Pssst, You Wanna Buy a Company?

There are three forces driving the incredible buy-out binge of the private equity firms: 1.) low interest rates, 2.) strong free cash flow growth of corporations, and 3.) the Enron-Sarbanes, Oxley effect. The first two forces are self explanatory and offer the opportunity for the buy-outs. Point three needs some discussion, but at its end, provides the motivation by all parties to do the buy outs. Sarbanes Oxley is the law that, among other things, requires CEOs and CFOs to certify all financial results under threat of criminal penalties. This law was passed by Congress in response to Enron, Worldcom, and the other corporate and accounting scandals that came to light in recent years. In short, Sarbanes -Oxley's only reason to exit is investors' mistrust of accounting and financial reporting in corporate America. Indeed, this mistrust of corporate America, which is both real and growing is the linchpin that holds the private equity juggernaut together. Is it any surprise that the recent explosion in private equity buyouts has coincided with the latest corporate scandals involving the back dating of executive options. The legacy of Enron, et al., means that investors must "discount" all corporate financial reporting for the possibility that what they are seeing "ain't" what they are getting. This discount is imposed on the entire market in a "one-bad-apple" effect and dampens how much investors are willing to pay for earnings. My PE model indicates that the Dow Jones Industrials should be trading at about 17 times earnings. It is now selling at under 15 times 2007 earnings. Now comes the private equity crowd with solutions aplenty. They offer to pay a premium for the "good-apple companies," which pleases the shareholders. (In truth, however, they are really only paying what the market price would have been in ex-Enron days.) "Good apple" corporate managers, who in another day would be fighting the private equity crowd, now become their apologists because they are offered their current jobs and bonuses, and they can leave Sarbanes-Oxley behind because its onerous rules do not apply to private companies. Finally, the private equity firms make their investors happy because they are buying companies on the cheap, and in 3-5 years, they will be able to resell the same companies back to the same shareholders for a 100-200% profit. Einstein is reported to have said that the greatest invention of all time was compound interest. He obviously had never heard about these private equity deals. I make the private equity crowd out to be sharks. They are not. They are just shrewd capitalists taking advantage of the fears and doubts of post Enron investors. But there is a sign that the perfect storm that the private equity firms have been riding is coming to an end. Blackstone, one of the largest private equity firms is going public. Let me say that another way: Blackstone, one of the smartest outfits on the planet is now willing to sell a piece of itself to the public and thus, become a public company, governed by Sarbanes-Oxley. I wish Mark Twain were alive today to give us a pithy quote.

A Few Thoughts About Private Equity

As I write this I am admiring the Cascade Mountains of Oregon. It is 17 degrees outside. It was 80 when I left Indiana. Gee, you mean you can't believe the Weather.com's predictions for Oregon's mountain country? With all this time on my hands that was supposed to be dedicated to learning to fly fish, I find myself just staring at these magnificent mountains while random thoughts flow through my mind. The thought that keeps appearing most often is,"What do all of the private equity deals mean?" Are they a good thing, or a bad thing. Are they an indication of just how cheap the market is, or are they just one more Wall Street gimmick that is going to crash and burn one day? Obviously, our firm has been collectively thinking about this for a long time. But in recent weeks, the buyouts have reached the point where Kohlberg Kravis Roberts, Blackrock, and Texas Pacific seem to be buying a company a day. These are high risk players, but they are obviously not fools. If you would have told me a year ago that companies as diverse as Biomet, TXU, The Tribune Companies, First Data, and Equity Office Properties would all be bought out by private equity firms in the span of six months, I would have told you that the Dow Jones Industrials would be over 14,000, maybe pushing 15,000. Something just does not add up about the rampant, almost frantic, pace of the buyouts and stock market's apathetic attitude towards it. Let me see, last month the markets sold off 5.5% in about a week. At the very same time, large buyouts were being announced almost everyday. Don't investors realize that the private equity money is only buying companies where cash flows over the next 5-10 years are expected to produce an annual rate of return of 15%-20%. Don't investors realize that this onslaught of private equity buyouts is going to keep rolling until prices of US stocks are much higher, and thus, puts a floor under any big market correction? But, as I sit here pondering the disconnect between big money buying everything in sight and the stock markets trading at PE multiples about the same as they were at the bottom of the bear market in 2002, I catch a beauty of a thought. If it's correct it might answer both behaviors. Let me sleep on it and I'll see if it still makes sense tomorrow. My wife just came in with snow shoes and a hiking map. She says we are adapting.

