Friday, December 28, 2007

Strong Banks are Very Cheap

This is the second part of a recent discussion between an old friend and client about the economy, markets, and interest rates.

Friend: So I think we both agree the subprime fiasco, while bad for housing and many banks, may not spill over as far into the overall economy as investors and the media now believe. If that is the case, what do your valuation models now say about stocks in general? I guess I'm particularly interested in the real bargains you might be finding.

GCD: We actually see bargains across almost all industry sectors, as well as, international stocks. But if you want to go where the bargains are, you go straight toward where the damage is the greatest: Financials. We still have to get through mid-January when all the banks and insurance stocks will be going to confession again, but if you stick to the highest quality institutions around the world, we believe their writeoffs will be well contained within their present capital structures, and if not, all they have to do is ask their friends in Asia for a little help. Selective banks are very cheap. Let's look at one in particular.
Wells Fargo is arguably the strongest bank in the US. They have a high double AA financial strength, a strong growth record, and enviable returns on total assets and equity. Finally, their largest shareholder is Warren Buffett, who would probably buy the bank and put in his hip pocket if they would let him. Thus, capital for expansion is not an issue.
The reason Mr. Buffett would buy WFC in a heartbeat is the chart above. It shows the comparison of WFC's dividend yield vs. the yield on a 10-year T-bond over the last 20 years.
The chart speaks a simple reality: 20 years ago there was nearly a 4% difference between the bond yield and WFC's dividend yield. Today it is zero, nada, zip.
20 years ago investors were betting that WFC's dividend growth would be at least 5% over the coming 10 years. If growth would not have been at least that much, the bond would have been a better buy by a wide margin. Indeed, over the last two decades WFC has grown its dividend in the low double digits and its stock has achieved a similar rate of return, beating bonds by a big margin.
Today, with WFC's dividend yield and T-bonds yielding the same, investors appear to betting that WFC will have zero growth over the next few years. That is hogwash. WFC will grow at least as fast as nominal GDP, which we estimate will run in the 5.5% - 6.0% range.
Almost all banks are as cheap as WFC. Some deserve their low prices, but a handful, at a minimum do not. Others that appear oversold to us are Bank of America and US Bancorp.
Banks have certainly made a wrong turn and now find themselves out wandering around in the weeds, but bad times for the average bank means good times for the big, financially strong banks such as WFC, Bank of America, and US Bancorp. With so many banks out in the weeds, these three big banks, along with a short list of foreign banks will gain market share over the coming years at an unprecedented rate.
Next time I'll discuss some other industries that look good to us.
We own all three of the banks discussed here, plus others.

Wednesday, December 19, 2007

A Discussion about the Economy with an Old Friend

Every year near Christmas time, a good friend and client comes visiting with Christmas presents for our staff. After the hub bub of the diet-killer delights he brings, he and I settle into a casual discussion of prospects for the coming year. I listen as much as I speak because I have found him to be a keen observer and a very good student of the markets, particularly human nature.

This will be the first of two or three items that we discussed.

Friend: Everyone seems to be bracing for a recession. I'm having trouble believing that a recession is imminent when most of the economic sectors are doing well with the exception of financial and retail. What do think the odds are of a recession?

GCD: I think they are less that 50/50, and I believe the consensus of our investment committe is that growth will slow, but recession is not the best bet. I have one chart I'd like to show you that I believe is not well understood and most people forget to take into consideration when they project recession.

The chart at the right is of US Net Exports of Goods and Services since 1970. The chart clearly shows that exports have not only been falling relative to imports since 1980, but that their rate of descent has accelerated dramatically since the early 1990s. That trend has been firmly in place until just in recent months when exports have turned higher relative to imports. Indeed, in the most recent quarter, exports represented nearly 20% of total real GDP.

Friend: So you are saying that exports alone may keep us out of recession?

GCD: No, I personally think the economy overall will be stronger than most people think. The housing issue is a tough hurdle to overcome, but I just don't believe that housing in most parts of the country got as overheated as in did in California and Florida, for instance; consequently, I don't think the unwinding of the excess housing stock in the country will linger as long as most people seem to believe. Export growth will almost certainly continue, so any good news in housing will produce more overall growth than Wall Street now predicts.

Friend: Exports are rising because of the fall in the dollar, correct?

GCD: I have said many times that oftentimes the seeds of destruction and the seeds of regeneration are in the same pod. The US's consumer mentality and heavy use of imported petroleum have caused a trade imbalance with almost every country in the world. In essence, we were trading dollars for goods. As those dollars were translated back into the home country's currency, dollars are sold and the home currency bought, ie., a weak dollar.

Friend: But for net exports to have turned higher, the dollar must have fallen sufficiently that our goods and services are now very competitive in the global economy? That still seems hard to believe. Most people think the dollar is destined to fall a far as the eye can see.

GCD: My best explanation for the power of a weaker dollar is the following: In the case of a citizen in Windsor Canada, a year ago a Cadillac at the local dealer and the one across the river in Detroit cost about the same. As a result of the collapse of the US dollar vs the Canadian dollar, the same Cadillac in Detroit is now nearly 20% cheaper than the one in Windsor. Thus, it pays the Canadian to drive across the bridge and "buy American."

Friend: I just saw where the big European consortium, Airbus -- Boeing's biggest competitor -- is saying that as a result of the collapse in the dollar, they will move $2 billion dollars of research on their new planes to a dollar denominated country. That would seem to mean that some, if not all of that work may come to the US.

GCD: I know we are speaking anecdotally, but this is happening all over the world. The fall in the dollar has made us more competitive and companies the world over have to deal with it.

Friend: Then I guess we are saying that the great bugaboo of a falling dollar is not all bad.

GCD: Yes, it eventually brings itself into an equilibrium level and begins to stabilize. That appears to be happening now, and I don't see it turning around anytime soon. I believe those people who are calling for a recession are missing the contribution of imports to the US economy .

Friend: That is what I have been thinking, as well.

Next time: Are US stocks overvalued?

Monday, December 10, 2007

McD's May Be Going Up, Because It's Going Up

Momentum is a wonderful thing, when momentum is in your favor. Only problem is momentum is like the wind -- nobody knows where or for how long it blows.

As the subprime crisis has extracted its toll from the banks and retail stocks, that toll has been invested in the so-called defensive stocks: consumer staples, oils, and utilities.

The chart at the right is our 20-year Dividend Valuation chart of McDonald's. If you wondered where the money went that they took out of your favorite bank stock recently, look no farther because a bunch of it went here. McDs has been moving straight up in 2007. Much of its rise has been warranted because the company has had a string of good earnings reports and a big dividend hike. However, some of the recent run up is probably due to momentum -- meaning its going up because its going up.

Our model is suggesting that the stock has a projected rate of return for the next twelve months of only 5%, give or take 5% (represented by the blue striped bar at right). In our way of thinking that means, judging from the last 20 years, the most probable year-ahead rate of return for MCD is between 0% and 10%. That does not give us much of a margin of safety if the US economy is a little stronger than many observers now believe. A stronger economy could well cause the momentum of MCD to reverse.

The Fed is meeting today, and to the extent that they keep cutting rates, the odds improve that economic growth may surprise on the upside in the year ahead. If that is the case, financials would be a better buy than staples. Almost all the financials we follow are nearly 25%-35% undervalued, again based on their long-term relationships to dividend growth.

A word of caution. We are only buying highly rated financials whose dividend is secure. I have no idea where Countrywide Financial or Washington Mutual will be a year from now. Additionally, while many consumer staples stocks are overvalued, many are not. I'll have more to say on some of the undervalued staples in future blogs. We will also have more to say on what financials we like.

Thursday, December 06, 2007

Could Oil Prices be Topping?

Oil prices recently flirted with $100 per bl and the consensus of most analysts is that it is only a matter of time before that level is taken out, and we move ahead to ever higher prices. The argument is that with the developing economies of China, India, and Russia growing rapidly and representing nearly half of the world's population, it is inevitable that the price of oil can only rise as far as the eye can see.

When I hear the term "as far as the eye can see," I recall how often it turns out that the eye can't see very far. Indeed, it is almost a certainty that the equilibrium price for oil is far less that the current selling price. Anytime the as-far-as-the-eye-can-see crowd is at work, you can bet that they have laid up lots of bets on oil and, thus, there is a speculative premium in the current price.

