Wealth International, Limited (trustprofessionals.com) : Where There’s W.I.L., There’s A Way

W.I.L. Finance Digest for Week of August 25, 2008

This Week’s Entries : This week’s W.I.L. Offshore News Digest is here.

August 26, 2008

The commodity bull market has a long way to go, says Jim Rogers.

Jim Rogers notes that the supply of energy is going down while demand is going up. The obvious conclusion is that prices are going to go up. He thinks by a lot. (The implication, not said here, seems to be that most of the rest of the commodities will follow.) Moreover, when commodities do well financial assets do not. So Rogers owns commodities and he does not own stocks. Forget diversification, he says. Pretty srtaightforward advice from one of the most successful investors of the last 40 years.

The commodity bull market has a long way to go. This bull market is not magic. It is not some crazy "cycle theory" I have. It does not fall out of the sky. It is supply and demand. It is simple stuff.

In the '80s and '90s, when people were calling you to buy mutual fund and stocks, no one called to say, "Let's invest in a sugar plantation." No one called and said, "Let's invest in a lead mine." Commodities were in a bear market and in bear markets people do not invest in a productive capacity. They never have. Perhaps they should have, but they have never done it throughout history and probably never will. There has been only one lead mine opened in the world the last 25 years. There have been no major elephant oil fields [of more than a billion barrels] discovered in over 40 years.

Many of you were not even born the last time the world discovered a huge elephant oil field. Think about all the elephant fields in the world that you know about. Alaskan oil fields are in decline. Mexican oil fields are in rapid decline. The North Sea is in decline. The UK has been exporting oil for 27 years now. Within the decade, the UK is going to be a major importer of oil again. Indonesia is a member of OPEC. Indonesia is going to get thrown out because they no longer export oil, they are now net importers of oil.

Malaysia has been one of the great exporting countries in the world for decades. Within the decade, Malaysia is going to be importing oil. 10 years ago, China was one of the major exporters of oil, now they are the second largest importer of oil in the world. Oil fields deplete, mines depletes. This is the way the world has been working for a few thousand years and it will always work this way. So supply has been going down for 25 years.

Meanwhile, you know what is happening to demand. Asia has been booming. There are three billion people in Asia. America is growing. Most of the world has been growing for the last 25 years. So supply has gone down and demand has gone up for 25 years. That is called a bull market.

One of the things you will find if you go back and do your research is that whenever stocks have done well, such as the 1980s and '90s, commodities have done badly. But conversely, you find that whenever commodities have done well, such as the 1970s, stocks have done poorly. I have a theory as to why this always works, but it does not matter about my theory. The fact is that it always works this way and it is working this way now.

So before I set off to my second trip around the world, I came to the conclusion that the bear market in commodities was coming to an end. So I started a commodities index fund. This is an index fund. I do not manage it. It is a basket of commodities we put in the corner. If it goes up we make money; if it goes down we lose money. But since August 1, 1998, when the fund started, it is up 471%.

I [mention this index] to show you that the commodity bull market is not something that will happen someday. It is in process right now, and it is going to go on for years to come, because supply and demand are out of balance. And by the time we get to the end of the bull market, commodities will go through the roof. There will be setbacks along the way. I do not know when or why, but I know they are coming, because markets always work that way. Commodities have done 15 times better than stocks in this decade and they are going to continue that [trend].

My 5-year old daughter knows this. She never owns stocks or bonds; she only owns commodities. She is very happy owning commodities. She does not care about stocks and bonds, but she knows about gold. I assure you, she knows about gold.

Some of you probably diversify, or believe in diversification. I do not diversify. I am not a fan of diversification. This is something that stockbrokers came up with to protect themselves. But you are never going to get rich diversifying. I assure you. But if you DO diversify, commodities are the best anchor because they are not going to do what the rest of your assets are going to do.

