Tuesday, December 30, 2008

Chevron: Cheap and a Winner in An Economic Turn Around

Every investor, except pure technicians, must operate from some basic belief about the shape of things to come. In this regard, I believe that the US and world economies will gradually find their footings in 2009 and will regain their long-term growth trends.
The world's economies have made it through bubbles before, and we will do so again. As I have said before, I cannot offer chapter and verse how it will happen, but I remain convinced it will happen.
In light of this, for some weeks now, I have been thinking more and more about the other side of this valley. Who wins? What does it look like? How long does it take? I don't have many answers yet, but I do have one: When the world economy emerges from current recession, the energy crisis will be standing their waiting on us. For this reason, and because the big international oil stocks are very cheap, we have begun to nibble on selected oil stocks. Chevron is our first pick.
We like Chevron (CVX) because of its strong double-digit dividend growth over the last 5 years, and their success in finding new oil reserves.
The chart above shows our Dividend Valuation Model for CVX over the last 20 years. The stripped bar at the far right of the chart suggests that the fair value for CVX over the next 12 months may be near $100 per share. That would be a nice gain from its present value of $74.
In my mind, the only thing we need for CVX to reach that figure is if we see a bottom in the economy in the first half of 2009. That may seem overly optimistic, but since I said at the beginning that I believe a bottom will come in 2009, it does not require much convincing for me to think that we might see CVX at $100 per share over the next 12 months.
The chart at the right compares the yield on a 10-year US Treasury bond versus the dividend yield of CVX. In recent days, the dividend yield (shown in red) has pushed above the yield on a T-bond (blue line). This intersection is saying that the market now believes that CVX is over valued and is likely to cut its dividend to return to a more normal spread versus the T-Bond. I just don't agree with the market's logic here at all.
I believe the only way that that could happen is if the Obama Administration trashes the oil industry. That is not a good bet, especially in the next two -three years.
The author, clients, and employees of Donaldson Capital Management own CVX.

Wednesday, December 24, 2008

A Christmas Short Story

We thank the Lord for this wonderful season of the year, when we gather together with family and friends to celebrate Christmas with gift-giving and feasts fit for a king. This is as it should be because at this time of the year, we do celebrate the birth of our King, Jesus Christ. We know family is very important to God. Jesus said that through Him we would become children of God, and we could call God "abba." As most everyone knows abba means something more akin to daddy, than king. Our country is going through a very difficult time economically, and there are many who preach gloom and doom as far as the eye can see. I just can't bring myself to be in that camp. I can't give you chapter and verse of how we are going to work our way out of the mess we find ourselves in, but I do know that God's word also says that His hand is upon the government of our country. Thus, I am confident that there will be government programs that God will bless and will become a blessing to us all. He will also continue to bless the sweat of our brows, as His word says. Finally, in these times when answers are so few and questions so many, more and more people turn to God for his divine protection and benevolence. When we do that, we are doing what Jesus instructed us to do, and he offered to us in advance how God will respond. Luke 11:11-13 gives us comfort that God hears our prayers, and will respond. Luke 11:11“You fathers—if your children ask for a fish, do you give them a snake instead? 12 Or if they ask for an egg, do you give them a scorpion? Of course not! 13 So if you sinful people know how to give good gifts to your children, how much more will your heavenly Father give the Holy Spirit to those who ask him.” We are not in this alone. The God of all creation has made known his love for his creation and he has promised to provide for us and to give us the strength to endure. I don't know about you, but I have found God's word not only to be a source of great wisdom and revelation, but also a source of great comfort and hope. On a cold night over 2000 years ago, a child was born in a manger. A child who would change the way the world understood God and the way the world would relate to God. Even though that child was later killed, we Christians believe he rose again and is still alive and still offers His peace and promises to every human being. Thank you, Jesus, for becoming one of us and feeling in your flesh our bumps and bruises, our sorrows, our hopes and fears, and finally our indescribable joys when we understand that it is in your stripes that we are healed. Merry Christmas to all,

Thursday, December 18, 2008

McDonald’s: Having It Their Way

McDonald (MCD) may be as well positioned as any company I can think of to prosper during these difficult times. The reason is the effects of three forces that all appear to be driving business to their stores.

  1. Trading down effect: It is clear that Wal-Mart (WMT) is winning over a bigger segment of the populace in these tough times with their low prices. I believe the same thing is going on at McDs. Eating out is the American way, but I’m betting that more and more Americans will be eating a little lower on the hog at their local McDs.
  2. Brand battle: The McCafe concept, which is being rolled out nationwide, will do battle head-on with Starbucks in specially brewed coffee. This thought might take a while to accept, but judging from the locations where I have seen it introduced, it is a big success. It is driving a different kind of consumer to McDs – more upscale, a little higher income demographic. By all accounts I have heard from my coffee-drinking friends and family, the coffee is top notch and it is less expensive than at Starbucks. Could be a big win.
  3. Competitive atrophy: The other big burger companies have almost all moved their target audiences out of direct competition with McDonalds. Burger King is appealing now almost exclusively to men and Wendy’s appears to be aiming at attracting women. Both appear to have given up much of the kid’s market to McDs.

The Dividend Valuation Chart below shows that MCD is undervalued for the first time in three years. It is trading nearly 20% under its average MCD 12-18-08 3PE of the last 20 years. Click chart to enlarge.

Mike Hull, our consumer strategist, believes that MCD can post 6% higher earnings in 2009 over 2008, and that the dividend will grow close to 9%. That kind of relative performance will draw buyers to the stock, especially when the average stock will have lower earnings in the coming year.

Mike believes that MCD’s business model is putting increasing pressure on their competitors, which could add up to big market share gains in the year ahead for McDonalds.

As always, this blog is for information only. Do not make buy or sell decisions based on what has be written here. The authors and clients of the authors own the stock. Although we have no plans to sell the stock, we will not comment here when we do so.

Wednesday, December 17, 2008

The Madoff Crying Shame

The news that Bernard Madoff may have stolen $50 billion from his clients puts an exclamation point on a tragic year for the finance industry. It’s one thing to make stupid subprime investmentments, as much of Wall Street and some of the banks have done, but it's another ball game when an individual outright steals people’s money. That is bottom of the barrel stuff, especially when so much of the money belonged to foundations whose aim it is to help those less fortunate.

There are many parts of the Madoff story that just defy credulity. He seemed to operate in the cracks of all of the various regulatory bodies.

One part of his operating procedures that we faced some years ago is that of being both a money manager, and the custodian of the assets. As a custodial investment manager, Madoff not only managed his client’s assets, but he also had direct access to the assets. To us that seemed like a lot of added risk and expense. Thus we chose to be a non-custodial manager. As most of you know, TD Ameritrade is our custodian. They hold the assets and make the trades. Our clients sign what is known as a limited trading authority that allows us to manage their accounts and collect our fees.

While being a custodial investment manager has some advantages for clients, such as more flexibility in moving money, the added risks, regulations, and capital costs that we would have had to incur to become a custodian manager outweighed the conveniences.

The only real encumbrance that we have to deal with as a non-custodial manager is that, since we have no direct access to our clients’ funds, TD Ameritrade requires a little more paperwork to authorize moving money around.

As the years have gone by, however, with faxes and email, this has gotten a lot easier, and knowing that we have a very capable custodian partner like TD Ameritrade gives us confidence that no money ever leaves an account that does not have the consent of the client and corroborating paperwork. I can tell you that having TD Ameritrade on board is a comfort to me, and I hope after the Madoff scandal, it is a comfort to our hundreds of clients spread across 29 states.

Friday, December 12, 2008

My Interview on Bloomberg About the Bank of America Job Cuts

I was interviewed on Bloomberg Television this morning about my reaction to the 35,000 job cuts announced by Bank of America (BAC). Since the nearest video up link is 100 miles away, Bloomberg just did an audio interview. Thank goodness for that because I would not have been a pretty site at 5:30 this morning in my bathrobe. Here is what I told the interviewer. The job cuts were not a surprise to me. After Citigroup cut 15% of their work force a few weeks ago, I expected job cuts from all the big banks. In this regard, BAC's 11% cuts were more modest than Citigroup's. I think the job cuts were 75% about the weak economy and only 25% about BAC's recent merger with Merrill Lynch. There will be some redundancy between Merrill's and BAC's investment banking operations, but it should not amount to much. BAC is just using the Merrill merger as an excuse to lower their cost structure. This, however, is an important step when considering that banks face more quarters of loan losses. BAC's job cuts will improve operating earnings by reducing costs by nearly $7 billion over the next three years. Aside from the obvious negatives at the personal level for those people who will lose their jobs, it is a negative that BAC will take a hit to net capital of some magnitude for the severance pay. This is important because capital is at a premium for all banks and this action will, indeed, lower BAC's net capital. I believe the job cuts are necessary and the key question is how rapidly and effectively they can get them done. If these job cuts drag on for three years, the morale at BAC will collapse and the productivity will suffer, diminishing the positive impact of the cost savings. It is a question of execution. In this regard, I am more optimistic than I was when I heard the news that BAC was buying Merrill Lynch. I would have preferred BAC stick to their knitting with more traditional banking activities. But the deal having been struck, BAC has an impressive record of integrating acquisitions. Their Fleet Boston and MBNA mergers, by most accounts, went very well. I'm guessing the Merrill Lynch merger will be the same. I told the interviewer for the present we were holding our BAC, but we were carefully analyzing all of the public statements BAC executives were making about future business. BAC and other banks must offer some hope of a turnaround for us to want to continue to hold them.