I said in a September 2006 blog that what always kills real estate is the gap between market prices and rents. When rents begin to lag way behind prices, it means that the supply of housing is greater than the demand, and the cost of carry will soon become a factor for speculators in the decision to hold or sell the property, even if prices appear to be moving higher.

As it relates to oil, I believe that the best measure of "true demand" is the price of gasoline at the pump. Gasoline prices are thought by many to be inelastic. After all, we have our lives to live and; well, we have to drive to live, etc., regardless of price.

I have been thinking for the last couple of years that to assume that gasoline prices are inelastic is probably not justified. The fact that demand for gasoline has not fluctuated much with higher prices in the past may be because total fuel costs for the average household budget has been a relatively small percent, in the range of 4%-5%.

The chart above is a scattergram (you may want to click to enlarge) that shows, as you would suppose, there is a very high correlation between crude oil and gasoline prices -- R2 of .94. Note the three arrows I have drawn on the chart at the far right. These points, which are the last three months, suggest that prices at the pump are much lower than we would expect them to be based on their historical relationship to crude oil. For instance, last week when oil surged to near $100 per bl, gasoline prices at the pump (Midwest) should have been near $3.50 a gallon. Oil prices in my region never got above $3.15. Currently with crude prices near $90 per bl, the chart indicates that prices at the pump should be near $3.20. Bloomberg shows that the prevailing price in the Midwest in currently $2.95 a gallon.

The lag in prices can be the result of only three reasons. 1. Oil refiners and marketers are holding down the price of gasoline, 2. Consumers are balking at paying much above $3.00 a gallon, or 3. A combination of both.

If consumers are balking at higher gasoline prices, crude oil prices would at the least flatten out, if not fall. The reason oil prices may fall more than you might expect is because of the rampant speculation in crude oil futures.

I'll keep you posted on this trend in future blogs. Could it be that some elasticity of demand is appearing? We'll soon see.

Wednesday, November 28, 2007

Beware of Momentum Shifts

There is so much money being bet on the front-running groups in the securities markets in recent months that there is a clear possibility that a sharp reversal in leadership may be in the offing. That is, the sectors that have been winning in recent months such as energy, consumer staples, materials, commodities, utilities, and Treasury Bonds may be running on pure momentum and not solid fundamentals. If this is the case, then as the financials find a floor, the front-runners may find a fall. Our models would suggest so. Energy is not cheap either on a nominal basis or a relative basis. Basic Industries valuations are off the map, consumer staples are fairly valued, utilities need for Treasury Bonds yields to stay at these levels to justify their prices, and Treasury Bonds need continued blood in the financial streets to stay where they are. We have been convinced that the subprime crisis would not wipe out the banks and that the Fed would do what they need to do to diminish the risks of a recession. It has almost been remarkable to us that subprime fears has spread so wide and so deep. In our judgment, the markets over the last 90 days have been more about smart-guy computer trading and less about anything resembling the present value of the long-term prospects of companies. Mindless momentum chasing is as prevalent on Wall Street as it ever has been, and it is likely to end up in the same place as most mindless endeavors: in trouble. Financials, consumer cyclicals, industrials, technology, and lower quality bonds have all been the whipping boys lately, but we believe the bad news is now fully priced in, and then some. We think there is a good chance that oil prices may have peaked (we will have more to say on this later). We think the subprime mea culpas may be nearing an end among the banks, and we think there is good reason to believe that the dollar's collapse may be at an end. All the worms are turning, and in our judgment, that which has been last shall likely be first in the coming year, and vice versa. Indeed, we are inclined to believe that the financials may lead the performance parade in the year to come, and the energy sector may well breath the hindmost fumes.

Wednesday, November 21, 2007

Thanksgiving Blessings

Each Sunday in our church, at the end of the service, the pastor stands before the congregation and gives us, what I believe is called the priestly blessing. It comes from Numbers 6:25-26 May the Lord bless you and keep you; May he make his face to shine on you, and be gracious to you. May he lift up his countenance on you and give you peace. These words never fail to cause my eyes to mist over. God is with us, and he is for us. There are worries a plenty in this world and in each of our lives. But on Thanksgiving day, I invite you to take the time to count the blessings in your life -- the people around your table, the food you will enjoy; the growth and promise of the younger ones; the strength and sacrifices of the older ones; the new faces at the table; the memories of those who have gone ahead. God's face does shine on us. If it were not so, this old world would have dried up and blown away a long time ago. May you all have a blessed Thanksgiving

Saturday, November 17, 2007

Berkshire Hathaway: Is It Overvalued?

Our valuation model for Berkshire Hathaway is suggesting that Mr. Buffett's pride and joy is modestly overvalued based on data from its recent financial report. This can be seen on the Valuation Chart at the right. The price line (in blue) is modestly above the green value bar for November 2007.
BRK/A is selling near $136,500 ($4,550 for class B) per share and the model indicates that its "normalized" value is just under $125,000 ($4, 170).
Having said this, our model's primary objective is to determine a company's probable price 12 months ahead. Plugging in our best guess for book value growth and interest rates in the year ahead, we get a price of $144,000 (4,800), shown by the green candy cane at the far right. That would put the stock approximately 7% undervalued.
In December of 2006, we arrived at a similar conclusion when we calculated that BRK was slightly overvalued on a near-term basis but undervalued based on a year ahead book value of $77,000. It now appears that BRK will end 2007 with a per share book value approaching $80,000, a remarkable performance in a tough market.
BRK/A is a great company and we have owned it for many years in our Capital Builder accounts. It's terrific performance in 2007 is a combination of its own solid results and a flight to the safety of Buffett's stable of "wonderful companies" and BRK's AAA rating.
Another driver has been Buffet's remarkable ability to find the gold in every crisis. BRK came out of 9/11 stronger than it went in. Buffett built 2007's powerful financial results partly in the aftermath of Hurricane Katrina by betting, though his insurance companies, that such devastation was an aberration and not an annual occurrence.
Since the rise of the subprime problems, he has been buying big pieces of Wells Fargo, Bank of America, and US Bancorp. He is rumored to be involved in taking positions in the municipal bond insurance crowd.
Buffett and Berkshire Hathaway have been on a powerful winning streak, and there are those who say he is due for a spectacular flop. Couple this with our Valuation model signalling that the company is fairly valued, and one might think it wise to take some profits in Berkshire Hathaway.
We are not following that plan. We think the current subprime crisis and Buffett's track record are likely to propel BRK much higher. Markets are not efficient. Greed and fear are powerful forces that do not end when valuations appear over or undervalued. They end when they exhaust themselves. To the extent that the subprime crisis stays in the headlines, BRK is likely to continue to climb. We do have a level in mind that we believe factors in all the possible good news for the next couple of years, but obviously, for the present, we are keeping it to ourselves.

Thursday, November 15, 2007

Just How Big and How Bad is the Subprime Mortgage Problem?

I have been trying to get my mind around the subprime problems for months. I keep asking myself the same questions everyone is asking: how can it be so bad and so widespread, who's next, and who or what am I missing? Over this past weekend, I decided to take a 30,000 foot look at the situation to see if I could make more sense of the crisis from that perspective than I had been able to wading around in the fast flowing currents of the news of the day. It occurred to me that the macro approach would at least offer a way of putting the subprime crisis into perspective, relative to the US economy. I quickly found that there is as much bad data on the subject as there is good. In truth, no one knows what the ultimate outcome will be; however, I found a way of thinking about the issue that made sense to me, and I have seen others coming to conclusions that are similar to mine.
  1. Subprime is about 13% of the $10 trillion total mortgage market, or about $1.3 trillion.
  2. Currently about 17% of subprime loans are delinquent. For our purposes here, however, let's assume that 50% of subprime loans ultimately default.
  3. That would put the total defaults at $650 billion.
  4. But remember these loans are backed by homes, so let's assume that when the homes are ultimately sold, the debt holders will receive 50 cents on the dollar, or $325 billion.
  5. My study of the situation indicates that the banks and investment banks sold about 50% of the loans to insurance companies, retirement plans, hedge funds, private equity groups, etc., and kept the rest. That would put the amount in banks and investment banks at near $163 billion.
  6. Next, assumed that approximately 70% of the loans stayed in the US and 30% went abroad. That would give us a final exposure to the US banking system of near $115 billion.
That figure would lean toward a worst case scenario. As of today, nearly $55 billion in write offs have been announced. On the surface it would seem that we have a lot of pain left to endure. But remember, even if the worst case comes to pass, it will not happen immediately because, as I said earlier, this exercise assumes 50% of subprime loans default, whereas, only 17% are delinquent today. Finally, if the ultimate losses do total the aforementioned figure, it will represent only .8% of US Gross Domestic Product of nearly $14 trillion, or put another way, less than one year of US bank earnings. I am confidant that if the problem is of the size I describe here there will be no lasting effect on the economy or the vast majority of banks. The only caveat to this line of thinking is it is hard to imagine that things have deteriorated so rapidly and we don't know how other parts of the economy will hold up under the stress of the real estate malaise. In this regard, the recent earnings reports were mostly favorable, but the Christmas selling season is very important to the US economy, so we won't have conclusive data until January. I am receiving many terrific questions from clients about our firm's views on a number of subjects. We will do our best to answer each question here so everyone can be informed. Next time we will look at some Consumer Staples companies we like, and some we don't.

