Tuesday, May 29, 2007

A Few Thoughts on the Private Equity Phenomenon

Private Equity is not going away. It will continue to grow and 10 years from now, we will think of it as just being another money management vehicle along side mutual funds, exchange traded funds, managed accounts, etc. Whereas mutual funds began as a way for small investors to improve diversification and have access to professional money managers, private equity funds are a means for institutions and the very wealthy to have access to more of a "hands on" business arrangement with corporate America. It is just another means of owning equity. As I have mentioned previously here, there is a growing feeling that a kind of imperial attitude has sprung up in corporate America. Corporate chieftains have figured out that they answer to everyone, while at the same time, answering to no one, and little by little they have begun to take advantage of their positions in ways that are increasingly unacceptable to many investors. I could not have imagined that this sort of imperial attitude would have become apparent so soon after the Enron fiasco, but $100 million dollar retirement packages for CEOs have become a way of life, with no end is in sight. I have always said that big money thinks and acts differently -- that's how they become "big money." I have a friend who is in this category. When he owns a stock, he will own several million dollars worth. He genuinely thinks that the CEO and the board of directors work for him ( he usually owns more stock than any of them), and if they act in ways that do not suit him, he does not cut bait and try another stock, he will pay the CEO a visit. He does not rant or rave, he just advises the person that he is unhappy, and he expects things to change. He usually has a list of things he does not believe are being handled well, as well as a list of costs that he believes are out of line. He asks for explanations, and if the answers are either not forthcoming or are evasive, he advises the CEO that he will attempt to change the make up of the board. I used to cringe every time he started off on one of his campaigns, but I have come to see things more his way. There are too many boards of directors who are not looking out for the good of the shareholders they are supposed to represent. They are only riding the gravy train just like everybody else. There are too many boards of directors who are not properly supervising their firms' strategies or top managements. They are just honored to be one of the "good old boys or girls" on an important board. My friend says says you can throw a dart at the Wall Street Journal and the odds are whatever company you hit can be run much more efficiently and much more profitably for shareholders if the company were being run by managers who ran the enterprise for the "owners." If my friend is right, and I believe he is, the private equity folks have enough companies to "clean up" to last a lifetime. The mutual fund industry is primarily engaged in the business of investing in stocks. The private equity industry is primarily engaged in investing in companies. There is an absolute world of difference between the two. Too many investors believe that the private equity crowd is bad for the markets and, like the leveraged buyout crowd, are destined to dry up and blow away. They are just as wrong in that assumption as they are in believing that the majority of boards of directors in this country are primarily serving the interests of their shareholders. There are private equity deals being announced every day. There is a simple meaning for their actions: US stocks are cheap, too cheap. With low interest rates and cash flows in good shape, if you throw a dart at the Wall Street Journal, you are likely going to hit a company that can not only be run more efficiently with a "owner" driven CEO, it can be bought with its own net worth. Private equity is just another way to own companies. My guess is that it is in its infancy and that is good news for the stock markets here and around the world. The surest evidence that this is true is that the government is moving to regulate it and tax it. I'm not going to tell you what my friend has to say about the government and taxes.

Thursday, May 24, 2007

April New Homes Sales Hot, Housing Still Cold.

Today the market sold off because of fears that a hot New Home Sales report will delay the Fed from cutting rates. I do not believe that will be the case. Indeed, as a result of the widening trade balance, the next GDP report will likely show that US economic growth has slowed to under 1%. Today's housing report is loaded with volatile data, and will likely be forgotten quickly.

New home sales did, indeed, shoot higher in April on the back of mild weather and price cuts. The two charts at the right, however, show that Housing is still in a free fall.

The National Association of Home Builders now claims that Housing is bottoming, but, hey, I thought they said that 5 months ago. The top chart, New Home Sales, shows the uptick has done little to change the trend of housing, and the lower chart, Median New Home Prices, is anything but positive for housing.
The lower chart shows that home prices in the month of April fell sharply (-11% year over year.) An 11% drop in prices on the average house is over $30,000. That is not good news for consumers. Neither is the fact that it puts lots of mortgage balances underwater relative to their underlying home prices, which will keep pressure on the mortgage banks.
The only good news I see in the report is that a capitulation stage is probably beginning in housing where speculators and builders with unsold inventories are beginning to cut bait. That makes for a kind of coincident beginning of the end and beginning of the beginning. But it is months off before we will see any true year over year growth in housing.
That means this report will be forgotten quickly as further economic reports are released showing very slow growth.
I am convinced that the headlines in the coming weeks will have more worries about slow growth than strong growth and that will be good news for stocks in the consumer staples, health-care, finance, and selected global industrials.