The Collapse of the Auto Bailout: Not As Bad As It May Seem

Even though news of the breakdown in talks to bail out the Big Three Automakers will send stocks lower at the opening on Friday, is the news so bad? I don't think so. What good does it do to bailout companies with an operating model and cost structure that has failed. The Big Three will only be back to the bailout window again, and again. The US automakers are hamstrung with thousands of dollars per car in so called legacy costs: costs associated with generous pensions and other benefits that have been agreed to by management and labor over the years. There is one small problem with these legacy costs -- Americans and world buyers won't pay them. Instead auto buyers the world over have, increasingly, switched to foreign based cars, many of which are manufactured in the US. Toyota is now the largest car company in the world. Nissan, Honda, and Hyundai have all made huge gains in the US and around the world. The common denominator of these companies is that compared to the Big Three US auto makers, they all produce cars that have lower costs feature against feature, offer better gas mileage, and possess better customer satisfaction ratings. It's tough for the Big Three to compete against those kinds of results, and it is not likely to change anytime soon. The Big Three auto makers need a new, lower cost structure, and the only way to get it is probably to seek bankruptcy protection. Under bankruptcy, they will able to renegotiate all contracts and debt. Bankruptcy may seem a harsh pill to swallow, particularly in these tough economic times, but bankruptcy does not mean an end to the US auto industry; it just means a time when the industry, creditors, and the unions can put together an operating model that has a chance to succeed in the global market. You and I have all flown on bankrupt airlines. In bankruptcy, planes still fly, most employees still have jobs; indeed, business is conducted pretty much as usual. It just means that management gets protection from creditors and contracts that are draining away their viability. Importantly, it is a time when management, creditors, and unions are under the gun of a bankruptcy judge whose job it is to keep the pressure on all the players to agree to a plan that has a chance to survive in the market place. The current high-cost structure cannot and should not survive. The US auto industry needs a complete overhaul. The breakdown in bailout talks may offer all the participants an opportunity to get it right. The markets won't like the uncertainty, but the markets will, ultimately, ecstatically embrace a plan that has a chance to survive. There may still be a reprieve and a bailout deal may be yet struck, but in my mind any deal that leaves the current operating and cost structures in place is doomed to ultimate failure.

Tuesday, December 02, 2008

Bill Gross and Stocks: Still Wrong After All These Years

Let's face it, the last time Bill Gross, manager of the $800 billion Pimco Total Return Fund, was bullish on stocks was a long-time ago. Indeed, in 2002, he said stocks were on their way to 5,000. Shortly thereafter a bull market began that drove stocks, ultimately, to 14,000. But then again, why would a bond manager ever put in a good word for stocks. That's not his "job." His job is to tout bonds. Today Mr. Gross said that bonds were a better buy than stocks. I agree that corporate bonds and some preferred stocks, which have bond-like qualities, are very good values, and we have been nibbling on them and will continue to do so. Having said this, stocks, in my mind, are dirt cheap compared to riskless US Treasury bonds. For the first time since 1958, the dividend yield on the Dow Jones Industrials at 3.65% is higher than the 2.7% yield on a 10-year T-bond. In addition, the Dow Jones Industrials are now trading at a P/E of about 11 times operating earnings. If you invert P/E, you get what is called earnings yield. A P/E of 11 equates to about a 9.9% earnings yield. The importance of earnings yield being this high is that if you owned the averaged company in the Dow, you would be earning about 9.9% yield on your investment from the income alone, irrespective of any future capital appreciation. In the lexicon of Warren Buffett and big investors of his ilk, earnings yield is seen as owner's income -- the money they can make from buying the whole company. In short, stocks as cheap as they are today will at some point kick off a buying spree from big money players. The only reason it has not happened yet is because stock prices have not been able to find a bottom. When the bottom is formed and tested, I predict a wave of takeovers will begin that will carry stocks to higher levels than most people would now believe. These are my personal thoughts. Please do not act upon anything I have said here. I'm just passing on my thoughts for what they are worth. Please consult your own investment advisor.

Wednesday, November 26, 2008

What's Berkshire Hathaway Worth, Anyway?

I have a contrary rule that has worked well over the years. When the sirens of Wall Street are trying to canonize Warren Buffett, don't get too excited about his company, Berkshire Hathaway. When the street is treating him like a guy whose run of luck has run out, get interested in his stock. I noticed this contrary indicator during the tech bubble. Buffett was excoriated for not getting on board that wave to nowhere. I remember a writer on one of the financial websites saying that Buffett should apologize to his shareholders. Well history shows that Mr. Buffett was wise in staying far away from the tech bubble. In the intervening years, his ascent to cult figure status began again when it was clear that Buffett had made the right moves during the tech craze. Over the last 12 months, Berkshire Hathaway stock has fallen nearly 30%. That is less than the S&P 500, but very un-Buffettlike. Lately, he is being chastised for making what now look to be bad investments in Goldman Sachs and GE. His insurance company has not had a good year, and his options bets seem to be going in the wrong directions. To all this, I say only look at the body of this guy's, work and you see something we are never likely to see again: a guy who not only makes a lot of profitable decisions; he makes them in tough times. Our valuation model for Berkshire Hathaway Class A shares (above) shows that its price is buried deep into its value. The model says that BRK should sell for nearly $140,000 twelve months from now (striped bar). Today it closed at just over $100,000 per share. Our model is based on a multiple regression of BRK's book value and interest rates. It isn't a guarantee or a promise. It is just a model that has done a pretty good job of tracking BRK's price over the last 15 years. In these crazy markets, has Mr. Buffett lost his touch? With his track record, I don't think it would be wise to bet against him. We own the stock. Do not make investment decisions based on this blog. It is for information purposes only.

Tuesday, November 25, 2008

The Fed May Be On The Verge of Buying Subprime Loans

It has been my contention since my March blog that the subprime crisis would eventually lead to the government buying subprime loans. I likened it to an icebreaker. Frozen subprime assets clogged banks', insurance companies', and other financial institutions' balance sheets and, thus, blocked the free flow of capital and normal economic activity. That is the reason that I was at first optimistic when the TARP plan was announced to do just as I had hoped. My optimism was dimmed when the TARP plan was altered in such a way that the purchase of the frozen assets was set aside in favor of direct government investment into the major banks. I was certainly not against the infusion of government capital into the banks, there will have to be more of that, but in my judgement, the frozen assets won't just thaw on their own. They must be broken up by the government. Today's announcement that the Fed will buy up to $600 billion in Fannie Mae and Freddie Mac notes and mortgage backed securities (MBS) is a giant step in the right direction and should push mortgage rates lower and benefit housing. It does not assure that subprime assets will be bought because the details of the plan have not yet been made public. But here is my thinking, today the Fed also announced that they were buying up to $200 billion in "AAA" rated asset backed securities backed by auto loans, education loans, credit cards, and SBA loans. The Fed's announcement regarding the purchase of mortgage backed securities made no mention of the ratings of the mortgages to be bought. I have a gut feeling that they plan to purchase mortgage backed securities with ratings lower than AAA. If they do that, they will begin the unfreezing process. The reason that I think the Fed will begin to buy loans with lower ratings is because there is a reasonably efficient market for AAA rated MBSs. It is the lower rated MBSs that are frozen. I'm hoping the lack of a rating announcement today means that the Fed is beginning the process of breaking loose the MBSs that include subprime collateral. If it does, it should significantly improve the housing market by freeing up billions of dollars that can be loaned to willing and qualified buyers of homes.

Friday, November 21, 2008

Thank You Mr. Geithner

Timothy Geithner is a person you probably don't know much about; you may have never even hear his name, but over the next four years, you'll get to know him very well. The reason is simple: Geithner has apparently been tabbed to be the next Secretary of the Treasury. Perhaps his job is now behind only the President of the US in power, influence, and importance. I have been hoping that he would be named for the position for the last several weeks. I spoke with a writer from Reuters right after the election, and she asked me who I thought should be the new Secretary of the Treasury and I said "the Chairman of the New York Fed." I couldn't even remember his name. It even surprised me at first, but then I realized that in his position as Chairman of the New York Federal Reserve Bank, he had been instrumental, according to news reports, for the actions taken with Bear Stearns, AIG, Lehman Brothers and probably a host of others. He has had skin in the game, so to speak. The other candidates President-elect Obama apparently considered were Lawrence Summers and Paul Volker. In my judgement, Summers is certainly qualified for the job and perhaps would offer some name recognition, something that might help us through this period of lack of trust. However, as I rolled his name over in my mind, I kept coming up with the thought that if he could't handle the faculty at Harvard, how would he handle the power elite of the world. As for Paul Volcker. I cringed when his name came up on the list. Don't mistake my thinking here. My admiration for what Mr. Volcker has done for this country is very high, but he is 81 years old and I questioned whether or not a man, even a brilliant and strong man, of his age could withstand the 24 hour-a-day struggle that lies ahead for the new Secretary. Geithner is 45 years old and has been instrumental in working through international financial crises going back to the Clinton years. He is in a powerful position now as New York Fed Chief, and by all accounts, he has a thoughtful and deliberate style, but is a bold decision maker. The stock market certainly liked Mr. Geithner's slotting. The market was trading about flat when I first saw the news, within the next 30 minutes it was up nearly 500points. Secretary Geithner just gave us a good day; let's keep him in our prayers in hopes that he might give us many more. Click here for Mr. Geithner's bio.