I will give you one brief case study about oil, because it is one of the most important commodities. Some of you know that a company called ARAMCO owns oil in Saudi Arabia. It was nationalized in the '70s. They threw out BP and Shell and Exxon. But the last Western company to leave did an audit [of Saudi oil reserves] and came to the conclusion that Saudi Arabia had 245 billion barrels of oil. Then in 1980, after 10 years, Saudi Arabia suddenly announced that it had 260 billion barrels of oil. Every year since 1988 -- 20 years in a row -- Saudi Arabia has announced, "We have 260 billion barrels of oil."

It is the damndest thing. 20 years ... it never goes up, it never goes down, and they have produced 67 billion barrels of oil in this period of time. When nuts like me go to Saudi, we ask, "How can this be? How can it be that they always have 260 billion barrels of oil?" (By the way, last year they said they have 261 billion barrel of oil). And the Saudis say, "You either believe us or you don't," and that is the end of the conversation.

I have never been to the Saudi oil fields, and even if I had, I would not know what I was looking at. But I do know something is wrong. I know that every oil country in the world has a reserve problem, except Saudi Arabia of course. I know that every oil company in the world has declining reserves. So I know that unless someone discovers a lot of oil quickly, the surprise to most people is going to be how high the price of oil stays and how high it goes eventually. That is the supply side. Let us look at the demand side.

The Indians use 1/20th as much oil as their neighbors in Japan and Korea use. The Chinese use 1/10th as much per capita. There are 2.3 billion people in India and China alone. Well, the Indians are going to get more electricity. The Indians are going to get motor scooters. They are going to start using more energy, so are the Chinese. But if the Indians just doubled the amount of oil used per capita, they would still use only 1/10th of what the Koreans use. If the Chinese doubled their oil use, they would still be using only 1/5th what the Japanese and the Koreans are using. So you can see what kind of pressures there are on the demand side for oil and energy, at a time of terrible stress on the supply side. These are simple things.

So I would urge you to take a lesson from my little girls. My little girls are learning Chinese. My little girls are getting out of the U.S. dollar. My little girls own a lot of commodities. I would urge you to do the same.

Commodity carnage: Where to turn next?

A commodities investor offers a somewhat measured opinion of the market, whose bottom line amounts to a call that we are in a cyclical bear market but that a secular bull market is still in place. For those who insist on trading, as opposed to following Jim Rogers's (apparent) advice to buy and hold commodities, it sounds reasonable to us.

There is nobody like an investment banker to deliver yesterday's news tomorrow, and charge you dearly for it. Goldman Sachs has turned bullish on the dollar, while Merrill Lynch is calling crude oil down to $80. If bandwagon jumping was an Olympic sport, these guys would have more gold medals than Michael Phelps. After pumping up the commodity and Euro bubbles all year, a whiff of a bear market and they shamelessly perform a high speed U-turn. ...

[T]echnically we are probably on the cusp of the kind of Bull Trap rally in commodities that will give the optimists one last hurrah before prices nosedive faster than the Chinese stock market (although 45% down in 6 months will be hard to beat). ... Ultimately, as in every previous cycle, most commodities will converge to their marginal production costs, implying a 50% plus decline from the recent peaks. Some are already close, like grains, but many like copper and oil have a long way to fall.

On the chart below, the 200 day moving average is a good target. When the bubble excesses are cleared in 6-12 months, and the banks have started shutting their shiny new commodity desks as volumes slump, I will be buying for the long term secular uptrend still in place.

We like that commodities desk indicator.

Bubbling over? Traders puzzle over what follows sharp price declines.

The commodities producing companies themselves are also scratching their heads about the current price declines. But none have aggressively expanded production, justifying their investments using projections that all-time high prices will last forever, and financing the expansion using stock offerings at inflated prices -- which is what typically accompanies a secular peak in any asset.

Amid the debate over whether the commodities pullback is a correction within a bull market or the ominous beginning of a bursting bubble, materials-production companies appear to mostly be biding their time to see if changes in strategy are in order.