John Burr Williams: Investing Versus Speculating

John Burr Williams believed that the stock market was far more volatile than the long-run dividend paying abilities of the underlying companies would justify. This fixation with the short-term, led to periods of gross over and undervaluation in stocks, which, in turn, led to booms and busts in the economy. Williams believed that the cycle of booms and busts caused many people to lose faith in the free market economy and the markets, which ultimately led to the socialist-like economic policies of the 1930s. His book was not about beating the market, or getting rich in the market, it was really a wake-up call to the investment elite of his time to offer them a theory of investment value that would encourage more long-term investing and less speculation. Williams realized that speculators would always be with us, and were a legitimate enterprise, but he wanted to provide tools for investors to aid them in making decisions based on the “investment value” of a company, not just its price momentum. Williams postulated that investors’ inability to properly value stocks, increasingly, led them to become speculators. Most people would not admit that they were speculators, but when they were asked to explain their buy and sell decisions, it was clear that they were not appraising the intrinsic value of companies, but betting that they knew something that the market did not. In one of Williams’s most insightful observations, he makes the following statement: “To gain by speculation, a speculator must be able to foresee price changes. Since price changes coincide with changes of marginal opinion, he must, in the last analysis, be able to foresee changes in opinion. Successful speculation consists in just this. It requires no knowledge of intrinsic value as such, but only what people are going to believe intrinsic value to be. . . . Hence, some old traders think it is a handicap, a real handicap, to let themselves reach any conclusion whatsoever as to the true worth of the stocks they speculate in. How to foretell changes in opinion is the heart of the problem of speculation, just as how to foretell changes in dividend is the heart of the problem of investment. Since opinion is made by the news, the task of forecasting opinion resolves itself into the task of forecasting the news. There are two ways to do this: either cheat in the matter, or study the forces at work. Cheating has been outlawed, so far as can be, by the Security Act of 1934. The other way to forecast the news, and thus the change of opinion and the movement of prices, is to study the forces at work, in the belief that ‘’coming events cast their shadows before.’ But, rare is the man so sagacious as to foresee, so certain as to believe, and so steadfast as to remember; he who is makes a good speculator. Every speculator’s life is strewn with regrets, vain regrets for the news that he did not understand until it was too late. That ‘time and tide wait for no man’ he knows full well; like a bird on the wing must be shot in a jiffy, or she flies out of range forever. Hence, the first speculative opinions are usually wide of the mark, and as such, they usually need to be revised by the later trading of those who have had time for a sober second thought.” John Burr Williams was not condemning the speculators, but he was trying to open the eyes of investors to the fact that, as Ben Graham said, “In the short run the market is a voting machine (popularity contest), while in the long run it is a weighing machine (measure of value).” This is the sum total, essence, bottom line, and raison d'etre of Donaldson Capital Management. Long-term values of companies are determinined by what you can get out of them. That is why we scrutinize dividend levels and dividend growth. This is where value is created. This is where value can be measured. Finally, this is where we can find opportunties. Opportunities that are being shunned because today's news is not positive or is murky, but opportunities that have already discounted all the bad news and now stand ready to rise, driven by the intrinsic value of the company. Amen

The Fed Still Listens to Mr. Greenspan

As expected, the Fed just announced that they are leaving interest rates unchanged. What did bring a smile to the markets' and to former Fed Chairman, Alan Greenspan's lips, was the very slight change the Fed made to their "leaning" language. For the last six months, they have proclaimed a balanced attitude between the forces of inflation and economic growth, and that "leaning" caused them to end their long string of rates hikes. In today's announcement, their "leaning" language shifted ever so slightly to more concern about slowing economic growth than inflation. As I said in my last post, that is what Alan Greenspan has been advocating, and, apparently, Mr. Greenspan's former charges were looking at the same economic data he was. Even this morning, I read where several noted economists were advocating a rate hike because of the high core CPI rates. They don't live in the real world. The economy has entered a slowing phase which often causes inflation to blip higher because of lost productivity. Thus, to look only at inflation statistics is to look in the rear view mirror. The real picture is being played out in the unfolding crisis in the subprime lending arena. The Fed and Mr. Greenspan know that this crisis will spillover in some way at some level into the prime real estate market and slow the overall economy. Remember this: Greenspan does not use one of those fancy GPS navigational instruments to pilot his car. He watches the road. The road is a lot more unforgiving and confounding than the GPS map, which does not show pot holes, stoplights, or other two-ton cars that may have lost their way. I believe the Fed has now signalled that they will soon cut rates. This poses a conundrum. The economic news and corporate earnings are likely to soften over the next year, but US stock prices are likely to continue rallying. Just as core CPI lags the actual underlying trend of inflation, US GDP growth lags changes in interest rates. If the Fed is poised to cut rates, that will be favorable for stocks even if the economy and earnings begin to slip.