Thursday, November 20, 2008

Rising Dividends Are Not An Endangered Species

I have managed money using some form of a dividend investment strategy for nearly 20 years. In 1993, I discovered that a "rising" dividend strategy produced better results than just focusing on high dividend yields alone. Indeed, I call that 1993 discovery my eureka moment because I was not expecting to find such a relationship, and it came almost by accident. I'll share the story in a future blog. The question I have been asked a lot recently is, "What if we have now entered a time when dividends won't be rising anymore. Indeed, what if we have entered a time when dividends will be falling for most companies? How will you decide what stocks to own, then?" If the economy slows as much as the alarmists are telling us, then the universe of rising dividend stocks from which we would have to choose would shrink. However, in the tens of thousands of stocks that trade on the world's stock exchanges, we firmly believe there will still be a group of 25-30 wonderful companies whose dividends would still be rising. Those would be the stocks on which we would focus and build our portfolios. Thankfully, we have had very good dividend growth in our portfolios over the past 12 months, and based on our research we believe most of our portfolio companies will have dividend hikes again in 2009. Over the last twelve months in our Cornerstone Investment Style (our main dividend style), we have owned 31 companies. In that time, one company cut its dividend, and we sold it immediately, and two other companies have cut their dividends, but we have held them because our dividend valuation models indicate that the companies are still solid values. The remaining 28 companies have all raised their dividends at an average rate of just over 11%, about the same as the portfolio's recent 5-year average dividend increases. These dividend increases in the face of one of the worst economic crises in memory convince us that dividend growth is not a thing of the past. In these bear markets it is important to remember that while almost all stocks are moving with the bearish trend, the prospects for all companies are not going down. Indeed, I believe the great majority of our companies will have better earnings and dividends in 2009 than they did this year. Our companies are unique in that they are very adaptable, as well as being multinational. They can shift resources anywhere in the world to where ever the sweet spots lie. These are very tough markets and good news has been hard to find, but Bloomberg had an item that will give you some idea of how cheap stocks have gotten. For the first time since 1958, the dividend yield of the S&P 500 is now higher than the yield on a 10-year T-bond. In addition, the PE ratios of the S&P and Dow Jones Industrials, based on next years expected earnings, are also at a multi year lows.

Tuesday, November 18, 2008

Vectren: 49 Years And Counting . . .

Hats off to Vectren (VVC), our home town utility. VVC recently announced their 49th consecutive annual dividend increase. That puts the company near the top of the list of companies with the longest uninterrupted strings of dividend hikes.
VVC provides regulated gas and electric services to approximately one million customers in Indiana and Ohio. They also have a non-regulated division that is involved in power sales and management, and VVC is one of the largest coal producers in our area.
Vectren currently yields 5%, and our expectation is that its dividend will continue to grow over the next 3-5 years at just over 3% per annum. Three percent growth may not seem like much, but when added to its current 5% yield gives a projected total dividend return of 8%. That's not bad when compared to the 3.5% current yield on a 10-year T-bond, especially when considering the defensive nature of the utility business and VVC's long history of success.
Finally, the lower chart above shows that 5% is at the high end of VVC's dividend yield range over the last 7 years.
The current management team of VVC, headed by Niel Ellerbrook, carries on a long tradition of being good stewards of their shareholders' and their customers' trust.

Monday, November 10, 2008

The Hidden Value of Dedicated Hearts And Minds

By Randy Alsman, VP and Portfolio Manager The bear market of the last year coupled with the seemingly spasmodic daily jumps and falls in price have shaken the confidence of many investors. Many days it seems that logic has left the building, with apologies to Elvis fans for borrowing the phrase. Also, people caught up in the visible market’s gyrations can lose sight of what the market really represents. A brief refresher might help restore faith in long-term investing for at least some of you. The stock market is nothing more than a place for centralizing and organizing the exchange of value. One part of that exchange is most often money…cash. That’s the visible part if you will. The other part of that exchange is equally, if not more, important. That other part, sometimes lost in the drama, is ownership. In the case of the stocks that we focus on, it’s ownership of some very high-quality companies. More specifically, shareholders own parts of tangible, and even more importantly, intangible assets. Obviously, buildings, equipment, inventory, etc. are some of those assets. And they have real and often significant value. But down yet another layer, shareholders own the most powerful and valuable of assets – ideas. Those ideas can be comprehensive and formal, such as patents, copyrights, and brand equities. A powerful new drug, a more energy efficient jet engine, a brand name that evokes high quality, are all intangible assets that can generate billions in revenue and profit. Equally or even more powerful are the smaller, daily ideas of thousands of employees trying to figure out how to better serve customers, outsmart competitors, or do their job more efficiently. In the best companies, job candidates are screened for their ability and tendency to think that way. Once they’re hired, millions of dollars are invested in training them to get even better at those thought processes and how to act on them more effectively. None of those intangible assets are much affected by short term stock market moves. Think about yourself, you go to work every day with some part of your brain trying to figure out how to do something better, earn a promotion through superior results, stretch your department’s budget to accomplish more with less, etc. Often, a setback on a project or a market downturn actually can cause you to work even harder for great new ideas. Those intangibles are the most powerful assets owned by an investor in a high quality company…the hearts and minds of thousands of talented, motivated people working every day to create more value. They can be defeated, and some of them are each day. But far more are finding new and better ways to win. When they do, they add to their small part to the larger total value that their shareholders own. When the market and the economy go through their down times, don’t lose sight of what a long-term investor in great companies actually owns. He owns a powerful force that does not accept permanent defeat. In total, across a portfolio of top companies, those hearts and minds have always found a way, and I think they always will. Hearts and minds may be the most powerful argument for taking the long view when investing. Temporary defeats may grab the headlines. The best employees of the best companies, however, never stop trying…and then they succeed. Those successes are often not directly reflected in stock prices over a few days, weeks, even over many months. But, for those who take the longer view, those accumulated victories have been rewarded handsomely.

Friday, November 07, 2008

Southern Company: Solid Defense, Good Offense

By Rick Roop, VP and Portfolio Manager With President-elect Obama having been ahead in the polls for many months, we have been digging into his statements on his proposed energy policies trying to figure “what’s next” particularly in the area of the electric generating industry. This industry has been in a state of confusion ever since it became clear Obama would likely be the next president because of the great differences between his public statements on the environment and reliance on alternative energy and the policies of the Bush Administration. This confusion has left a big question mark in the minds of many in the utility industry as to where to invest capital for the next generation of electricity producing assets. According to the most recent Annual Energy Outlook from the Department of Energy’s Energy Information Administration (EIA) electricity demand from 2006 to 2030 is expected to increase 25%, using the middle forecast; 30% if you go with the upper forecast. However, nowhere in the report is there a weighting for the additional load required from the use of electric cars by U. S. citizens between now and year 2030. According to the Obama/Biden New Energy for America Plan, a goal is to place at least 1 million Plug-in Hybrid cars on the streets of America by 2015. The production of electricity is a highly capital-intensive business. New power plants, transmission lines or gas pipelines are not only very expensive but they take years to build. With the recent crisis in the financial markets, financing has become more difficult and expensive, adding more risk to any utility wishing to add additional capacity. Add to that the 5 to 7 years it takes to permit and build a coal fired or nuclear plant, and you have just layered on additional risk to process. Our research at DCM has led us to choose utilities that in the short term (3 to 5 years) appear to have low risks in the areas of finance, regulatory environment, and industry concentration as we wait for a concrete Obama plan to come into view. One such company in our opinion that meets this risk profile and yet offers solid growth potential is Southern Company (SO). For over 25 years through my work with the International Society for Automation, I have been privileged to get to know a wide range of SO’s managers. I believe they are among the most “heads up” of all electric utility management teams in the nation. Southern Company is a good fit for our clients at DCM because of management’s ability to minimize their risk profile without limiting opportunities for growth. This has been accomplished by successfully maintaining 85% of their business under the protection of the regulated utility umbrella, while building a competitive wholesale business outside the regulated service territory. Southern company has leveraged their ability to generate good profits under their protected territory by maintaining a very cooperative relationship with regulators. As a further hedge against risk, it has been Southern Company’s policy to insist on fixed long-term energy contracts for capacity added outside their protected territory. Going forward we believe that any utility with fossil fired power plants will come under much tighter clean air regulations, which will in the end drive costs up for the end consumer. New clean air compliance equipment will raise the cost of production for all coal fired power plants. As a result, any utility that can avoid or diminish these costly capital additions will increase their profit margins. Southern Company will benefit in this regard because they are already 15% nuclear and have applications in place to increase that level. Southern is a rare utility in many ways. They have maintained an A debt rating, which makes their cost of capital lower than many companies in the industry. They serve a part of the country that is experiencing population growth, thus, they are growing faster than many utilities. They have a long-term track record of increasing their dividend. With a current dividend yield of 4.9% and prospects for dividend growth in the 4% range, SO offers a generous potential return from a high quality company that sells a product we can’t live without. We own the stock. This blog is for information only. Please consult your own financial advisor about SO.

Wednesday, November 05, 2008

Does Obama's Tax Plan Change Our View of Dividends?