"At this point, the industry itself is not quite convinced that this is the beginning of a bear market," says Michael Gross, broker and futures analyst with OptionSellers.com ... Sentiment may change if prices continue to fall over the next month, Gross says. In that case, companies could resort to production cutbacks, for example slowing down ethanol refining or scuttling plans for mining facilities.

The retreat in commodity prices in the last few weeks is reminding some of the tech bubble that burst in 2001 and the current pounding of the real-estate market. They see a bursting bubble as index funds and other investors sell gold, agricultural products and oil. Yet when other market participants look back on the commodities run, they see a series of corrections in an overall upward-moving trend, including this one. That leaves production companies weighing their options.

"If we were to see a clear reversal trend and prices stay in a decline for a while, that could affect future production decisions," says Gary Thayer, senior economist at Wachovia Securities. "But a one-month decline in the market, even though it's been significant, doesn't erase what we've seen."

Xstrata (ticker: XTA.UK), for one, appears to be betting that the platinum market will rebound; it just made a GBP5 billion (about $9.8 billion) bid for platinum producer Lonmin (LMI.UK), despite recent declines in the metal.

Commodities companies have reaped windfall profits as their products have hit record highs -- and that could continue if people such as the noted commodities-bull investor Jim Rogers are correct in their assessment that materials have a long way to go up.

To take advantage of increasing prices, shareholders have urged many commodities-producers to reduce or eliminate their hedge books. However, the recent depreciation in commodities may encourage a return to more aggressive hedging, says Stephen Platt, analyst with brokerage Archer Financial Services.

A disadvantage to not hedging: Sales are not locked in, but input costs are often set in advance, Platt say. Costs that have soared on energy's price rise. That squeezes margins, even with higher product pricing. When pricing power weakens as commodity prices decrease, margins could shrink further.

But companies are not changing strategies just yet, as commodities prices are still well above historic norms, according to Frank Lesh, broker and futures analyst with FuturePath Trading. He cited $5 corn, $8 wheat and $12 soybeans -- which have risen 3-fold over the last decade. "It really was not that long ago that we were blowing through $100 in crude," Lesh says. "I think we are going to find that these prices will maintain up here."

Commodities and Emerging Markets: Joined at the hip?

Substantial air has been vented from both commodities and the emerging country stock markets this year. There are some fundamental factors that drive both markets, most obviously with coutries whose economies are commodities dependent such as Russia and the Middle East. But some other emerging markets, such as China and India, would seem to benefit from lower commodity prices. As the bear market progresses, one might expect the market to make a finer distinction among emerging markets than it has so far.

The growing sense that the air is quickly going out of the commodity bubble has only served to dampen the already-waning interest in emerging market stocks.

Indeed, the received wisdom that emerging market equity returns and commodity prices are tightly linked rests on two key assumptions: First, that the explosive growth in emerging market countries is a major driver of commodity prices. Second, that commodity prices are major determinants of emerging market economic growth, and therefore, equity returns.

While there is certainly some intuitive appeal -- not to mention some truth -- in this thinking, the relationship between commodities and emerging markets may be less straightforward than is generally assumed, meaning investments in the emerging markets asset class may still be worth considering.

Wheat heads back to earth.

Wheat has been one of the leaders of the commodities bull market. Drought ... depleted stockpiles ... China and India consuming more meat which will require more grain ... and so on -- justifications for the runup were not lacking. But stories justifying price moves are never lacking. Now, we are told, demand for wheat is moderating and supplies are coming back, thus "explaining" the recent substantial pullback in wheat prices. It is all enough to turn one into an ardent embracer of technical analysis.

U.S. wheat futures were the bulls' darling in the spring as prices soared to all-time highs in the wake of global crop failures. But the grain probably will not be invited to any parties this fall.

Wheat quickly became a wallflower when farmers expanded plantings worldwide to take advantage of lofty prices. After a quick retreat, the market was left sandwiched between bearish forecasts of record global production and bullishness about steady export demand. But demand appears anything but steady. Importers are expected to back off on purchases once they replenish supplies drained last year during the price run-up and widespread production problems. U.S. prices should slip, along with demand. ...