What is Greenspan Really Worried About?

A casual glance at the financial headlines this past week might have lead a person to conclude that Alan Greenspan was still Chairman of the Federal Reserve and Ben Bernanke was still giving lectures at Princeton U. The financial pages were full of Greenspan speaking on a wide range of matters related to the US economy. Significantly, he has had almost a quote a day on the subprime mortage crisis and how it relates to the overall real estate market and, ultimately, to the overall economy. I have spent most of my professional life trying to learn "Greenspeak." I claim no fluency in this arcane language, but I have have picked up an understanding of a few of its words and principles. The main thing to understand about Mr. Greenspan is that his primary goal in his public statements is to initiate debate, shape it, or correct it. Do not make the mistake of thinking that he is talking in some attempt to remain in the spotlight. He knows his place in history is secure. In my mind, if he is talking, it is because his take on the economy is different from the consensus. Here is a short list of what I think Mr. Greenspan is trying to say by his recent public comments.

1. He genuinely believes the subprime real estates woes will spill over into the prime real estate market, at some level.
2. Although there is no evidence, yet, the poor real estate market will slow the overall economy, perhaps, into negative territory.
3. He believes the primary problem the Federal Reserve should be addressing is economic growth and not inflation.
4. If the Fed waits for core CPI to fall to the comfort level before starting to cut rates, they risk letting recession take hold.
5. A time to "break the rules" is at hand. The Fed must have the boldness to start cutting rates when the economy appears to be growing at its optimal level and core CPI is above the comfort level.
6. He is doing this because he does not believe there is a consensus for this action either in the market or at the Fed.
7. Finally, heaven forbid, that the Fed should hike rates to fight inflation in the face of the coming economic slow down.

Mr. Bernanke and his fellow members of the Federal Reserve are meeting this week. We'll listen carefully to their official statement. If it is primarily aimed at fighting inflation, I have the strong feeling that Mr. Greenspan will stay on the offensive. If they emphasize that economic growth prospects appear to be dimming, I think Mr. Greenspan will stand down.

Seeing Through the Smoke and Noise

The stock market fell sharply again today on weak retail sales and continued worries about the subprime mortgage market. The air is getting thick with worries: Weakening US economic data, Mr. Greenspan’s utterance of the “R-word,” and bad news in the real estate market. When economic worries begin to mount, I believe the best way to understand the “real” economic risks in the markets is to ask the question of each problem, ”Whose lap is this situation ultimately going to fall in?” If the wallet that is in the hip pocket of that lap is financially loaded, the problem will be solved in a short time. If the wallet doesn’t have much in it but family pictures and a maxed out credit card, the problem will keep going and growing. Here’s the shortlist of the problems and my analysis of whose lap the problem is headed toward. 1. Over the past week, there has been a string of weaker US economic data. GDP is now tracking just about 2%, down from earlier reports of over 3%. Retails sales were weaker than expected, job growth was muted, and the capital goods sector appears to have slowed sharply. This slow-down in the US economy is the natural result of the Fed’s string of rate hikes. When interest rates go up, it is a form of a price hike, and under the law of supply and demand, higher prices, ultimately, lead to a softening in demand. The Fed had a major responsibility for putting the brakes on the economy to slow inflation, and by law, they have the responsibility to deal with the slowdown by cutting rates. I have been back and forth on when the rates cuts will happen, but I have remained steadfast in saying that real estate problems would, ultimately, be the driver of lower rates. 2. Ex-Fed Chairman, Alan Greenspan, said in a speech in Hong Kong that he thought there was a 33% chance of a recession in the US. Those odds were much higher than Wall Street estimates, and as a result, he has been roundly criticized for sticking his nose where it doesn’t belong. As I have thought about it, I believe Mr. Greenspan might have been speaking directly to Ben Bernanke and his cohorts at the Federal Reserve, advising them that they cannot wait until they actually see a fall in inflationary data before cutting rates. That is the old lagging Fed policy that Mr. Greenspan exposed as a failing strategy during his 18 years on the job. The Fed has to lead, and in this case, that means cutting rates before improved inflation data are evident. I believe the real risk in the US and world economy is just this: Will Bernanke and the Fed have the nerve to lead, by cutting rates soon, or will they employ the lagging policy that lead to booms and busts in the 40 years prior to Greenspan. I believe Mr. Greenspan was saying “pay attention boys and girls. Don’t just watch the data, get out and kick the tires. See if they are moving, or parked in the back lot.” 3. Real Estate worries: For the last 9 months, my contention has been that real estate was in worse shape than the public perception. The subprime market is a small piece of the US mortgage market and the troubles there would not seem to be causing such a row in the overall market. Here’s the bottom line on why the subprime market is important. The capital the subprime lenders loaned to their high-risk customers was borrowed from big mortgage and investment banks. The real worry that is now gripping the market is: how much of this high-risk debt do the big banks have and who has it? In my mind, this is the easiest of the issues to answer. Major US banks and investment banking houses are in the best financial shape they have been in since before the savings and loan crisis of the early 1990s. The subprime loan problems are not big enough to cause permanent damage to the majority of major US and international banks. Subprime troubles will continue to fill the headlines, but the lap they are falling into (the big banks) has a wallet that can easily handle the losses. The stock market is jittery and will continue to bounce around, but let me remind all of you dividend investors: Your income is unchanged; indeed, there is the strong probability that it will grow in the year ahead. Bouncing stocks are speculators tossing them back and forth for the sport of it. The intrinsic values of your companies are not changed by the headlines and the prognostications of this trader or that stock market guru. The intrinsic values of your companies are determined by how well our companies can execute their business strategies and how much of their profits their boards of directors decide to share with you. We have carefully chosen companies that have a steady hand and have an ironclad history of writing dividend checks that mirror their profits. As I stated in my most recent blog, John Burr Williams and Arnold Bernhard were convinced that the stock market was much more volatile than the underlying value of the average company. These two giants of the investment business complained about market volatility and tried in every way they knew how to help people see through the smoke and noise of stock market volatility to the true value of stock. That is our mission, as well. History has proved that Mr. Williams’ and Mr. Bernhard’s theories of valuation were correct, but most investors still refuse to take the time to do the math. If they did, they would find a lot of bargains today.