President-elect Obama has promised to roll back the Bush tax breaks on dividends and capital gains. Many people have asked me if such a change in taxation would change our favorable view of companies with consistently rising dividends. The answer is no. Many years ago I experienced a kind of eureka after an extensive look at 50 years of data for the Dow Jones Industrial Average (DJIA). I found that dividends and earnings were both highly correlated to price over this long expanse of time. But there was an important difference. Earnings had an annual standard deviation, think volatility, of nearly 23%, while dividends had a standard deviation of just over 8%. Indeed, I was surprised to find that DJIA earnings had a higher standard deviation than that of the Dow's price, which has been 14.5%. Annual dividends have fallen very few times over the last 50 years, while earnings have fallen about every 4 years. In short, I found that using dividends in combination with interest rates could produce a very tight fit between a prediction of the year-end price of the Dow and what actually happened. In our investment strategy, dividends represent not only a cash payment to us, which we prize, it also serves as a sort of tracer bullet to let us see the trajectory of the path of the market. The only change we may make in our clients' portfolios is that for clients in the top tax bracket we may suggest they switch to our Capital Builder investment style, which features lower dividend yielding stocks whose dividends are growing much faster than the average company. The overall performance difference between Capital Builder and Cornerstone (our higher yielding, lower dividend growth investment style) has been very small.

Monday, November 03, 2008

Procter and Gamble Is Not Much of a Gamble

By Mike Hull, President Portfolio Mgr. and Greg Donaldson Director of Portfolio Strategy
Nearly 15 years ago Mike Hull oversaw the building of a plant for a Fortune 500 company in China and was instrumental in marketing the firm's nutritional products throughout the country. After his time in China, he came back to the US with the notion that the Chinese had gone too far down the road of capitalism to turn back, but they still had a lot to learn about the rule of law in property, both real and intellectual. He says that the best way to understand China's business prospects is to understand that the Chinese government will do anything they can to keep economic growth going strong. They need economic growth to keep the millions of peasants that have come in from the countryside working. Any long-term disruption in economic activity would throw people out of work and be a threat to the Chinese Communist Party.
Mike believes that among foreign companies, Procter and Gamble, (PG) caught on to the Chinese way of doing business earlier than most other companies. He remembers early on PG sold shampoo in small tubes that might resemble samples in the US. Yet in China these small tubes of shampoo, which were still expensive to the average Chinese worker, were a sign that a family was moving up in the world, and Chinese women by the millions bought the tubes of shampoo almost as a status symbol. Today P&G does about 20% of their business in Asia and it is growing very rapidly.
PG now does less than 50% of its business in the US, and that figure will continue to fall as developing world growth, albeit slowing, continues to outpace US growth.
The chart above compares the dividend yield of PG versus the yield of a 10-Year US Treasury bond over the last 20 years. We have been showing these "yield" charts because we believe they tell a powerful story: many high quality companies are very cheap.
Our research reveals that in the case of companies that consistently raise their dividends, which PG has done for over 50 consecutive years, the long-term growth of their prices will mirror the long-term growth of their dividends.
The chart shows that 20 years ago, investors expected PG's dividend to grow about 5% (8.5% - 3.5%) That is what it would have taken for PG's total return to equal a T-bond's yield ( 3.5% dividend yield plus 5% price growth).
Looking at the right hand side of the chart, we see today that investors are only requiring dividend growth of 1.5% for PG yield to equal a T-bond's yield. We realize, of course, that there is great fear in the market, which has driven bond yields down and PG's dividend yield up, but we think it is highly probable that PG will grow its dividend by more than 1.5% over the next few years. Especially since they are doing more and more business in China and the developing world.
We believe PG will continue to build their businesses in the fast growing parts of the world, and that they will likely increase their dividend in the range of 8%-10% over the next decade, just as they have over the last 50 years. If we are right, PG's total return over the next 10 years will dramatically outperform that of T-bonds.
We own the stock. This blog is for information only. Please consult your own financial advisor about P&G.

Friday, October 24, 2008

GE: Out Like A Light, Or Just On a Dimmer?

By Randy Alsman, Vice President, Portfolio Manager Questions about General Electric’s future are flying among investors lately. The stock has recently set a series of new 52-week lows. Criticism of CEO Jeff Immelt abounds, including left-handed compliments from legendary former GE CEO Jack Welch. GE Capital, a $65+ billion finance subsidiary, one so far without the same access to the full range of federal support available to banks, generates much concern. Its huge commercial property division is struggling with the decline in that market. The housing slump has hurt GE’s appliance division – now up for sale along with the storied lighting division. Even good news is sometimes seen as bad. Investing “genius” Warren Buffet recently professed his confidence in GE and bought $3 Billion of new preferred GE stock to prove it, but GE had to pay him 10% and the warrants that he got are now underwater. Despite its litany of problems, GE’s credit is still rated AAA. Only five other companies occupy that lofty perch. So, in many ways, GE is seen as embodying America’s economic preeminence in the world. However, there is enough fear in the air and blood in the water right now for the darkest of predictions to seem inevitable. Is General Electric destined to become another General Motors? Or at least, is GE going to deteriorate into one of those once-great companies that loses its way and can no longer put together a string of growing annual revenues and earnings? Maybe so. No one can see the future perfectly. But like a smoke screen, the current bad news hides some very solid, very positive things about GE. Most divisions of the company, except GE Capital, have been growing rapidly, and not just in the U.S. Heavily entrenched in the global conventional and alternative energy infrastructure markets, GE will continue to benefit from the world’s insatiable appetite for energy. GE is a world leader in sophisticated turbines for power generation and aircraft. It supplies locomotives to the energy-efficient rail industry. Aging Baby Boomers in the US and around the world will demand more MRI’s, CAT scans, cardiac imaging tests, and other diagnostic measures - markets that GE dominates around the world with only a few other firms. The entertainment business is viewed by many as recession-resistant, and again GE is a major player. The cash flow from NBC Universal continues to be very strong. The current double-whammy of a credit crisis and economic recession has hampered or damaged each of GE’s businesses. An objective eye will see, however, that none of those problems will last forever. Also, GE still is seen with good reason as a company just packed full of extremely competent workers, managers, and executives. Jeff Immelt does not make every decision that determines the future of GE. He has lots of very talented help. Finally, GE does a better job than possibly any other company of linking one division to another, enveloping large customers in the full range of GE’s product offerings. Things are rough and troubled right now. However, unless you think all hope is lost and we’re reverting to candles, voodoo medicine, horse-drawn wagons, and a barter economy, GE should continue to be an increasingly valuable company for many years to come. With today’s PE of 8.0 and a dividend yield of over 6%, one is buying GE on the cheap and is getting paid to wait out the economic turnaround that will inevitably come. GE is poised to provide handsome returns for investors with the courage and patience to ride out the latest storm. We own GE in a number of our investment styles. Our principals also own the stock. Please do not make investment decisions on the basis of this information. Consult your own investment professional for investing advice. Find out more about Randy Alsman and our other portfolio managers at the following link: http://www.donaldsoncapitalmanagement.com/right-template03.php?nav_ID=58&nav_Parent=45/

Wednesday, October 22, 2008

Johnson and Johnson Offers More Than A Band-Aid

I still believe that the hedge funds are the main culprits behind the continuing sell off in stocks. Their client defections are running high and their funding sources have disappeared. Without the ability to borrow, they have only one choice -- sell. The sell off is creating some unusually attractive bargains. The chart at the right compares the dividend yield of Johnson and Johnson (JNJ) with the yield on a 10-Year US Treasury bond, going back 20 years. In 1988 the T-bond yielded nearly 9% vs. about a 2% dividend yield for JNJ. JNJ's dividend growth and price growth have had a high correlation for many years, thus, to break even a buyer of JNJ in 1988 would have had to have expected at least 7% annual dividend and price growth to justify buying the stock.
The second Chart shows the actual annual dividend growth of JNJ over the last 20 years. Its dividend growth has averaged nearly 14% per year, well over the break even level required. Even with the recent swoon in the market, JNJ has produced a mid double digit total return over the last 20 years. Looking back at the top chart, we see that a 10-Year T-bond now yields about 3.75% and JNJ's dividend yields just over 3%. This relationship is betting that JNJ's dividend and price will not grow in the foreseeable future. I don't think that is a good bet and neither do the analysts who follow the stock. The consensus average of the analysts is that JNJ's earnings and dividends will grow by just over 8% annually during the next 3-5 years. If JNJ's dividend does grow 8% annually, as the analysts are projecting, and its price continues to grow at about the same rate as it dividend, that would produce almost an 11% total return over the next 3-5 years. Sounds too good to be true, especially when we see the carnage that has befallen Wall Street lately, but I believe many quality companies such as JNJ will continue to produce solid results in spite of the uncertainties that are confounding the markets. We are passing through a financial storm. Yet, we now have the whole world working to repair the effects of the storm. History shows us that when we have gotten the whole working on a problem, it has been solved. I believe this will happen again. I will review other companies in the coming weeks that appear to be oversold. We own JNJ in our clients' accounts. The principals of the firm also own it. Please consult your own adviser on the merits of JNJ.