Friday, May 18, 2007

10 Thoughts after Looking at 2,000 Stocks

Stocks in the US and around the world have made a series of new highs over the last three months, which has prompted a chorus of boo birds to start chanting that the market has come too far too fast. They are just as wrong now as they were when they said that the Dow could not get through 11,000 last year. I spent two days this week running almost every big stock in the US and Europe through our dividend and earnings models. This is what I see:
  1. US big cap stocks are about 8-10% undervalued.
  2. Europe is pushing close to fair values in a number of countries.
  3. There are lots of formerly dead cats bouncing all over the world. This is not a bad thing, it is in recognition of the growing global economy and the consolidation in many industries.
  4. The most overvalued sectors worldwide are the Utilities, REITs and Basic Materials.
  5. The most undervalued are the consumer staples, and to a lessor extent the health-care stocks.
  6. The banks are still cheap in almost every country I looked at, especially in the US.
  7. Telecommunications, except in rare cases, are running on something other than value. They are the new Tech stocks. The old Tech stocks are, well, old.
  8. The Industrials are the most surprising sector in the US and abroad. These stocks have had good moves, but are as much as 15-20% undervalued in our models. Their gains and those to come, again, are the result of the explosive growth in the developing nations.
  9. Energy stocks are high and going higher. The global economy is showing no signs of slowing and ethanol's limitations are coming into view.
  10. The keys to a continuation in the bull market are the staples and banks. They represent 35% of the market cap of the S&P 500 and are underperforming. I believe they will catch their wind as we move through the summer and the slowing economy causes the boo birds to start chanting recession.
  11. When US retail stocks begin to participate, this phase of the bull run will enter a period of consolidation.


Monday, May 14, 2007

Berkshire Hathaway -- New Valuation Estimate

As regular readers know, 99.9% of our research is directed toward dividend paying stocks. We follow dividends because, as it says in the masthead above, we believe they are more predictable than earnings and are an actual component of a stock's total return.

Having said this, for many years we have held Berkshire Hathaway in our Capital Builder style of management because we have found that BRK's price is highly correlated to changes in its book value and interest rates. Periodically, we update our valuation model on BRK using a multiple regression of its book value and interest rates relative to its stock price. Below is a chart of our valuation model going back 15 years. You will see that the fit is very tight and, based on the just-released data, BRK class A is selling just about at fair value of $109,500.

Using our internal estimates of the growth of BRK's book value and the changes in 10-year Treasury bond rates, we arrive at a year-end value for BRK class A of $119,800.

We think that is as good a guess as we can make, and in light of the slowing economy, we still believe BRK class A is a good hold for the year ahead.

BRK class B is 1/30 of class A, therefore its current projected year-end value is near $4,000 per share.

Thursday, May 10, 2007

Our First Webcast -- Market Comments

In this our first webcast, Mike Hull and I discuss the stock market's recent run up and the prospects for its continuation. The webcast lasts about 20 minutes and covers a wide range of topics from the global economy to inflation, interest rates, Fed policy, and the areas of the stock market that we believe are most undervalued. Since this is our first shot at putting "voice" to our thoughts, please let us know what you think. You can also pick the winner of our little debate. (To start webcast, click the green play button on the player above.) gdonaldson@dcmol.com mhull@dcmol.com