John Burr Williams and the Theory of Investment Value, Part 2

Mr. Bernhard was echoing Williams in pointing out the need for generally accepted criteria to value stocks. He also joined Williams in warning that the effect of not having such criteria resulted in excess stock market and economic volatility, which damaged investor confidence not only in the stock market but also in the free markets. Bernhard then boldly states, “In our own experience, during periods of inflation as well as at other times, in this country and abroad, it has been found that dividend-paying ability is the final determinant of the price of a common stock. Whenever, over a period of years, the dividend, or the ability to pay dividends, went up, so too did the price of the stock. When the dividend-paying ability went down, so did the price of the stock, inflation or no inflation.” In applauding Williams’s theory, however, Bernhard inserted a subtle twist to Williams’s basic premise by adding the words, “the dividend, or the ability to pay dividends.” By adding just these few words, he reentered the world of earnings and left behind the “dividends only” world that Williams had described as so important in determining long-term intrinsic value. Warren Buffett, Chairman of Berkshire Hathaway and the most famous investor of modern times, makes a similar twist. He is famous for saying that investing is easy: “just buy wonderful companies at good to great prices.” When asked to explain what good to great prices means, he credits John Burr Williams’s formula for intrinsic value, but defines it with a different twist: “The value of any stock, bond, or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset.” Warren Buffett substitutes cash flow for dividends and Arnold Bernhard substitutes earnings. Neither Buffett nor Bernhard nor many of the thousands of others who have quoted John Burr Williams over the years is saying the same thing Williams said. Williams was speaking of dividends alone, not earnings, cash flow, or a combination of the two. Williams went so far to keep dividends at the center of his methodology that he included in his thesis a section titled “A Chapter for Skeptics.” There he explained that he was certainly aware that without earnings and cash flow there would be no dividends, but he steadfastly asserted that they mattered only if you owned the whole company..” Indeed, in what must be one of the most amazing paragraphs in the history of doctoral dissertations, he offered the following: “Earnings are a means to an end, and the means should not be mistaken for the ends. In short, a stock is worth only what you can get out of it.” [Italics are the author’s.] He then added the following poem: “ Even so, the old farmer said to his son: A cow for her milk, A hen for her eggs, And a stock, by heck, For its dividends. An orchard for fruit Bees for their honey, And stocks, besides, For their dividends. The old man knew where milk and honey came from, but he made no such mistake as to tell his son to buy a cow for her cud or bees for their buzz.” In saying dividends, not earnings, were the determining factor in calculating intrinsic value, Williams knew he was reversing the normal rule that every investor learns when they start investing in the markets. Williams answered this issue with the following statement, “The apparent contradiction is easily answered, however, for we are discussing permanent investment, and not speculative trading, and dividends for years to come, not income for the moment only.” John Burr Williams struck a bright line between being in the chicken business and being in the egg business. He believed, as we will see later, that buying and selling chickens had no predictor and thus was pure speculation. On the other hand, investing in egg-laying chickens was completely different. It was possible to calculate the present value of a chicken by estimating its total egg-laying potential during its lifetime and then discounting it to a present value.