Tuesday, November 06, 2007

Bank of America: Dividend Growth Will Continue and the Price Looks Right

Many readers have asked that I show the Dividend Valuation Model for Bank of America. The company recently announced disappointing earnings and has seen it price fall off with the other big banks.

Having said this, I believe the bank is dealing with its issues in investment banking and will be one of the first big banks to get its writedowns behind it.
The current dividend yield is 5.5%. BAC has raised it dividend in each of the last 20 years. Dividend growth, during that time, has averaged nearly 13%, and nearly 15% over the last 5 years.

The past is no guarantee of the future, but I believe the company will continue to increase dividends, albeit at a slower pace.

Wall Street analysts are now estimating that BAC's earning over the next 3-5 years will average near 8%. The chart above uses 8% dividend growth in 2008.

The green candy cane at the far right of the chart is the implied value of BAC at this 8% dividend growth rate. That price is $56 per share.

No one knows the magnitude of the subprime loan problems that lurk in bowels of banks today, but we can make some simple observations. Unless the US economy falls off a cliff, the banks have enough capital to withstand a lot more trouble that the subprime problems appear to present. BAC's management has a reputation for being straight talkers. They did not sugar coat their writeoffs, and CEO Lewis said the performance was unacceptable and that changes were coming in the investment banking group.

By the swiftness of the subsequent actions, the plans must have already been underway on the day of the earnings announcement, because three weeks later they have already replaced many of the top managers of investment banking, and announced the elimination of 3,000 jobs.

Including dividends, if BAC reaches $56 per share over the next 12 months, that will represent nearly a 29% total return.

I admit that it doesn't seem possible in light of the news of the day, but, as I said earlier, if Fed does its job and the economy has even modest growth, the subprime fiasco will gradually fade from the headlines, which will allow the banks to move higher.

I own BAC and have for many years. At 5.5% dividend yield, it doesn't take much price appreciation to make a double digit return. That might look pretty good a year from now.

If you are not a client of DCM, please do not act on my discussion here alone. Consult your own financial advisor.

Thursday, November 01, 2007

The Fed Got it Wrong!

My prediction that the Federal Reserve would lower their target rate by 50 basis points was wrong, but in my judgment, they will see the error of their ways and continue to cut rates very soon. I do believe, however, that they missed the opportunity to stay out ahead of the unfolding worries in the subprime market. Today's downgrade of Citigroup by Wall Street analysts is proof of the pudding, so to speak. Citigroup is down nearly 7% on rumors of more write offs and the possibility that they may have to cut their dividend. Citigroup's bad news has spilled over into the general market, pushing the Dow down nearly 1.5%. If you recall in the blog where I predicted the 50 basis point rate cut, my central theme was that the yield spread between Fed Funds and T-Bills was signalling continuing worries about the banks, especially the big investment banks. When the Fed Funds Target Rate is significantly above the rate on T-Bills, it is a clear message that sophisticated buyers are opting for government-backed paper over bank-backed paper. When I first started talking about this phenomenon in early September, the difference was over 1.25%, as high as it had been in nearly 20 years. As a result of the mid-September rate cut, yesterday that difference had fallen to near 1%. Yesterday, after the Fed announced only a 25 basis point cut and indirectly expressed the notion that future cuts may be unnecessary the yields on T-Bills began to fall. For those of you worrying about inflation, a fall in T-bill yields is a very big bet by very big investors that you are wrong. Indeed, a fall in T-bill yields says two things:
  1. The odds are increasing for a recession.
  2. The Fed got it wrong.

I do not believe there is a high probability of a recession, but I do believe that the Fed got it wrong. The good thing is, they can still get it right and well before the next meeting in December. Fed governors give speeches everyday. All they have to do is to take away the implication that the rates cuts are done.

They have now lost the lead in taming the ongoing banking worries, and they will have to do some heavy lifting to regain that position, but if they speak with one voice, they can regain their rightful leadership position by December.

As it now stands, the Fed Funds Target Rate is 4.5%. After yesterday's and today's rallies in T-Bills, they now yield about 3.7%, yield spread of about .8%. That is still high by historical standards and implies the credit and liquidity crunch is far from over.

The Fed is the banker of last resort, and I'm confident that they will ultimately get it right. Having said this, I think they made a mistake in reading the markets that Alan Greenspan would not have made.

Tuesday, October 30, 2007

Fed Rate Cut: 50 Basis Points or 25?

Trading in Fed Fund futures is signaling over a 90% probability that the Fed will cut rates on the 31st. Trading also suggests that the most probable cut is a quarter of one percent. That is also the best guess of our president, Mike Hull, who is now sporting a 0-1 win-loss record against me. Last time, I predicted that the Fed would cut rates by a half percent because I believed they recognized that a credit crisis was underway, and they needed to get out ahead of it and signal that they were more worried about an economic slowdown than an uptick in inflation. One of the indicators on which I based my prediction was the yield spread between Fed Funds, the overnight rates at which banks loan money to each other, and T-bills, the short-term rate at which the US government borrows money. That yield spread had spiked to more than 1.25%. I suggested then that such a wide yield spread was not only unusual (it had only occurred four times in the last 20 years) but a clear signal that loaning money to a bank was considered much more risky that loaning money to the government. This crisis of confidence regarding the creditworthiness of the banks jeopardized the economic health of the US economy and had -- and would continue to cause the banking system to freeze up, unless decisive action was taken. I advocated a 50 basis point cut as a preemptive move to "knock" the bankers on the head and remind them that the Fed was in charge not only of fighting inflation, but also ensuring liquidity in the banking system and economic growth. The Fed's subsequent 50 basis point cut was a bit of a surprise to the stock market and it responded by powering higher nearly 300 points. The Fed needs to cut rates by 50 basis points again because the yield spread between the Fed Funds rate today, 45 days after the last cut, is still nearly one percent: Fed Funds rate 4.75% and T-bills at 3.85%. In my mind this wide spread is still signaling the credit crisis is alive and well. I think the Fed should cut rates until the yield spread falls to no higher than .5%, and they need to do it swiftly. They currently have the liquidity crises corralled but not tamed. They need to tame it, and the best tool they have to do this is to continue cutting rates at a pace greater than the market predicts. The value of these continued sharp cuts will ultimately get the market's attention and allow equilibrium to return the banking system and the economy. If need be, the Fed can take back some of the rate cuts after normalcy has been restored. Even though I realize it is a long shot, put me down for a half percent cut. Shawn, Ken, David, Mike, Joe, Jay, et al, here's your chance to get your money back.