Thursday, October 16, 2008

Dr. Ed's Explanation For Yesterday's Stock Tailspin

By their very nature panic-driven markets defy rational understanding, but yesterday's plunge simply made no sense to me. The weak economic data was blamed for the big drop in stocks by most of the media that I have read, but as I went to bed last night, in my mind the weak retail numbers alone just did not justify a 700 point fall on the Dow. Everyone knows that there is a gawkers affect, and the constant headlines of bank bailouts and failures would certainly keep people away from the malls. It just did not add up to me that the market could not see that the cavalry was on the way. With all of the assistance world governments are giving banks, the new programs for troubled homeowners, and a new stimulus package moving through Congress, it would have seemed that the markets should have reacted far less violently. I believe my suspicions were answered this morning when I read Dr. Ed Yardeni's morning economic report. Dr. Ed, a widely respected economist, reported that investors had pulled $43 billion from hedge funds in September alone. He went on to say that as a result of the demise of Lehman Brothers and the pull back in higher-risk lending by investment banks and commercial banks the world over, that the hedge funds are under siege. In short, their lending sources have all but dried up. Thus, when investors want out, the hedge funds have no choice but to sell stocks no matter what the price. That is what Dr. Ed is convinced drove the Dow's fall yesterday. That makes much more sense to me than the market's reaction to a weak economic number that will be adjusted many times in the coming months before we know for sure how the economy is faring. I have spoken before of the reasonably good long-term correlation between GDP and the Dow. It's not tit for tat, but particularly since 1960, the two have moved together. With yesterday's close around 8,500 on the Dow, the Dow is back to were it was in 2002. At that time, the cumulative real GDP of the US was just under $10 trillion. The most recent reading of GDP is $11.8 trillion, nearly 12% higher. With the Dow at this level, that would mean that the economy has grown by nearly its long-term average over the past six years and stocks have not grown at all. Inflation is the only headwind that could cause the Dow's current reading to accurately reflect the value of its 30 stocks. With oil having fallen to under $80 p/b, it is clear that inflation will be falling in the months ahead. Today's CPI showed zero headline inflation and .1% at the core level. The are many unknowns in all the new governmental plans to bail out the banks and stimulate the economy, but we remain convinced these plans will do their jobs, and that as consumers become more confident of this, they will not continue to stay at home and eat microwave dinners. There will be more spells of hedge fund selling, but their selling has very little to do with the underlying values of the companies that they are selling. Their selling is just bailing out to payoff exiting customers. As the bank stabilization plans come clearer into view, we believe the hedge fund selling will likely diminish, if not turn to buying. I am in Dallas Texas for my oldest son's wedding. He is marrying a wonderful belle of Texas. He asked me just a few weeks ago what I thought the future was for his generation in light of all the problems in the economy. I laughed and told him that I wondered the very same thing when his mother, Joyce, and I got married years ago during the first oil OPEC embargo. I told him the world is far from perfect but that progress is unstoppable. Where free men and women are given the tools, they will always innovate and come up with better ways of doing things. And these better ways of doing things need lots of people to make them happen and move them around the world. Furthermore, I told him, he and his new bride would help cause this new world of innovation to unfold. Justin is getting his PhD in Informatics from Indiana University. He works in areas I cannot describe. How can he or I be pessimistic with this new generation of thinkers and doers on the move?

Friday, October 10, 2008

United Technology's Dividend Hike Signals Business Isn't So Bad

In one of the worst weeks in US stock markets history, there was a positive event that occured that suggests that what we saw this week may have been more about fear than about a collapse in underlying business prospects. That important positive event was United Technologies (UTX) dividend hike of just over 20%. A dividend hike in bad times is always a good signal as to how a company's board of directors view the future. UTX's board could have raised the dividend even as little as 7%, and it would have been good news, but raising it 20% causes one to pause a little longer and think about what this big dividend hike might mean. First it is important to note that UTX has raised its dividend an average of nearly 18% per year over the last 5 years. During this time their earnings growth has averaged nearly 15%. In the last twelve months, UTX's earnings have grown 16%. So, the 20% hike was not statistically out of their recent patterns. What is surprising is that the dividend hike is at the high end of their recent range and comes at a time when their stock is under heavy selling pressure. Indeed, UTX's price is down almost 38% in the past twelve months. Was the dividend hike an attention getter to buy back some of the sellers? That's silly. In recent months, dividends have been the last thing on people's minds. UTX would also not seem to be a company that would be slipping through the weakening economy without some bruises. The construction business is important to their Carrier division; the strength of the global economy is important to their Otis Elevator division; and they have tough competition in their Pratt and Whitney and Sikorsky Helicopter divisions. The conclusion I come to is that UTX's business is on balance good. Their geographic diversification of 48% North American sales and 52% global sales is serving them well. Innovations across all their product lines are being well received, and in a world that is increasingly interested in more efficient products, UTX is delivering. This means that UTX's new products are replacing existing installations early because of cost saves. In addition UTX has developed a low-heat geothermal product that is gaining wide acceptance all over the world. I can speak a thousand words or just a few about the week's market's collapse, and one dividend hike pales in comparison to the wealth that was lost this week. However, if the lost wealth this week was about a collapse in business prospects, I believe it would have been reflected in the amount of UTX's dividend hike. Since UTX hiked their dividend at the high end of their recent history and because of their size and influence in our economy, it is a signal to me that business is not falling apart, as the market would have us believe. Indeed UTX's dividend action would suggest that business prospects are still good on a global basis. This was also born out in IBM's spectacular earnings report this weak. The G-7 is meeting this weekend to try to find a way to restore order to the banking system and the markets. With the crushing the markets took this week, investor expectations are not high that a workable approach will result from the talks. I am praying that the market is wrong. I invite you to pray in whatever way is your custom for the men and women who will try to find solutions to the problems of our banking system. Here is mine. Oh Lord, you are the giver of all good things. Your Word says that You bring rains in the proper seasons that provide bounty to the land and food to the cattle and sheep of a thousand hills. Lord a deep fear-driven drought has come to the the financial markets of the world. We ask Lord that You would bring life giving rain in the form of wisdom and truth to our world leaders. Guide them to good policies that are pleasing to you and that will bear fruit. Grant us the courage and the wisdom to do endure these times of uncertainty. Grant us relief from this hour of uncertainty and replace it with the joy that is yours alone to give and you delight in giving. Amen.

Tuesday, October 07, 2008

How We Turn the Markets

I spoke with one of the savviest financial people I know this morning on my way into work. He asked me for my take on why the markets’ seemed to be in such a tailspin. Before I could get into my explanation, he said, “The markets are acting completely irrational. Business is not falling off the table the way that stock prices are.” I told him that his explanation was my explanation. Fear was driving the selling with rationality having left the building. I explained that the bank rescue plan came as a surprise to Congress and they did not do a good job of selling it to the American people. The plan is certainly a rescue, but in its original form, it was not a bailout of $700 billion because the government would be buying frozen assets at greatly discounted prices and would likely make back their investment from the mortgage payments alone, let alone the fact that a house was attached to every loan. The public got up-in-arms because they were angry at not only Wall Street but also the politicians, and as a result, they inflicted their wrath on the halls of the House of Representatives. The House, sensing that they were in a no win position with the electorate, punted and voted the rescue plan down. The stock markets reacted with a vicious sell off that continues to this day, even though the plan was eventually passed. My friend asked why the sell off has continued now that the bank rescue plan had been passed. I answered that I thought there were three reasons:
  1. We have a real problem of liquidity and bad loans in our economy and the rescue plan will take weeks if not months to get moving, so there is still bad news almost everyday to which the markets must react. The volatility will continue until the bank rescue plan and other measures taken by the government begin to work and unfreeze liquidity.
  2. Bank bailouts have hit Europe, with banks in Holland, Germany, and England being bailed out in one form or another.
  3. The most important issue, however, is that stock traders realize that the bank rescue plan being on the front pages for nearly a week has raised the awareness of the American people to the problems in the banking system and will lead to a pullback in consumer spending. Consumers are angry and frightened, and since they represent roughly two-thirds of US GDP, the economy, which has been muddling along, will likely slow; perhaps even dip into negative territory in the coming quarters.

Consumers were already on alert before the banking crisis was on the front pages. Recently released Federal Reserve data show that for the first time since 1998, consumer debt fell in August by 3.7%.

My friend said he agreed the economy would slow but that the stock market was down over 25%, which was dramatically more than the economy would fall. He said, “How does a market get over these kinds of irrational fears.” I said that I thought the market would get over its fears, the same way it got over its greed.

Three years ago everyone thought that home prices would go up forever and everyone got in line to buy a house. The banks, particularly in the hot real estate areas, bought into the forever-rising real estate story along with their customers and they started cutting corners on assuring the creditworthiness of their home buyers. So greed took over. Prices went up everyday. Buyers started offering more for houses than the sellers were asking -- and on and on. What killed greed is that in the end you run out of foolish buyers. The higher you go, the more value-oriented people, shall we say “rational” people, drop out, so at the end it is just the greedy doing business with the greedy. Then some of the value-minded people realize that prices have gotten too high and they start selling. Pretty soon, prices start leveling off and then start down because value-minded people keep putting more real estate on the market. As prices begin to fall, the people who were still buying at the end are quickly underwater. In stocks it’s the same way. Right now some people are selling because they believe that earnings and dividends will be significantly hit by a slowing economy, which would make their stocks worth less in the short run. But the great majority of selling is being done by people who aren’t thinking about earnings or dividends at all; they are selling because the market is going down and they are afraid. Fear has seized the day and it will run its course the same way that greed did: until value-minded people step up.

So far it has not made much sense for value-minded people to get in a hurry to start buying. The markets have been getting rocked everyday, but value-minded people realize that there will come a day very soon when the sellers will run out of steam. At that point, the value-oriented buyers will begin buying and the markets will at first calm down and then begin to move higher.

Here’s a very simple reason why: the sell-off in stocks has created great values. The Dow Jones Industrials now yield over 3%. That is a higher yield than a 5 year Treasury bond. That means that investors who buy the Dow today will at least match the income from Treasury bonds and get all the growth in dividends and prices over the next 5 years for free. It is that kind of value that brings the value-minded people off the sidelines.