Monday, May 07, 2007

Sock it to 'em Sarkozy

Nicolas Sarkozy won a bruising battle over his socialist rival Segolene Royal for the Presidency of France with 53% of the vote to 47%. This was as the polls and the betting parlors were predicting. I will limit my comments on the elections because I have written two previous pieces on the importance of the French elections to the global economy, but I would like to comment on the commentators. The main stream media in the US and abroad is essentially saying that Sarkozy's election does not mean much because the French are the French, and they have it pretty good. Nothing could be farther from the truth. France is bleeding from both ends of the financial spectrum and they know it. There is virtually no hope of landing a meaningful job for young immigrants in the country. They have become a permanent non-working class, and increasingly violent. Yet, their existence is subsidized by the wealthy, where taxes can reach as high as 72% of income. In recent years, the wealthy have been voting with their feet and moving to lower-tax countries. Sarkozy is very direct and he believes he has a mandate to get people off the dole and put them back to work. This will not likely be an easy job in a country that has large segments of the population that are anti-capitalist and rally under the banners of communists, socialists, and, yes, even anarchists. France is a colorful nation in every way, even in it politics. I am more optimistic than many and my reason is this. If the French are anything, they are proud. Indeed, they are the originators of the products that epitomize fine living: perfume, wine, design, architecture, cooking, etc,. Increasingly, these products and services are beyond the budget of the average French citizen, and there is a growing recognition that the bon vivant lifestyle that the French brought to the world is now slipping from their grasp. Sarkozy will have a very difficult time in putting France back to work, but he is said to be a very tough minded person, and I believe he will bring increasingly seen by the French as a man who can help them reclaim their glory. Recently, we bought our first French company, Axa, one of the world's largest insurance companies. We see two or three other French companies that we like, and if we can get them at our price, we will add them as well. Blessings,

Saturday, May 05, 2007

Slowing Economy, Rising Stock Prices, Part 2

Greg Donaldson and Mike Hull write:

In our October 27, 2006, blog we wrote that while the economy would likely continue to slow, US and international blue chip stocks would likely continue to rally. The following is a quote from that piece:

"Markets seldom feel right because we human beings have a habit of projecting today's headlines onto tomorrows stock performance. Remember, the stock market is not a democracy. Prices move in the direction that big money pushes it. Fortunately, big money is normally rational and understands economic cycles and the power of the Fed to slow and speed up the economy.

Big money has a problem. The places where it has been treated well over the past few years are all rolling over. Treasury bonds yield are under 5% in most of the major industrialized nations of the world. Bonds simply are not competition to stocks. Real Estate and commodities are no longer competing effectively for investors against stocks because they are now in downtrends.

Blue Chip stocks, alone, stand out as a value now that bonds, real estate, and commodities have become over owned and over valued. Finally, blue chip stocks are in an uptrend. This positive momentum is a rarity in today's world's financial markets. As long as earnings growth holds near 10%, stocks will continue their strong advance."

Since we wrote that piece, stocks, as measured by the Dow Jones Industrials, have risen nearly 12%, including dividends, (an annualized return of over 20%) while the US economy has slowed to under 2% real growth.

And here's the answer to the question we are asked most often: Yes, stocks have room to go higher and the path of least resistance is up for the same reasons we explained in our October 2006 piece -- stocks are still cheap and they have no competition from other forms of investment. In addition, with economic growth having slowed and inflation cooling, the Fed is poised to begin lowering rates sometime in 2007.

The chart below shows our most recent update of our proprietary Dow Jones 30 Dividend Valuation Model.

As you recall, the Dividend Valuation Model is a single formula that is constructed from the associations between dividends, interest rates and prices. You might think of the green bars as the values predicted by the normalized relationship among the data points. The actual prices are shown as a blue line.

It is important to keep in mind that every green bar on the chart, which goes back 25 years, is produced by the same formula. By comparing the green bars, which we call "value steps," and the actual prices, it is clear to see that the fit is very tight.

The key areas to note on the chart are the late 1990s, when the value steps clearly showed that prices were overvalued, and the DJ 30's turn in 2002, which occurred almost precisely on the predicted "value step."

Since 2002, the chart shows that, even though actual stock prices have risen sharply, they have remained consistently in undervalued territory. The model currently predicts that fair value is near 14,100. That would be our best guess of where the market runs out of value, and where we would become less bullish about blue chip stocks.

Finally, the recent run up in stocks has been met with fear and not greed, as is the usual case in run ups. Everyone is now talking about pullbacks and the old adage of,"sell in May and go away." We have found that when USA Today or your local newspaper starts telling you to "sell in May and go away," that it might not be a bad idea to "buy in May have a nice payday by Labor Day." Granted its not as catchy as the original adage, but we suspect it will be more profitable approach this year.