Monday, October 29, 2007

The Flip Side of Maximum Pessimissm

Last time, I discussed John Templeton's investment strategy of investing in the world and stocks where there was the most pessimism. He practiced this strategy because he believed that as an economy, industry sector, or individual stock becomes completely tarred and feathered deeper pockets and steadier hands often step in to buy the stock that the momentum players are dumping. I have noticed that in periods of maximum pessimism there is an equal and opposite force that I will call maximum optimism. In this regard, investing is a zero sum game. If the momentum crowd bails out of bank stocks, as they have, the money has to go somewhere. If it goes to cash, it drives down short-term interest rates. If it moves to bonds, it drives down longer-term interest rates. Finally, if it goes into stocks in different industry sectors or even different countries, it will tend to drive the stocks in those new areas higher. In the recent sell off, some money has gone into short-term, high quality bonds, but it is clear that little has gone into longer term bonds because bond yields have not moved much. To my eye, it is clear that the money that has left the bank and financial stocks has moved to energy, consumer staples, and commodity related stocks. Now guess what? Stocks in those sectors are now reaching fair value and, indeed, energy has pushed into overvalued territory. So, does that mean that under John Templeton's investment strategy we should be selling the energy stocks? Good grief, that is nuts, isn't it? Doesn't everyone know that oil prices are going to continue to go higher through the end of the 21st century? The new middle class of China, India, Eastern Europe, and South America are going to drive Lexi, aren't they? Aren't they going to end up consuming about the same per capital amount of energy as, for instance, the middle class of Europe? My answer is -- not by a long shot. Motorola had incredible success in China in the 1990s selling pagers. There were few telephone land lines in most areas of the country, so the early form of communication in China was by pager. Gradually pagers gave way to cell phones. Land lines are still in short supply in the country, but second and third generation wireless telecommunications are filling the needs of many of the new middle class in the nation. The same thing is going to happen in transportation. Second and third generation modes of transportation are and will continue to explode. Intra-city public transportation is growing at a high rate, and high speed bullet trains are in the works. You can bet that these "centralized" forms of transportation will be the rule in the country because that is the one area where the old Communist mindset makes sense. The same goes for India and South America. They know they cannot rely on the suburban American model of 2.2 cars for every household and ribbons of high-speed asphalt highways connecting every city in the country. Public transportation is how the Communist leaders can maintain a modicum of relevance. Communications in most of these countries will continue to be like the wild west, but transportation will be more controlled, more out of those famous Communist five-year plans. As the world comes to understand the "new world" model, it will become more clear that natural resource consumption will not grow at geometric trends, as is now feared. In short, oil prices are not going up as far as the eye can see, or the mind can think. Energy stocks are overvalued, but we are not selling yet. Indeed, we would be foolhardy to announce in advance that we think oil stocks have reached their peaks. Just say that oil stocks are fully prices, and we will be keeping a keen eye out for prices that factor in oil prices rising "forever." We think that is what Mr. Templeton would have done. He knew that the "crowd" often gets it wrong. But, why take your profits too early when the crowd will always push prices beyond reason, both in sectors where the news is bad as well as where the news is good.

Tuesday, October 23, 2007

Templeton's Theory of Maximum Pessimism

John Templeton, founder of the Templeton Funds (now part of Franklin Templeton), will leave a giant legacy when he passes on to his reward. He is widely recognized as the father of international investing. He was investing in foreign lands before most US citizens were even investing in the US. He was an early apostle, as he put it, for "turning Americans into investors instead of savers." When he was advocating this only about 20% of Americans had any money in the stock market; today that figure is over 50%. He was born in Tennessee and he kept the commonsense of the Volunteer state while amassing a fortune helping people invest their money though the value investing principle of "Maximum Pessimism." He was a rock-bottom value investor. He wanted to invest in countries and companies where there was not only blood in the street, from an investment perspective, but it had dried. He wanted to buy just after the last person at the local stock exchange had turned out the lights. "Maximum Pessimism" to him meant that in a country or company all the bad news was completely out and known by everyone from school teachers to captains of industry, from alderman to the President of the country. He wanted abject pessimism. He would then begin to buy. Templeton believed that once "Maximum Pessimism" was reached the odds swung in his favor. It was at this point that the citizens, capitalists, and politicians were fully cognizant of the problem and each in his or her own way was pressed to do the right thing -- stop the bleeding. Crises result from bad decisions gone bad. Crises call out for leadership to solve the problem -- stop the bleeding. This "stopping of the bleeding" is difficult and requires that very proud men and women (usually men) to admit that they have failed. Most business leaders do not have the courage to do that the right thing when it makes them look bad . It is only when the markets turn against them that they are actually rewarded for admitting their failures. Stopping the bleeding is facing the fact that something is wrong, identifying what is wrong, and cutting it out. Consumers, bankers, and the government have been riding the magic carpet of debt. The recent subprime crisis has shown the magic carpet for what it is -- a rug. The leadership of companies that are the first to acknowledge that the magic carpet is a rug and value it appropriately will survive. Those who hold any illusion that the carpet has any powers of flight will find themselves without a job very soon. Thus far, I believe one of the first bankers to call the magic carpet a rug is Kenneth Lewis of Bank of America. My guess is that John Templeton would approve of Mr. Lewis' confession that the had learned about all he wanted to know about investment banking. I'm betting that Mr. Lewis will stop the bleeding in BAC's investment banking division, and in doing so, persuade deep value investors who are followers of John Templeton that "Maximum Pessimism" has been reached.

Wednesday, October 17, 2007

Investing versus Speculating -- UTX

Just a few days ago, I was extolling the virtues of United Technologies and its high level of predictability. Today the company reported outstanding earnings but warned that 2008 earnings growth would be in the range of 10%-14%, at the low end of its heretofore projected average growth rate of 14%. Since UTX has had a good run this year, the traders headed for the door and UTX was down nearly 2.5 points.

If I thought UTX had significantly changes its stripes, I would be selling too, but I don't believe they have. They operate in 4 areas: Aerospace and defense, Otis elevator, Carrier HVAC, and their security division. Few companies in recent years have been as well positioned and running as smoothly as UTX.

Their announcement of slowing earnings growth is reasonable and proper. We believe the US economy will slow in the coming year. UTX derives 50% of their profits in the US, so it is predictable that the company would warn about a slowdown in earnings.

UTX's strength, however, is their inroads into the rest of the world. Think global economy: think Otis Elevators and Escalators. Think energy conservation: think the new line of Carrier Heating and Air Conditioning systems, which is reported to produce energy savings of up to 35%. Thinks Aerospace and Defense where UTX is a leader in jet engines and helicopters. Think terrorism: think UTC security and protection.

Our Dividend Valuation Model suggests UTX has a high probability of reaching nearly nearly $90 per share in the year ahead, even using the company's lower earnings growth targets.
Notice how tight the actual price (blue line) has been over the last 20 years to the model's predicted price (green bars). This very tight fit is suggesting that, even at a slower growth rate, UTX has a lot of room to run.
Good to great companies aren't on sale unless there is some vexation going on. UTX is a wonderful company undergoing a mild case of vexation. We think it will pass.
We own the stock and have owned it for a few years.
The old saying on Wall Street is that the momentum players cut bait and sell to the value players when the timing is poor but the price is right. All the value players have to do is wait Our model is giving us a clear message that UTX's price is right. Unless UTX's earning and dividends slow to single digits, if we are patient enough, time will provide us a nice profit. It certainly is not guaranteed, but the tight fit of the model suggests that it is as good a guess as we can make of what to expect in the year to come.

Monday, October 15, 2007

Using Dividends to Predict Stock Prices

The academics have been telling us for years that the stock market is efficient. That is, it is not possible to use technical or fundamental analysis to predict the winners and losers in the stock market because each stock's current price already factors in everything that can be known about its future. Warren Buffett has said that the academics are off their rockers because he could not have amassed his $50 billion fortune if their concept of the efficient market were true. Our approach to investing is a bit different from either the efficient market approach or Warren Buffett's approach. We call our investment approach the Predictable Market Approach, and of course, the driver of the PMA is the dividend. We have found that approximately 100 of the 500 stocks in the S&P 500 have some correlation between price growth and dividend growth. By adding in interest rates, we can increase the stocks that have some predictable qualities to about 150. In the Dow Jones Industrials, we have found that about 15 of the 30 stocks are significantly correlated to their dividend growth and/or changes in earnings and interest rates. On the contrary, we can find little correlation in the S&P 500 between prices and dividends, earnings, or economic growth. As academia would say, the S&P 500 is random. On the contrary, we believe the Dow Jones is not as random in its movements as the S&P 500, mainly because the companies that comprise it have consistently paid a higher percentage of their earnings in dividends, which makes them more predictable. Here's a brief look at the PMA.
  1. Predictable: first we look for companies where some combination of fundamental data reaches an acceptable threshold of correlation to changes in their stock prices.
  2. Undervalued: second we look for companies where the predictability equation suggests a stock is undervalued, based on a simple one year projection of fundamental changes.
  3. Momentum: third we look for companies that pass the first two screens and have some validation of their undervaluation manifested in the upward movement of their stock prices.
Here's the bottom line--predictability of the potential total return for a stock is a tremendously under appreciated concept. Think about it this way, the price of United Technology (UTX) in the Dow Jones Industrials is over 90% correlated to changes in its annual dividend growth and changes in interest rates. IBM's price, on the other hand, is not correlated at any significant level to any company or economic data; it's random. You might be the world's greatest expert in predicting the dividend or earnings growth for IBM, but history tells us that there has been little opportunity to profit from this knowledge. On the other hand, if you have been skilled at predicting dividends or earnings for UTX, you have had a very high probability of predicting when UTX was over or undervalued, and profiting from this knowledge. Currently, our work shows that among the 150 companies in the S&P 500, which have some predictive qualities, 27 meet the three criteria listed above. That may seem like a low number, but that is up from 17 a month ago.

