or "neutral" ratings.  About the only stocks with "sell" or "underperform" ratings are those of companies in obvious fundamental distress such as being in an industry facing long-term decline.

What particularly troubles me is the common reaction to bad news and a plummeting share price.  The typical response by analysts to bad news and a plunging share price is to downgrade their rating on the stock after the plunge in the share price.

We all make mistakes, and we all are entitled to change our minds when given new information.  But what good does it do investors to recommend selling a stock after it has already plunged?  (Hence, "Operation Barn Door," or shutting the barn door after the horse has bolted and is well down the road.)  

Now, there are cases when such a stock will continue to fall.  But the analysts often seem to present their ratings changes as though investors can take advantage of their changed opinion and still get out without suffering a large decline in their holding.

Take SuperValu, which is a grocery retailer that has struggled under a large debt load while facing business challenges from Wal-Mart, Target, and traditional retailers.  I made money on SuperValu shares last year because at the right price, almost anything can be a good investment.  Conversely, even a company as superb as Apple can be a poor investment if bought at too high a price.  (The starting price of an investment is crucial.)

After the close of trading yesterday, SuperValu reported quarterly earnings that were much lower than analysts had forecast.  They also eliminated their dividend on the stock.  In response, today the stock has plunged 50%. In response, several analysts downgraded the shares.  So a shareholder is supposed to sell after absorbing a 50% loss in one day?  

In such a situation, I always admire an analyst who has been negative or neutral up to that point and upgrades the rating in response to a large price decline, because the odds of making money would seem to be much better amid such pessimism and with a much lower entry price for the stock.  As for those analysts who were positive going into the bad news and plunging share price and stick to their position, I admire their fortitude, but question their judgment at having been so wrong.

I won't wade into the question of whether SuperValu is a "buy" today since I haven't followed it for some time.  My hunch is that for one with ample funds for speculation, it might be worth a look.  My main point is that when securities analysts engage in "Operation Barn Door," they provide little value to investors.

Steve Lehman