[B]uying interest should ease as harvests progress around the world, assuming good crops in other countries. When that happens, wheat on the Chicago Board of Trade could slip $1 to summer lows around $7.50 a bushel, according to Bill Nelson, analyst for Wachovia Securities. Nearby September wheat closed [last week] at $8.65, up 5% on the week. This spring, nearby CBOT wheat topped out at $13. "I am supposing that we will have these other sources become available progressively over the next few months," Nelson says.

The world is expected to grow more wheat than ever this year, with the global crop pegged at a record 670.8 million tons. That is up nearly 10% from last year, according to the Agriculture Department. Importers know they will eventually be able to secure what they need, so they are wary of paying too much for their purchases, says John Kleist, broker/analyst for commodity research firm Allendale. They are replenishing supplies, but "on their own terms," he reports.

The U.S. should see solid demand from countries seeking high-quality wheat at least until it becomes clear whether Australia will have a milling-quality crop, analysts say. Production is expected to rebound Down Under this year after two years of severe dryness.

Is a coffee price breakout imminent?

Coffee is up 140-150% in the last two years, underperforming commodities as a whole. This piece predicts it is due for another major leg up.

Coffee futures are not my favorite to trade. They are so volatile that it is tough to distinguish a true breakout from noise. ... Taking a step back, the long-term trend for coffee is up, up, up:

Long-term fundamentals are very favorable for long positions. The world continues to increasingly caffeinate itself with coffee, driven by -- you guessed it -- China and the rest of East Asia. A small but growing coffee market continues to gain ground on tea, the traditional caffeinated drink of choice.

On the supply side, most of the world's coffee comes from Brazil. So coffee supplies are heavily dependent on the quality of the Brazilian harvest, for better or for worse.

Coffee fundamentals are set up for us to see a super spike over the next 5 years. I firmly believe we will see $2+ coffee [vs. sub-$1.50 when the piece was written] at some point. And coffee has not yet had a major run up, like many of the other agricultural commodities -- so it is certainly due.

Commodities Go Kerplunk: Why Are Prices Falling?

No analysis of the commodities bubble/not question would be complete without input from the Elliott Wave International pundits, blessedly untainted with any hint of fundamental analysis.

It is official: The 5-year long commodity boom has gone from white-hot to white-not. To wit: since the start of July 2008, the futures markets have seen more jaw-dropping free falls than the Beijing Olympics diving competition.

As for the biggest splashes: That is the what. As for WHY commodity prices are plunging south, well -- The mainstream financial media offers more sides to the story than a house of mirrors, their "reflections" on the sell off as infinite and varied. ...

From the moment its heels touched the edge of the platform, the July 2008 Elliott Wave Financial Forecast (published June 27) went on high alert to the downside potential facing the commodity sector. In the Financial Forecast's own words:

"... Whereas the underlying driver of stock prices is a rising sense of optimism, commodities are driven by fear ... [This] suggests energy trading has reached an important mania era endpoint."

The July 2008 publication also noted the emergence of "parody" and "satirical financial takes" on the commodity mania and wrote: "This, is in fact what happens when a bubble is about to burst."

Following on its heels, the August 2008 Elliott Wave Financial Forecast added: "The stage is set for a long-term reversal that permeates the commodity markets."

So there you have it. EWI says we have a burst bubble on our hands, or at least a "long-term reversal."

Investors Chase Phantoms

And finally, we have arch-dollar bear/commodities and gold bull Peter Schiff, author of Crash Proof: How to Profit from the Coming Economic Collapse, and his perspective. He concludes: "There is absolutely no basis for a significant dollar rally, or further weakness in gold, oil, or other commodities," and thinks the abrupt swings in sentiment are a bullish sign. Point well taken.