Another thing that would help a lot would be if the Fed and other world central banks did a coordinated rate cut.

Friday, October 03, 2008

The Shortlist: Wells Fargo On The Move

Two weeks ago I offered a shortlist of five individuals or corporations whose wealth and power made them ideally suited to play roles in turning around the US banking system. On my list were Wells Fargo, JP Morgan, Warren Buffett, WalMart, and General Electric. I identified each participant because, in my judgment, their presence would be a vote of confidence to an increasingly fragile banking system that was having trouble raising capital. I have now updated this list three times as first Warren Buffett stepped up and took a big position in Goldman Sachs. JP Morgan joined in by buying the assets of troubled West Coast thrift, Washington Mutual. Today in the biggest news of all, Wells Fargo has offered to buy Wachovia in a deal that will not require FDIC involvement. Of all the deals announced so far, the Wells Fargo - Wachovia deal is the most important because it is the biggest and is directly involved at the heart of the mortgage crisis. Wachovia, which was formerly one of the most respected banking institutions in the world, fell from grace after its ill-timed purchase of Golden West Financial, a California based thrift. Golden West was one of the leading sellers of an exotic home mortgage called "Pick a Pay", which as its name implies, allowed mortgagees to pay varying amounts on their monthly mortgage payments, even amounts less than enough to cover interest. Pick-a-Pay losses mounted sharply after Wachovia took over Golden West, casting a pall over Wachovia and causing worries that the bank would not survive. What makes the Wells Fargo takeover bid even more interesting is that it tops a deal that the FDIC engineered last week in which Wachovia's banking operations were sold to Citigroup for $2 billion. The Citigroup deal did not include Wachovia's large brokerage and mutual funds operations. Wells Fargo was apparently involved in the bidding for Wachovia all along, but did not have the winning bid in the end. They have clearly rethought their bid and upped the ante considerably. Their bid today is for the entirety of Wachovia, including the brokerage and mutual funds operations, and totals $15 billion. This has created a dicey situation between Citigroup and Wells Fargo and threats of lawsuits are already in the air. It will be very difficult, however, for Citigroup to stay in the battle for Wachovia with such a wide gulf between their bid and that of Wells Fargo's. At the very least, Citigroup is going to have to raise their price and that probably still won't be enough because Wells Fargo's offer takes the FDIC off the hook, while Citigroups keeps them on. Here's the bottom line. This battle for Wachovia could mean we are nearing the bottom of the credit crisis. When two large healthy banks go toe to toe over a bank that only weeks ago was rumored to be close to bankruptcy, it means that big, smart money believes the worst is about over and good values are present. Today the House of Representatives passed the bank rescue plan. The outcome was in doubt until just hours before the vote. The bank rescue plan will free up critical liquidity and allow banking in this country to slowly return to normal over the coming year. It won't happen overnight and there will still be plenty of bad news coming on the economy and banking. Nonetheless, a fight breaking out for Wachovia, the passage of the bank rescue plan, and the courageous actions of JP Morgan and Warren Buffett will undoubtedly improve America's confidence in the US economy and its banking system.

Tuesday, September 30, 2008

The Greatest Stock Market Wisdom I Have Ever Heard!

It is an understatement to say that the stock market did not like the defeat of the bank rescue plan yesterday. No matter what your politics are, the defeat signaled to the financial markets that politicians are every bit as greedy as the Wall Street types they condemn. The election polls said the American people were against bailing out the banks, and a majority of politicians from both sides of the aisle, gave the people what they wanted. The only problem was that they did not give the country what it needed, which was a plan to unlock the banking system. You can talk all you want about bailouts or rescues, but the truth of the matter is a bank near you will be biting the dust in the near future if there is no plan forthcoming. In this regard, it is my understanding that the Senate is working on a plan. Let's hope they are more successful at formulating something that does the job. I have been through a lot of market turmoil in the 33 years I have been in the business, but the single most powerful wisdom I have ever heard in how to deal with bad markets came during the height of the 1987 crash. On that day, as you know, the market was down nearly 23% and people were just swept away with panic. Almost unbelievably, I got almost as many calls from non-clients as I did from clients asking what to do. Since everyone knew, even by mid morning, that the sell off was going to be unlike anything we had ever seen, there was some disagreement among the investment professionals at the firm I worked with at the time about what we should do. Cut bait, or ride it out, those were the choices on the table, and cut bait sure felt better than riding it out because we all knew that it was going to get a lot worse before it got better. A very successful elderly client strolled in on his way to lunch and announced to our huddled little group, "What are we buying boys?" We were all a bit taken aback because we were certainly not thinking about buying. Then he said something that I will never forget. He said, "You know, when you think about what is a safe place to put your money in times like these you have to remember one thing: If the greatest companies in the world are not worth anything, then nothing else is. I'm not talking about this little company or that one. I'm talking here about the great blue chip stocks. If they have survived for 50 years or more and have risen to leadership in their industries, it is not an accident. They know how to survive and prosper. They know how to make it through wars, recessions, oil embargoes, market corrections, and politicians of both stripes. They know how to adapt and change and remake themselves over and over. They know how to get close and stay close to their customers. They will survive this crisis and they will be stronger on the other side of it because they will not hide; they will use this great uncertainty to gain market share. You watch, a year from now; five years from now the great blue chip stocks will be higher, a lot higher." The man's words were echoed almost verbatim when I received a call from a very successful lady a few minutes later. She wanted to know what to buy. She had a substantial sum of money that she wanted to put in the market and wanted me to tell her what to buy. I tried to caution her, but she stopped me and said, "Look, Greg, I'm a big girl. I know the risks, but my husband and I have amassed thousands of acres of farm ground, and we did it by buying every time other people were afraid that farm ground was going down the tubes. Great companies are like great farm ground. They always come back and they always rise to the top. Stock traders don't know what they are buying and selling. They are just like commodity traders in that regard. They are not dealing in something that in their minds has true value. They are just selling prices, and the prices are falling, so they want to sell. Next week the prices will be rising ,and the traders will be right back in line trying to buy the very thing they sold last week. I'm not buying prices when I buy farm ground, I'm buying something that I know what to do with. The same goes for the great companies. They are not just prices; they make something that's valuable. They'll come out of this bad time, and I'm going to make a lot of money when they do." Neither of these people went to Harvard or Yale. Neither even had a college education, but both had amassed fortunes, and they knew exactly how they had done it: Go where others fear to tread. But stick with the best, because the best will survive and by surviving they will prosper you. The next few days and weeks will be volatile, but just remember the high-quality dividend paying companies that we own make products that we use everyday. One or two might run into trouble but in a portfolio of thirty stocks there will ultimately be a lot more winners than losers a year from now.

Friday, September 26, 2008

The Shortlist Shortens Again as JP Morgan Buys Washington Mutual

Last week I offered a shortlist of individuals and corporations whose wealth and power made them ideally suited to play roles in turning around the US banking system. On my list were Wells Fargo, JP Morgan, Warren Buffett, WalMart, and General Electric. I identified each participant because, in my judgment, their presence would be a vote of confidence to an increasingly fragile banking system that was having trouble raising capital. I reported on Wednesday that Warren Buffett had moved off the shortlist first by investing $5 billion in Goldman Sachs (GS) preferred stock, with warrants to purchase another $5 billion of common stocks. I fully expect more activity from Mr. Buffett and Goldman Sachs. Goldman has registered themselves as a bank holding company, which would mean they could eventually take deposits. Since this is a very low cost method of funding their operations, there is a good chance they are going to want to buy a good sized bank to enter this business. The second departee from the list is JP Morgan (JPM). JPM bought Washington Mutual after the FDIC closed the bank Thursday evening. You will recall that I thought Wells Fargo was the likely suitor for Washington Mutual, and that JPM was a good match for National City. It is now clear that JPM chose to go after WM to gain a West Coast presence. I still expect Wells Fargo (WFC) to make a major acquisition within the next few weeks. With GE deciding to strengthen the financial position of their GE Credit division, they become less likely to be a buyer of banking assets. Walmart would require a change in the laws to become a player. They have not said anything publicly about such a move, but they have made it clear in the past that they wanted to be in the banking business, and in light of the current crisis, their strong balance sheet would be a welcome addition as a possible acquirer. As I write this, the wire services are saying that an announcement about a plan to save the banks will be issued before the markets open on Monday. Politics has entered the mix which makes a deal more difficult, but I believe politicians on both sides of the aisle realize that without some sort of plan more banks will fail in the coming weeks, wiping out hundreds of billions of peoples' income producing assets. Perhaps as you read this, you think that is just what should happen. After all risk is risk, right? Here's the problem: bank's stocks have long been seen as so-called widows and orphan's stocks. Banks are owned by the same people who own utilities and telephone companies. They count on the income to live. The Washington Mutual take-over model undertaken by JP Morgan brought safety to depositors of the institution, but probably wiped out all equity and debt holders. Thus, JP Morgan gains a valuable assets, but it was done on the backs of conservative income investors as well as the bigwigs. Washington Mutual was aggressive and has paid the ultimate price. But had a rescue plan been in place like the one that Treasury Secretary Paulson proposed, it may have been possible for WaMu to have survived and given an opportunity for the shareholders and bondholders to have gradually made a comeback as new capital was made available to the bank. I have heard a lot of high sounding rhetoric about moral hazard and not bailing out the bank bigwigs. That misses the point that bank stocks are not like tech stocks. These bank stocks that everyone seems so anxious to let go down the tubes have been in business for generations, and many investors have such low bases in the stocks that they have been reluctant to sell. The tech craze largely affected younger and savvier investors. If banks are left to dangle in the wind and then fail, many innocent older people are going to be hurt. We tough nosed investors can say all we want about letting the bigwigs get their comeuppance, but before you drive your Hummer into that gathering of bigwig bankers on the street out in front of their building, remember, you will also be plowing through Aunt Minnie, grandmother, cousin Fred, and the endowment plan of the church on the corner. If this rescue plan turns into a lynch mob of bigwigs, we will be returning an evil for an evil, and the only winners will be the bigwigs from that other bank in that other city. The small investors' assets will die at the exact moment as does the bigwig's.