Thursday, October 11, 2007

It's a Subprime Crisis, Not a Banking Crisis.

After Countrywide Financial warned in July that they were experiencing delinquencies across all credit quality classes of mortgages, the stock market went into a tailspin, assuming that all banks were either deep into subprimes or that prime mortgages were beginning to default.

We were watching the chart at the right, which shows the % of delinquencies of subprime (blue line) and prime (orange line). It has been clear that subprimes have been in big trouble for the last two years, with delinquencies now running at over 15% of subprime loans oustanding. So if the big banks are deep into subprimes, they will, indeed, be taking big write offs. However, if they have managed to sell off or avoid their low quality loans, the prime sector of mortgaes would appear to be in very good shape, with only 2.7% of prime loans currently delinquent.

Our analysis of Bank of America, Wells Fargo, and Wachovia, tells us that these three major US banks have only modest amounts of subprime loans and that they are well secured and manageable.

Wachovia said in their July earnings meeting that they did not have any subprime loans. Since then they have announced that they are going to commit $15 million to the lower quality market. We think this is a smart move, since almost everybody else is exiting the sector. There are probably some great bargains.

The evidence is growing steadily that the big banks in the country sold off their high risk mortgages to the big pools of money that Wall Street was throwing their way.

The market is on pins and needles awaiting the big banks to announce their earnings, or lack of them. We are firmly in the camp that believes the news will be better than Wall Street now believes, and for this reason, we believe the aforementioned banks represent very good values.

Saturday, October 06, 2007

From Sea to Shining Sea

Americans are provincial. Whether you live in New York or New Harmony you believe that your world revolves around the good ole US of A. You are wrong. As much as we are proud of our country and what it has given to the world, we live in a global marketplace. The unions will try to deny and fight it, the Democrats and Republicans will try to politicize it and prevent it, but at the end of the day, unless we want to turn back the clock of progress, you will realize that we are just a big part of a bigger world. Mamma's let your children grow up to be cowboys, because a cowboy might be a better profession than an autoworker, steelworker, or software engineer, perhaps even attorney and stockbroker. The times they are a changin', and the times for the us US of Aers will change the most. We have won the battle and lost the war. We have proved to the world that freedom and free markets are the instruments of progress and the touchstones of life, liberty, and the pursuit of happiness. Only a handful of countries in the world now believe that central planning can bring prosperity to its citizens. In the early 1980s Ronald Reagan said that only 2o% of the world believed and practiced freedom and free markets, and that was the reason that the world was so stuck in a rut. He railed against a taxation system that rewarded those who road on the wagon without ever taking their turn at pulling it. He condemned the politicians worldwide who were so blind to think that taxing the efforts of the few could provide life, liberty, and the pursuit of happiness for the many. Quite frankly, he changed the world, and caused freedom to ring around the globe. But as the scriptures say, the dog returns to its vomit, and Russia, which collapsed under the weight of its own corruption, is returning to it effluence. Europe, which always speaks the poetry of wisdom, but practices the witchcraft of feudalism is raising up the lords and ladies of royalty as bequeathed by the power elite. Even the home country of Mr. Reagan, the USA, has decided that the rich must pay more than their fair share to be citizens of this county. Democrats and Republicans in this country have completely forsaken the simple wisdom of President Reagan, and they now grovel in front of a demanding electorate that has decided that the strong will carry not only the weak, but also the able. No politician in this country has the courage to name the charade for what it is: from him who has, to him who has not; not by choice, but by law. The problem is him or her who has, knows how he or she got it and how much it cost, and he or she is not going to give it away just because the politicians say so. Money moves at the speed of light from sea to shining sea. The time is fast approaching when the flags of the pullers of the wagon may well move to a country with different stripes. Companies are moving their headquartes out of this country for lower taxes, citizens will be next. Canada has just lowered it tax rate for corporations to near 25% less than that of the US. How long do you think it will be before they get real smart and lower their individual tax rates below that of the US. They are a long way from from that today, but they can see the it is near an inevitability that taxes are going up in the US. Don't you think the same Canadian lawmakers who cut corporate tax rates are going to figure out that if they cut individual tax rates they might attract the cream of American entrepreneurs, and the jobs that will accompany them. You think I am talking nonsense? You have your head in the sand. I cannot count on two hands the number of Canadians I know who left Canada because of the taxes, and I cannot count on two hands the number of Americans who would gladly move to Canada if the price were right.

Wednesday, October 03, 2007

New Estimate of the "Fair Value" of the Dow Jones Industrials

Periodically, we plug in new estimates for dividend growth and changes in interest rates for the coming year and make a prediction for the "fair value" of the Dow Jones over the next 12 months.

As a reminder, in our January 2007 Barnyard Forecast with the DJ 30 near 12400, we said that our Dividend Valuation Model was signally that the "fair value" for the Dow in the year ahead was near 14,000. Indeed, that is about where the market stands today.

We have updated the model from time to time over the last 9 months to reflect actual dividend growth and changes in interest rates, and except for a brief period in early summer when rising interest rates drove it lower, the model has stayed near 14,000.

In our judgment, the solid performance of the Dow has been spurred by the near 12% dividend growth for 30 companies in the Average .

The chart above shows our estimate for the "fair value" of the DJ 30 in the year ahead, again using our estimates of dividend growth and interest rates. The predicted level turns out to be near 15,500. That would be a price increase of near 10%. Adding in dividends, our best guess for the total return of the Dow Jones over the next 12 months would be near 12%.

That may seem a bit optimistic in the face of all of the uncertainties in the markets and the economy, but we would not be surprised to see a return of that magnitude. We believe the US economy will be stronger than most people are predicting, and US multi-national firms will continue to benefit from the expanding global economy.

In addition, you will notice that the model has done a good job of identifying the "fair value" of the DJIA. It did not go along with the "tech head fake" of the late 1990s and correctly signaled how undervalued the Dow became in 2003, 2004, and 2005. Until it proves otherwise, we don't think it would be wise to ignore the voice of the model.

We'll keep you posted on how this estimate turns out as the year progresses.

Friday, September 28, 2007

Target is on Target

We believe one of the best signals for investing in the retail sector is right after the retailers bemoan the fact that for whatever reason, "This year Christmas will not come." This week Target warned about potentially soft sales and earnings through year end. Since Target (TGT) is a leader in mass retailing, we would expect many more retailers to be making similar declarations in the weeks and months

Real estate news is gripping the headlines, but it is interesting to note that only 2.7% of "prime" mortgage loans are in default and that is where 90% of all mortgage loans are located. The subprime mess is a small part of the mortgage pie, and even though it is causing lots of pain, it does not drive the economy of the United States. Jobs drive the US economy and America is at work and that is the reason that delinquencies on prime mortgages are so low.

Indeed, as it relates to the retailers, we have also found that "he who hollers first" is often the ultimate winner. In this regard, Target is a company we like a lot. They have the right strategy, the right product mix, and we believe they will have a solid Holiday selling season and continue to gain on Walmart.

Our Dividend Valuation Model above shows that TGT is as good a value as it has been since 1996.

Target may not seem like an obvious pick for these times, but who doesn't know that? The "Christmas isn't coming" crowd got out of retail a long time ago. When they see that they are wrong, they will be back pushing Target and the other top flight retailers higher.

Monday, September 24, 2007

Oh Canada !

Whether or not the central banks of many of the world's developed nations acknowledge it or not, they will soon begin cutting interest rates. The reasons are plentiful but two stand out: the US economy will soon begin to trend lower and with it most of the rest of the G-7 nations.

Europe has already slowed, Japan is having one of its never-ending political upheavals, and China and India are attempting to slow their economies in the face of rising inflation.

Additionally, the recent cut in rates by the US Federal Reserve has spiked the US dollar lower against most of the other world currencies. This will give US companies a powerful competitive advantage in the global markets, and at the same time, make foreign exports to our nation more costly. Taken together, these forces will cause a string of interest rate cuts around the world, probably beginning with Canada.

In the picture I see forming, our Canadian neighbors may well come out looking very good for a period of time. They are a natural resource exporting nation, so their products will continue to be in demand, even if prices begin to stabilize.

Canada's banks are strong, with few of the subprime issues that will continue to nip at the heals of American banks, and finally, the country's Conservative government is finally beginning to deliver on some campaign promises. Importantly, as I said last time, Canada just cut corporate income taxes to near 30%, among the lowest in the developed world, and well under US corporate tax rates.

In running Canadian companies through our Dividend Valuation Model, I see many that are cheap. In the coming months, I will describe a few here.

The best valuation I see is Toronto Dominion Bank (see chart above). It is the second largest bank in Canada and has been making strategic acquisitions in the US. Its combination of a 2.8% dividend yield and low double-digit dividend increases over the past few years has made it a solid performer but has still left it significantly undervalued.

Our model says (I am showing TD in its local currency) that the stock may be as much as 15% undervalued, based on my estimate of next year's dividend growth.

Canada's natural resource oriented economy will insulate it from the economic slowdown that may hit most of the rest of the G-7 nations. Indeed, Canada and the US may be the only G-7 nations that will not experience any negative quarters of economic growth over the next six months to a year.

Sunday, September 23, 2007

Soaking the Rich Will Backfire on the Politicians

Ask the proverbial man or woman on the street if rich people should pay more taxes and the answer is a resounding yes. Ask almost any of the Democratic contenders for the presidency what this country needs most and you are likely to hear tax fairness, in the form of higher taxes for the wealthy. There seems to be almost universal agreement that one of the great ills of the United States is that wealthy people do not pay enough taxes. The facts, however, suggest that higher income people in the US are anything but under taxed. According to an Op/Ed piece in the April 2007 Wall Street Journal, the Congressional Budget Office (CBO) reports that in 2004, people making more than $43,000 (the upper 40%) pay 99.1% of all taxes. That, of course, means that the lower 60% of the American population pay under 1% of federal taxes. But there is more. The top 10% earners in the United States, those families making more than $87,300, pay almost 71% of all federal taxes. What makes this so remarkable is that in 1979 the top 10% paid only 48%. Heaven forbid that a person be in the top one percent of earners in this country; according to the same CBO report, their part of the total federal tax bill was 37%. Many will make the point that the rich make all the money, why shouldn't they pay all the taxes? The problem with that kind of attitude is that rich people become rich by knowing the score and putting their money where it is treated the best. One of the reasons Francois Sarkozy won the French presidency was the shocking revelation to the citizens of France that many of their wealthiest and most prominent families were moving to Belgium to avoid the high taxes in France. Soaking the rich can not go on indefinitely. It has its costs. The wealthy can vote with their feet. Corporate Taxes are another huge problems in the US. The motto of many in this country is "Let's squeeze the big corporations." They make their money here, they should pay their fair share. Well, my friends, it may surprise you to learn that at 38% the US has the highest corporate income tax in the developed world. Canada just lowered their corporate tax rate this week to approximately 31%. Germany, Britain, Spain and France (yes France) have all cut corporate income taxes in recent years and none of these countries now taxes corporations at a rate of greater than 30%. The author of the Op/Ed piece, Ari Fleischer, makes the following statement: Our tax system comes up short in a lot of ways: It doesn't foster economic growth. It isn't simple. And it certainly isn't fair. The one place it does excel is at redistributing income. Soaking the rich is not solely a strategy of the Democrats. The present system has been largely brought to us by Republicans. The current tax systems is a recipe for disaster. Too many people in this country are paying virtually no federal income tax, thereby pushing their rightful burden off on to the fat cat down the street. The problem is if the economy in this country were to slow quickly, the income for the top 1% would also slow sharply and the current budget deficit would become a budget chasm. The country needs to simplify taxes and make sure that everybody pays to keep the country's light on. Most importantly, we need to regain our historical position as the low-tax country in the world. Low taxes encourage people to take chances, because when they win they get to keep most of the winnings. Ronald Reagan knew that and his tax cuts in the early 80s put our country on a growth path that is the envy of the world. But Ronald Reagan spoke incessantly of requiring everyone to climb down off the wagon and help pull it. Former President Reagan is surely turning in his grave at today's situation, when only 40% of Americans are on the ground pulling the wagon, while the other 60% get a free ride.

Tuesday, September 18, 2007

Stocks Twelve Months After a Rate Cut

If history is a guide, the Fed will cut rates today and will continue to cut for at least the next four months.

The top part of the chart at the right shows the graphs of the Fed Funds Target Rate and the yields on 90-day T-bills. The bottom of the chart shows the difference between the two in red. I discussed the significance of the recent divergence between the two short-term rates in our Sept. 4th post.

There have been four previous divergences that have approached one percent over the past 20 years: the crash of 1987, the S&L troubles of 1989, the Asian Financial crisis in 1998, and the popping of the tech bubble in 2000. In each case, as the divergence between Fed Funds and T-bills approached one percent (.9% more precisely) the Fed cut rates and the differential and, ultimately, the crisis went way.

I have done some additional studying of these divergences and I see two additional areas of interest:
  1. On average, after rates were cut, Fed Funds were lower by .75%, within four months . Thus, if history is to be our guide, today's cut is just the beginning.
  2. Twelve months after the first Fed rate cut during three of the credit crunches (1987,1989,1998), stocks were higher, including dividends, by nearly 20%. In the year following the tech bubble, stocks were down nearly 15%, including dividends. The average for the four periods was about 12%.

After what we have waded through 2007, the hopes of a 12% total return over the next year sounds very acceptable. However, I think it may well be better than that because of the unusual circumstances surrounding the poor performance of stocks in the year after the popping of the tech bubble. That pushed us into the time of Enron and then the 9-11. It would have been hard to imagine that stocks could have risen during that time, no matter what the Fed was doing.

Thus, I think it is best to call the period after the tech bubble a special case and drop it from our analysis. If we do that, as I said earlier, the average total return after the Fed started cutting rates in the other three occurrences of a credit crisis, was near 20%.

As they say, the future is not the past, but sometimes it is the best guide we have.

Wednesday, September 12, 2007

The Dawn of Bernankespeak or Not Speak

Alan Greenspan was the master of the overstated understatement. A group of investors could listen to his testimony and come away with diametrically opposed interpretations of what he had said. By contrast, Ben Bernanke has promised a new openness and clarity, but it has been slow going so far. It is my belief that he has a bit of a tin ear to the markets. He had not come to the realization that HE IS the news and billions of dollars of bets are spring-loaded in computerized trading systems hanging on his every word. Greenspan had a lot of faith in the markets. He listened to them, and he talked to them. If he saw the traders going off in the wrong direction he would say something simple and clear to get them back on the right track. If he thought they had it about right, it seemed to me that he became more obtuse. Next week we have the first real test of the Bernankespeak. The Fed meeting on September 18th, is now on the lips of everyone from cab drivers to cowboys. Will he, won't he? That is what we are all asking, and all of us have become closet economists arguing our points of view, no matter how silly or off the wall they may be. At the rate we are going, by next Tuesday, all of the markets will grind to a halt awaiting the Fed's decision on interest rates. In the midst of all the talkers are a group of investors who are making bets, so to speak, on the outcome via Fed Fund Futures. Bloomberg has a new analytical tool that extracts the implied probability of changes to Fed Funds by analyzing the trading data. Today's readings for Fed Funds Futures, are as follows:
  • 4.75%. . . . . . .74%
  • 5.00%. . . . . . .26%

If you do the math, 100% of investors in Fed Funds believe at least a .25% rate cut is coming. Significantly, and perhaps surprisingly 74% of investors believe a .50% cut is at hand. I'm in this latter camp for reasons I have discussed earlier.

Here's where everyone is flying a bit blind. If Greenspan would have seen this Fed Fund action and he had no intentions of cutting rates by half a percent, he would have Greenspeaked it --talked it down.