Wednesday, September 24, 2008

The Shortlist Just Got Shorter: Buffett Does What He Does Best

Last week I offered a shortlist of individuals and corporations whose wealth and power made them ideally suited to play roles in turning around the US banking system. On my list were Wells Fargo, JP Morgan, Warren Buffett, WalMart, and General Electric. I identified each participant because, in my judgment, their presence would be a vote of confidence to an increasingly fragile banking system that was having trouble raising capital.
We can take Warren Buffett off the list because he has done what he always seems to do: shocked the investment community with his activities. He announced the purchase of $5 billion of preferred stock of investment banker Goldman Sachs (GS), with warrants to buy an additional $5 billion of common stock.
What was so shocking about the purchases was that Mr. Buffett had a very bad experience a few years ago with Salomon Brothers, now a part of Citigroup. I will have to admit that I did not think Buffett would enter the canyons of Wall Street again. But there was an overriding issue with Goldman Sachs that trumped his previous bad experience on Wall Street. Goldman Sachs is considered the Gold standard of Wall Street. The saying goes that in every merger or acquisition deal that one chair is always reserved for Goldman. They are seen as the so-called smartest guys in the room, and they have proved it year after year.
This is actually Buffett's second acquisition in a week. Last week he announced his holding company Berkshire Hathaway (BRK/A) was buying troubled energy company Constellation Energy. A deal the company had with a French concern appeared to fall apart at the last minute, and Buffett stepped in to provide much needed capital.
My guess is that with Goldman's brains and Buffett's bucks and brains we may see more out of this terrific twosome.
Now if we can just get the other four members of the list up off their behinds and into the water, we'll get this economy and market turned around, and not have to wait on the hot air that seems to always hover over our nation's capital.
At the right is our model for Berkshire Hathaway's latest Fair Value. As you may remember, the model is based on BRK's historic relationships to growth in its book value and long-term interest rates. The model says BRK is currently approximately fairly valued at $128,000 per share. The model is suggesting that based on next year's predicted book value growth that in the next 12 months the stock may rise to near $137,000. That doesn't exactly put BRK in the cheap column, but with the newsmaking ability that Mr. Buffett has and his recent opening of his check book, I would not be suprised to see the $137,000 reached sooner rather than later.
We own BRK/B in our Capital Builder accounts. We offer this discussion for information only, and as we all know that past relationships will not necessarily work in the future. The reason we show the Valuation Model is because it has been reasonably accurate in the past at predicting BRK's price.

Monday, September 22, 2008

Ben and Hank's Plan Was Inevitable, And It Will Work

"The Fed and the US Government will ultimately put together some sort of bail out plan for the $300 billion in subprime bad debt. The amount is smaller than the S&L bailout in the late 1980s, and it is the only way to keep the real estate market from being a drag on the economy for years to come." Rising Dividend Blog March 25, 2008. This is a quote from my March 25, 2008 blog entitled Tough Questions, Controversial Answers. I was wrong by 60%, but right in principle that the US Government would eventually be forced to buy the bad mortgage debts from the banks to end the mortgage crisis. I heard many negative comments about that blog. I heard about free markets, moral hazards, and a host of other issues that didn’t mean a twiddle. I heard them, and I listened patiently, but I knew where this subprime debacle was heading. Now we are here at a figure of $700 billion instead of my $300 billion. Could the number have been smaller had Ben Bernanke and Henry Paulson moved faster? No, they have moved as fast as they could. Politicos cannot move much faster than the populace, and the people were not ready for a government bailout until recently. The following is a paraphrase of the last question of the March 24 blog. Question: What about the precedent of bailing out people and institutions who made unwise investments? Answer: It is not the Fed's job to impose moral judgment on society. It is their job to maximize sustainable economic growth and minimize inflation. One could just as easily use the argument about the moral hazard of people in the US who live directly in hurricane alley, or tornado alley, or wildfire alley, or earthquake alley, or any other dangerous alley in the country. Why should the rest of us have to pay when Katrina rips away New Orleans or Houston, or a tornado tears through a city in Kansas. These people all built homes or bought homes in harms' way. Shouldn't we just leave it to them to clean up their own piles of trash? No, that is not the way our country works. There is no hiding place from the storms of life -- physical or financial. Our country has stepped forth time and again to calm the storms and solve the problems in one economic sector or region of our country so that the troubles of that area do not spread to other areas and take us all down. Of course, there were egregious lapses of judgment on Wall Street, but they are paying for it in the hundreds of billions of dollars in write offs they have taken, bankruptcies they have filed, and in the tens of thousands of jobs that they have lost since the beginning of the subprime debacle. I don't like bailouts any better than most of our readers, but some bailouts are necessary when the foolishness of one group imperils the general populace. I believe the subprime-real estate crisis rises to that level. Had the government not bailed out the S&Ls in the late 1980s, the S&L problems would have lasted a decade, cost hundreds of billions of dollars, and slowed overall economic growth to a crawl. As it was, the Resolution Trust Corp. cleaned up the majority of the mess in only a few years at a fraction of the $500 billion at stake. In almost all economic crises, the death knell is the freezing up of valuable assets behind fear and risk aversion. In essence, when the government steps in, they act as an icebreaker by breaking apart the frozen assets and keeping them flowing, then putting the assets up for sale in an orderly basis. That is what happened in the S&L crisis. That is what I predict will happen in the subprime crisis. So, now we long-term investors wait and watch the politicians as they wrangle their political advantage out of the bail out package. While they spout and speak of things they know and care very little about, the markets will dangle in a cloud of unknowing, and as a result, will swing with the wind. When the package is delivered to the President for his signature, if it is along the lines of Secretary Paulson’s proposal, the markets will calm and the seeds of trust and confidence will sprout. If it includes tag-ons like more “bridges to nowhere,” the market will see through it like a cheap suit, and we will have more weeks of rough weather until the politicians get it right. I am not worried about the future because in a crisis US politicians usually get it right. Politicians are pawns of political pressure. Political pressure is beholden to the will of the public. The will of the public is not as far from the truth as many in the media elite would have us believe. The public are figuratively in the streets chanting for a stop to the financial carnage. They know that much of New Orleans is under sea level, but they reach out to New Orleanians as the storm surges over their seawalls anyway. That’s what’s so great about America. We are a nation that forgives and forgets and moves on. You say things have changed and it won’t happen this time. History says you’re wrong.

Thursday, September 18, 2008

Here Is a Shortlist of People and Institutions Who Can Make the Financial Crisis End?

We are living through a financial riot, and it is not a comforting feeling. We have found that the rating agencies might not quite be on top of things the way we had come to believe over the years. We have found that financial statements from insurance companies and banks do not show the toxicity of the loans they call assets. We are reminded again of the many conflicts of interest that rage on Wall Street. We have learned that the bank down the street with its giant mirror of a building that always seemed to imply power, strength, and the sky's-the-limit is up to its cooling towers in loans that seem to have seeped up from the sewers. We are in a financial riot, but just like physical riots it will not last indefinitely. It will end and it will be the government who ends this financial riot just like it is government that ends physical riots. It is not shopkeepers who fight back the inflamed mob and quell the riot, it is government through the police or the army. But it will not be government who will rebuild the financial system. That is the job for private enterprise. This is not a third world country. We are not dependent on the United Nations to solve our problems. This is a fabulously wealthy country that has blessed many entrepreneurs and corporations with wealth beyond their wildest dreams. There is no shortage of capital to solve this crisis; there is a shortage of nerve and courage and the willingness to take some blows to give fresh capital and clear-headed management principals time to turn the financial system around. It time to cut loose the bodies of capital that can solve this problem. I believe the following short list of participants should be allowed or encouraged to help clean up the mess.
  1. Wells Fargo (WFC) has dodged all the sludge so far, and they have made it clear that they are not in the turn-around business. I want to remind them; however that it was the ideas and leadership of a bunch of people from the old Norwest Bank out of Minnesota, who turned around the country-club banking types in California and enriched them in the process. John Stumpf, America needs your business acumen and banking genius to reach down into this mess and pick up something that you can correct. Many banks are selling for a fraction of their book values. What STAGE are you waiting for to get in the business of helping solve the banking crisis, and ultimately to enrich your company even more. You know its the truth. You just need to move. I think Washington Mutual is your best bet. They have a sales culture similar to yours. Unfortunately they have been selling the wrong products. If you give them the right products and risk management systems, they will rise.
  2. JP Morgan (JPM) and Mr. Diamond, you cut a heckuva deal on Bear Stearns. However, you need to get a little more skin in the game this time. National City Bank (NCC) has lost its rudder. They are a natural fit to your old Bank One territory. National City has always been a good meat and potatoes bank. They fell into the sewer when they tried to join the caviar crowd in the subprime world. National City would offer incredible consolidation possibilities because of its overlap in your Bank One territories.
  3. Wal-Mart (WMT), you have been trying to get into banking for years. In exchange for allowing you to get into the banking business, you should seriously look at Wachovia(WB). It's big. It's got the Sunbelt covered. It can provide you with the expertise to cross sell hundreds of investment products to your your millions of loyal customers both in the US and around the world. The government should change the rules to allow you to do it. You have capital coming out of your ears, and you have a bond with Mr. and Mrs. America that is among the strongest of any company on earth. You can help your fellow Americans the way you did in Hurricane Katrina and recently with Hurricane Ike.
  4. Warren Buffett, what are you waiting for. You are worth$70 billion, your company is worth over $100 billion(BRK/A). You also need legislation to allow you to get into the banking business. Your party is in power currently in Washington. It ought to take you about 36 hours to be in business. J Pierpont Morgan is said to have saved the US from financial calamity at least twice by loaning money to the country. Here's your opportunity to join Mr. Morgan as a man whose legacy will live through the ages. Buy somebody smart in the banking business like you did with MidAmerican Energy and turn them loose amalgamating the banking system like MidAmerican has done in energy and power. It may not be shooting fish in a barrel, which is your preferred method of operation, but America is calling on you like it once did on J. Pierpont Morgan. I know you own bank stocks, but it not the same as owning the companies outright. You know that.
  5. General Electric (GE): I know the Kidder Peabody purchase did not work, but the hubris on Wall Street is at an end for awhile and the complexity of your company would benefit from the expertise and business connections of an investment banking firm. JP Morgan is swinging in the breeze looking for a buyer. You have a AAA rating; you do business in every corner of the world; you are at the forefront of all the alternative energy solutions that have a chance of working. Your biggest problem is going to be helping your customers finance your technology. Morgan Stanley can do that. That is their business. They can also help guide you to important acquisitions in the areas of the world you want to be in and to the companies with bona fide products and capable management teams.