We don't know if that is how Bernanke is going to operate. He may believe in more openness but less guidance and less Bernankespeak. If this is the case, my thinking is a quarter percent cut will be viewed as a disappointment by the stock market and it may well sell off. Heaven forbid if rates aren't cut at all.

The saving grace is the Fed's statement accompanying their decision. They can still signal there intentions in the statement which would have the effects of muting the actual move they might make. That may be where Mr. Bernanke has decided to speak.

I can't remember a Fed meeting in years where so many investors are so confused about the outcome. Should make for an interesting day.

Thursday, September 06, 2007

We are Bullish on Stocks

Each week our investment policy committee deals with the events and issues of the day, as well, as charting the course of our investments.

There are four of us: Mike Hull, our president, who has wide experience in consumer attitudes and consumer products; Vice President, Rick Roop, who has had many years of experience in energy production and organizational systems, Vice President, Randy Alsman, who has a background in finance and has been an executive in both the consumer products, as well, as the pharmaceutical industries; and Greg Donaldson, who has a long history in economic strategy, financial institutions, and valuation metrics.

This past week we had a wide-ranging discussion of the goings on under the sun, so to speak. The following in a general synopsis of our thinking: The points seem rather straight forward, however, we can tell you the getting-there was not so straight forward, but a flood of thoughts and ideas that sprang up and were either shot down or allowed to pass on. In the end, this is what WE believe, and I (GCD) am proud to say it is reasoned, reasonable, and, in my judgment, a good bet to come to reality

We saw the troubles in real estate coming. We were convinced they would be worse than what most people thought. We said as much here 15 months ago.

We are surprised that the subprime mortgage mess is as widespread as it is. Unknowns in the banking system are always unnerving, and we believe the damage is enough to warrant the Fed starting to cut the Fed Funds rate.

In the short-run, say the next six weeks, the market could be very volatile. But, if the Fed moves in a measured way, the economy and the corporations that produce most of our goods and services will perk up in the coming months and provide a very healthy stock market. Here's why:

1. The Fed has done an excellent job of gradually slowing economic growth so that inflation has not gotten out of hand. Their actions have been appropriate enough that we see a slower economy ahead but no recession -- a soft landing.

2. The Fed's second responsibility (after holding off inflation) is to stimulate economic growth to create jobs. So far, the unemployment numbers tell us the economy hasn't slowed enough. But, that is looking in the rear view mirror. Every Fed tightening in recent history has ended with a "financial accident." These accidents have become a signpost for the Fed that by raising rates, they have slowed some area of the economy enough to do some damage. This time it was housing and sub-prime lending (both of which needed some cooling off - greed had taken over the decision-making in that part of the economy).

3. Many investors, politicians, and corporate leaders are yelling about a pending recession and calling for the Fed to cut the Federal Funds Target Rate. This is the second signal that tells the Fed they can cut rates. If the CEOs of major corporations believe we are heading for a recession, what happens to their hiring practices? Right, they dry up. Their screams for rate cuts precede a rise in unemployment.

The credit crunch and the housing market could well get worse before they get better. It does appear, however, to be fairly contained. But, at this point, the Fed does not want to rescue the bad decisions made there. In fact, they see the losses and pain as healthy for the economy longer term. And, the stock market will see that, too.

We say all of this to reach these logical conclusions:

  1. The Fed has slowed the economy. Unemployment is going to rise.
  2. That will give the Fed the room it needs to revert to stimulating the economy by lowering interest rates.
  3. We think they will begin soon and continue doing so at a measured pace for several months.
  4. The stock market loves it when the Fed lowers rates -- it means the Fed does not fear inflation and is trying to stimulate economic growth.
  5. That will lead to an attitude that earnings growth will be stronger and more sustainable.
  6. As the market looks ahead to 2008, stock prices should start to rise and that could continue as long as the Fed continues lowering rates.
  7. We are bullish on prospects for stocks over the next 18 months.

Tuesday, September 04, 2007

The Fed Rate Cut: How Much?

By Greg Donaldson and Mike Hull

As we returned from the Labor Day weekend, there are still some in the financial media that are saying that the current state of the economy does not warrant a cut in the Fed Funds Rate.

We don't agree and history shows that the Fed has cut rates in the past, even when the economy was not in or near recession.

The chart at the right shows the yields on 90-day T-Bills (blue line), which are backed by the full faith and credit of the US Government; the Fed Funds Target Rate(green line), the rate paid and guaranteed by banks; and the difference between the two at the bottom (red line).

The top part of the chart shows that for most of time over the last 20 years the interest rates on 90-day T-Bills and fed funds have stayed very close together. This would make sense. One strong bank borrowing from another would not expect to pay a rate of interest much higher than the government would have to pay for a short-term loan.

However, when fears of recession or the strength of the banking system is called into question, the spread between fed funds and T-Bills widens. Why, because big investors decide they feel safer in government backed T-Bills than they do in the banks and they bid T-Bill yields lower.

To see this, let's focus on the red line at the bottom of the chart, which shows the difference between the Fed's Funds Target Rate and the yield on a 90-day T-Bill.

Each time the yield differential has been at least one percent, the Fed has cut rates within a short time. In addition, you will note that T-bills have always led fed funds lower.

There have only been 5 times in the last 20 years when the yield differential between T-bills and fed funds have been approximately one percent: immediately after the stock market crash of 1987, during the Saving and Loan Crisis in 1989, during the Asian Flu of 1998, in mid 2000, when it was clear that the Tech bubble was popping, and today.

The chart is a month-end chart so it does not show every day for the last 20 years, but it is remarkable that on a month-end basis that the events of September 2001, did not produce a one percent spread.

These one percent spikes have occurred coincident with an extreme crisis of confidence in the financial markets, not necessarily in the economy. The US economy was fine in 1987, 1998, and 2000 at the times of the spikes.

Thus, the arguments today that the Fed won't cut the fed funds rate because the US economy is not close to recession is beside the point. The point is the Fed has a financial crisis to deal with and history shows that the way they deal with these types of events is to cut rates. They can always raise rates later if the crisis passes without a sharp fall off in the economy.

The arrow at the far right of the chart shows that the recent spike is higher than at any time going back to 1989. In our minds, the question is not if the Fed will cut rates, but how much? One of us thinks .25%, the other .50%.

Friday, August 31, 2007

The Fair Value of the Dow Jones Industrials --Too Cheap

By Greg Donaldson and Mike Hull

By our reckoning the stock market, as measured by the Dow Jones Industrials, is significantly undervalued, maybe as much as much as 13-15%. We make this call based on the readings of our Dividend Valuation Model using the most recent data available.
The chart at the right shows the model going back to 1975. The blue line is the average annual price of the Dow and the green bars are the model's predicted values. The model uses only the dividends paid by the 30 companies in the Dow and long-term high-quality bonds.
We have previously explained that we believe the model has done a good job of indicating when the market was cheap and when it was dear.
Until the early 1980s the model indicated that values remained flat. This was a period when interest rates were shooting higher, and their ascent overwhelmed the modest dividend growth during the period.
During the mid to late 1980s and early 1990s the model said the market was undervalued, which turned out to be correct. Prices and values came into equilibrium in 1994 and 95, before prices went off into their tech fit -- and the model refused to go along.
Since the end of 2002, the model has signaled that the market has been undervalued.
The model's exact reading as of today is 13,980. That is based on dividends paid thus far in 2007 by Dow companies and interest rates at their current level. But this coincident pricing is not the way that the stock market operates.
During normal times, the market discounts what it can see, which is normally a year or so ahead. If we add in our projections of dividends and interest rates for he next 12 months, we arrive at a total return for he Dow of just over 14%. This would include the catching up of the current undervaluation and then achieving a fair value on next year's growth.
We think this is very possible if the Fed begins to cut rates. Importantly, we believe that kind of rate of return will come sooner rather than later, once the Fed makes it first rate cut. Think of it as being front loaded.
Our best guess is that the current gyrations in the stock market and headlines of this doom or that will provide cover for a new leg of the bull market that began in 2003 to begin.
We cannot see the future better than anyone else, but we are students of the past and that is how markets usually react, once a crisis is beginning to wane.