Ken Lewis, of Bank of America (BAC). I shudder every time there is a financial crisis because I know you will be there with your checkbook, even if nobody else is. Thank you for your bravery; thank you for your belief in America. I pray that your courage and strength of character will be blessed with strong profits for many years as a result of the moves you have made during this crisis.

I criticized your Lasalle Bank and Countrywide Financial purchases; I cringed with the Merrill Lynch purchase, but you appear to have paid pennies on the dollar in all cases and something seems to be speaking to you about the future that none of the rest of us are hearing. Call Warren Buffett. See if he'll fight this battle with you.

Moves like these will ultimately occur. I don't know if these people and companies will come forth, or if it will be other brave souls. This short list, however, if they put their shoulders to it, could solve our current problems.

Friday, September 12, 2008

Might the Fed Cut Rates Again? Lehman Brothers' Demise Probably Means Yes

A rate cut may be in your future. After rising inflation worries put the markets on the alert for a rate hike earlier this year, the thought that the Fed's next move might be to cut rates would seem a little far fetched. At one time, using Fed Funds trading as a guide, nearly 75% of money was being bet on the side of a rate hike by year end. That very high bet on rate hikes has diminished in recent months, but the great majority of investors still believe that the next rate action will be up. I have a hunch; however, that a rate CUT is now nearly a 50% possibility and my reasons are simple: With the stock market down nearly 15% from a year ago, investors have lost nearly $2 trillion. In addition, with real estate prices down about the same amount, homeowners have taken another $2 trillion in paper losses. Without adding to the list, investors have taken a $4 trillion hit. That is a deflationary force that has not taken hold yet because it takes most people a long time to quantify these kinds of losses. But almost every asset they thought they had a year ago is now worth far less. My belief is that as the magnitude of these losses gradually reaches more and more Americans' psyches, they will begin to pull back even farther on their impulse and status purchases. I am not alone in my view that deflation is the biggest worry in the next few years. Thirty-year Treasury bonds yield only about 4.4%, far lower than the near 5% they yielded a year ago. The long bond crowd used to be called the bond vigilantes because they voted their inflation views with their Quotrons. If they thought inflation was a real problem that was not being addressed directly enough by the Fed, they sold long bonds, driving bond yields higher. If they thought the Fed was being too aggressive, they would drive yields lower, signaling the Fed was too tight. Thirty-year yields have been falling in recent weeks. The worries about the banks and the investment banks have created some flight to safety, but another bond yield shows clearly that the bond vigilantes are beginning to feel like the Fed needs to cut rates: 90 day T-Bills. Ninety-day T-Bills are currently yielding 1.45%. With Fed Funds at 2%, the bond crowd is signaling they don't want to put big money in the banks. They would rather take a lower yield from the government than the higher Fed Funds rate from the banks. The average difference between Fed Funds and T-Bills over the last 30 years has been .25%. With the difference now .55%, and long bond yields falling, the bond vigilantes are saying deflation from a slowing economy is a bigger worry than inflation. I realize this may fly in the face of conventional thinking and current inflation stats, but I have always considered the bond vigilantes the smartest trading crowd on the street. You can be sure Mr. Bernanke is watching. To get through this rough patch with the banks, we must have a strong economy. The economy is losing too many jobs, thus soon at a bank near you, you might find a lower rate. Addendum: The Lehman Brothers situation. Unless there is a miracle of some sort, Lehman Brothers, the 158 year old Wall Street firm, will soon close its doors. A last minute attempt by Treasury Secretary Paulson to convince, badger, cajole, plead, and all the other verbs that cry out for somebody to do something, appears to have failed. Clients of Lehman should be OK. SEC rules requires that client positions be transferred to the next owner of the firm. That said, however, billions of dollars of capital will vaporize in the fear-induced selling that has gripped the shares of big Wall Street investment banks. As we have learned bit by painful bit, they are all up to their necks in bad loans and increasingly investors have given up on them; as has the US government, since it refused to bail out Lehman. Without the government's largess, no large bank, sovereign wealth fund, private equity firm, or investment bank was willing to take a chance on what was thought to be the smartest bond firm on the street. The markets will probably be rocky on Monday. Uncertainties will certainly abound, but the failure of institutions with failed strategies was inevitable, and the markets will be better for it in the long run. Just as inevitable was the fact that the US government would stop bailing out companies who appeared to have no moral, ethical, or financial compass by which to steer a new more profitable course. These companies bet the ranch on high risk debt: but they were dead wrong, and the ranch will soon have new owners. I look for most of the other pure investment banks to seek new owners in the days ahead. Even venerable Goldman Sachs seems to have lost some of its hubris. We are going to make it through this travail. There will be survivors and the survivors will have far less competition for business in a wide range of financial product offerings. Bank of America, Wells Fargo, and Barclays Bank appear to be the big winners so far. We'll keep you posted as the great disappearing of Wall Street firms continues.

Sunday, September 07, 2008

Hank Paulson Got It Right on Fannie and Freddie

On Friday as I saw the 6.1% unemployment data released, I began writing a blog. Even though GDP was revised up, the meat and potato issues of lost jobs and homes were sure to cause the media to go on a "sky is falling, duck and cover" campaign that would leave most Americans wondering how we were ever going to get beyond this housing debacle, and in the process, freeze spending and weaken the economy in an even broader way. So I wrote that government must do more; that government must do what it could to stabilize all mortgage markets. To accomplish this, they must become direct participants in buying mortgages to push mortgage rates down, which would stimulate demand for housing and refinancing opportunities for those that qualified. Please read my Friday blog. It was not broadcast because I did not finish it until after 5:00 PM CDT. Late in the day, the Wall Street Journal carried a story that Hank Paulson, Treasury Secretary, was readying a takeover of Fannie Mae and Freddie Mac. In essence the US government was getting into the mortgage business. Hallelujah. This is something that I have been calling for since March, and this was the direct approach that I was advocating in the Friday blog and in previous ones. I repeat that I am a free market advocate to my bones, but the housing bubble threatens to set our economy on a decade-long bubble unwinding, which would produce sub par growth and economic malaise. The housing debacle has become a threat to our national security and that is a job for government to solve. Our friends on Wall Street and in the banking business have finally bitten off enough risk that they had choked the whole economy. The actions of Secretary Paulson will be debated and second-guessed, but I am convinced that they were necessary and that they will soon begin to bear fruit. Here's why. The weak link in the US economy is housing. If a floor is put under the housing market, the rest of the economy is still humming along reasonably well and will continue to do so. Oil prices and commodity prices are falling, which will have a positive psychological and economic effect on Americans consumption. High oil and commodity prices have not been overly worrisome to me from an inflationary standpoint because they have acted more like a tax on consumption. If these prices continue to fall, or even stay near current levels, inflationary pressure will diminish dramatically, and consumers can breathe a little easier and plan a little more long range. I believe Secretary Paulson's actions will be seen by worldwide investors as necessary and responsible and will cause money to begin flowing back into the US from foreign investors. The actions were bold, they were decisive, and even though I wish they would have happened a month ago, they will be rewarded with positive reactions in the US stock market. The government has more work to do to unfreeze the economy, but today's actions with Fannie Mae and Freddie Mac are a powerful message that Paulson and Bernanke are on the same page and will use every tool they have to produce an under girding to our economy. I also like the fact that the takeover of Fannie and Freddie has sunset provisions that will require the next administration and congress to act, or these changes will be gradually unwound.