Sunday, August 26, 2007

Dividends Do it Again

The recent meltdown of the subprime mortgage business has caused stocks in the US, as measured by the S&P 500 Index, to fall by 1.9% over the last 30 days. That return, however, as poor as it is, is mild compared to the return of the average stock in S&P 500 Index, which has fallen 3.7%. This disparity between the rate of return of the Index itself and that of the average stock in the Index means that stocks with higher market capitalizations have performed better during the sell off than smaller members of the Index. In addition to the larger companies doing better than smaller companies in the index during the last 30 days, the rates of return by dividend yield is very telling. Indeed, breaking the 500 stocks into quintiles shows a remarkable inverse relationship between dividend yield and average loss.
  1. Top 100 highest yielding stocks -1.4%
  2. Next 100 highest yielding stocks -2.8%
  3. Next 100 highest yielding stocks -3.6%
  4. Next 100 highest yielding stocks -3.6%
  5. Lowest 100 yielding stocks . . . . . -7.1%

The inverse relationship is very tight with stocks with the lowest dividend yields performing the worst and stocks with the highest dividend yields faring the best.

One might conclude that this is the way it ought to be because higher yielding stocks are more mature and usually more creditworthy, but that would miss the point that many REITs and Banks are included in the highest yielding quintiles, and these sectors, initially, took a solid thumping before recovering.

My conclusion is going to sound familiar: dividend paying stocks are easier to value because a good portion of their rate of return is produced by their dividend, thus, in a manner of speaking they are more transparent.

Speaking of transparent, that will be the key word to describe the recent subprime mess. Too many companies were more deeply involved in the subprime market of one variety or another than they disclosed in their quarterly and annual reports. When management is playing fast and loose with their shareholders' capital and not disclosing it, it is a breech of trust and they deserve to be fired without benefit of the usual golden severance package. I'll have more to say on this in the coming weeks.

Friday, August 24, 2007

Barclays is Cheap

After Wells Fargo and Bank of America raised their dividends in early August by 12% and 14%, respectively, we said it was a clear sign to us that they were not in the eye of the storm of the subprime problems, and their stocks were too cheap.

The chart at the right shows that both stocks have recovered smartly over the last two weeks, as it has become clear that, indeed, neither is likely to take big losses. As we write this, however, we believe both stocks may be still as much as 15% undervalued based on the long-term relationships between their dividend growth, interest rates, and their stock prices.

We want to add another stock to the list of banks that we believe has been unfairly punished by the recent liquidity crisis. Barclays Bank is a London-based bank with offices spanning the globe. They have three world-class divisions: banking, capital markets, and asset management (ishares Exchange Traded Funds).

The stock has fallen by nearly 20% over the last 60 days on fears of Barclay's involvement with sub-prime loans, private equity, and hedge funds. There is no way for us to know their precise exposure to these groups, but the company has repeatedly stated that they are not experiencing any large scale losses.

Barclays recently raised their dividend by nearly 18%. A dividend hike of that magnitude is real money since they now yield over 5%.

The chart at the right is Barclay's Dividend Valuation Model. The blue line is the actual annual price over the last 15 years, and the green bars are the model's predicted values. The chart shows a close association between the model and prices over the last 15 years and a predicted 2008 value of just over $55.

From today's price of approximately $49, including the dividend, our model is suggesting that Barclay's may be even more undervalued than BAC or WFC.

Barclays has been in business since 1736. With that kind of longevity, we believe they might know a thing or two about how to navigate financial storms. Their AA bond ratings ensures access to the capital markets and minimizes liquidity issues.

The bank has been in a pitched battle with the Royal Bank of Scotland to acquire ABN Amro, a Dutch banking giant. We believe that the market is worried that Barclays may be dragged into a bidding war. In our minds, Barclays had done a lot of things right over the past 270 years. We're inclined to follow with their judgment with ABN Amro.

Tuesday, August 21, 2007

Energy: The New Y2K -- Boeing, Toyota, and United Technologies

While we are grappling to understand the height, width, and breadth of the mortgage crisis, another crisis that we have detailing has fallen off the front pages: the energy crisis. Here's why we have been describing energy as the next Y2K:

  1. 9-11 was a harsh lesson in the Islamists' visceral hatred of our Western way of life, and the fiendish extremes to which they would go to harm us.
  2. The internecine fighting in Iraq, if anything, should be a constant reminder that the terrorists seek to destroy anyone who stands in their way, even their own people.
  3. Katrina showed how fragile our refining and energy distribution systems were.
  4. Too much of the American, yes the Western, way of life is held hostage to energy; and too much of the world's energy supply is in countries who hate not just Americans, but any country that follows an open society of free markets and democracy.

The recent sell off has hit almost all stocks and sectors. During this sell off, we have been nibbling on the three stocks that we believe currently possess the best technology and products to dramatically reduce energy consumption, without abandoning out our way of life-- Boeing, Toyota, and United Technologies. These three companies currently have products on the market that can reduce energy consumption by up to 50%(compared to older technologies) in planes, automobiles, and heating and air conditioning systems, respectively.

Here's our bottom line, and we are borrowing from a press release by the World Business Counsel for Sustainable Development (WBCSD): There is a talk about "green" this and "green" that, but, thus far, most individuals, companies, and governments have done very little to diminish energy consumption.

Energy conservation may seem like an oxymoron, but we believe that a true cost-benefit inflection point is near, when people will realize that the technology is available and affordable here and now to dramatically reduce energy consumption.

The reason we call this an Energy Y2k is because when that day comes, there will be a mad rush to get aboard the new technology. We don't know what will cause it, and we have no special skills at seeing the future, but no individual, corporation, or government can live beyond its means indefinitely.

In saying this, we are not talking about doomsday or end-times. We are just saying that there are technologies available that offer people some insurance against rising energy prices, resulting from uncertain energy supplies, and the wisest course of action may be to own both the new technologies and the companies who own them.

Sunday, August 19, 2007

Barron's Drive-By Shooting of Cramer

Maybe the city where you live has enough drive-by shootings that they don't spark much interest anymore. Where I live, Evansville, Indiana, population 150,000, however, drive-by shooting are very rare, and when they happen, everyone knows it wasn't a crime of passion or of larceny, gone wrong, but a professional job. As I was passing through the Atlanta airport today, I noticed that Jim Cramer of CNBC's "Mad Money" and the was on the cover of Barron's weekly. Barron's cover and lead stories were all about shooting the "jester", or as I call him the "edutainer" of Wall Street. They had gone back to the beginning of the "Mad Money" show and measured how an investor would had of fared had they followed all of Mr. Cramer's touts on the air. The news wasn't good. Barron's crowed that investors would have been better off to have shorted his picks. The charts and graphs were interesting reading and everyone likes to see the sages knocked around every now and then. But as I sat there waiting for my 2 hour-over-due plane, it occured to me that this past week saw billions of dollars evaporate in one of the worst meltdowns of the markets we have seen in a long time. Indeed, the country's largest home mortgage company, Countrywide Finance, may have come within a heartbeat of going bankrupt. And in this time of great volatility and uncertainty, Barron's had chosen not only to do a drive-by shooting on Mr. Cramer, they had put it on the front page. Three things bothered me about Barron's actions:
  1. Touch: Good grief what a lousy idea to focus on the Jester when the stock and bond markets of the US and the world were reeling, and people genuinely wanted to know what was going on.
  2. Times: It is common knowlege that investors are increasingly getting their investment news from the web and not the traditional financial media. It is also well known that, Mr. Cramer's online investment site, is very successful and widely respected. Barron's own website seems to be in a constant state of reintroduction.
  3. Timing: The thought is almost too delicious to utter. Could it be that the editors of Barrons were trying to show their new boss, Rupert Murdoch, that they can sucker punch the competition with the best of them?

I know Mr. Cramer is an edutainer because reprints this blog from time to time, and our investment style is as far from his, as Indiana is from New York. We are long-term dividend oriented investors. Our average holding time is 5 years, Cramer's holding time is measured at most in months, if not days, yet Jim Altucher of the Daily Blogwatch often mentions our site to provide a long-term conservative perspective.

I am truly hoping that this is not the first example of the "new" Barron's hard-nosed financial reporting. It is out of touch, it is a cheap shot, and the timing reeks of -- let's show off for the new boss.

I would like to suggest to the folks at to do an long-term analysis of the track record of Alan Abelson, Barron's long-time feature editor. When he has been bullish, go long the S&P 500, when he has been bearish, short the S&P 500. My guess is that the results will be ugly. In my mind, Mr. Abelson has predicted 7 of the last 2 bear markets.

Booya, Jim, the blue-bloods are attacking the blue collars. This is what you probably always wanted.