In football, when a running back intends to cut to the left, he often first fakes right. This move is designed to make the defense commit their resources in the wrong direction. It is my experience that markets often follow a similar path. Just prior to a major move in one direction, markets often make a sharp move in the opposite direction first. With respect to the dollar, gold, oil and other commodities, many on Wall Street have bought into the head fake, and will soon be watching in amazement as the runner sprints to the end zone.

Over the last few months, as the dollar rose more than 10% against a basket of other currencies, and as gold and oil sank to multi-month lows, many investors concluded that a threshold had been crossed, and that the bearish trend for the dollar and the bullish trends for commodities had finally come to an end. But rather than representing a sea change, these counter trend moves more likely signify that the established trends are about to kick it into a whole new gear. My take is that if you thought you had seen a bear market in the dollar and bull market in gold, oil, and other commodities, well, "you ain't seen nothing yet."

Corrections are often vicious, designed to shake loose as many investors as possible prior to a major move. The best bull markets carry as little excess baggage as possible. With few speculators on board to sell into every rally, the true believers who remain can receive the full benefit of a fundamental upswing. Violent downward moves also force out those that were too highly leveraged, or those who showed up late to the party with little understanding of the true fundamentals. Those who panicked and jumped out too low often scramble to reestablish positions at higher prices, further fueling the bull market.

This recent correction saw the most dramatic change in sentiment that I have ever witnessed. But the head fake that caused the market to commit was in fact not worthy of a high school benchwarmer. With absolutely no significant developments that could explain either a bottom in the dollar, or a top in commodities, investors placed their faith in price moments alone. Once the numbers started to show some retrograde motion, everyone simply assumed that a real change had taken place, and the momentum buying and selling began. The rapid movement reveals how clueless participants in these trades had become. Even those fund managers that seem to understand the fundamentals were fooled by the sharp price movements and the rhetoric they spawned.

Lacking any real change in fundamentals, such abrupt changes in sentiment following extreme price swings are as bullish a sign as I have ever seen. There is absolutely no basis for a significant dollar rally, or further weakness in gold, oil, or other commodities.

The U.S. is the focal point of the world's financial turmoil. We convinced creditors around the globe into loaning us trillions of dollars. Now that it is becoming increasingly apparent we cannot pay the money back, Wall Street has concocted a scenario where our shell shocked creditors respond by loaning us even more. More alarming is that many brain dead investors see this as a likely development.

The fact is that the outlook for the dollar has never been bleaker and the prospects for gold and other commodities have never been brighter. The rationale for a new dollar bull market, or bear markets in commodities, is just as flawed as those used to justify investments in internet stocks and subprime mortgages. Interestingly enough, it is mostly the same suspects advancing the arguments.

August 25, 2008

"When there are opportunities, they are there; and when they are not, they are not."

This piece from Barron's features a hedge fund manager, Kyle Rosen, who takes advantage of overpriced volatility premiums by shorting certain options. This is less dangerous than it sounds, as Mr. Rosen hedges his positions so that the direction of the market does not matter. He only loses if volatility gets even more expensive, and apparently he does not lose often. Nevertheless, this is not something you can just do from the comfort of your home.

The most useful lesson to be gleaned here is Mr. Rosen's philosophy about trading, which is do it only when you know the odds are in your favor. If the odds or not in your favor then do not trade. Pretty simple. Many investors who say their goal is to make money have an unstated priority of getting some "action" by playing the market. This leads to overtrading and trading when you shouldn't. Better to feed that later goal by going to Vegas.

This is the story of a battle. Our hero is a quiet hedge fund manager armed with a Dell computer, giant flat-screen monitors mounted on a wall and a keen sense of options volatility. His antagonist, widely known by the nom de guerre the Standard & Poor's 500, is a ruthless and vicious index that hereafter is called Mr. Market.

This year our protagonist, Kyle Rosen, is ahead of the market. He recently notified his investors that their fund's year-to-date gain through July was 28.71%, compared with Mr. Market's 12.65% decline. In July, Rosen Capital Partners advanced 2.92%; Mr. Market declined 0.84%. The fund has returned 196% since its 1998 creation, compared with Mr. Market's 10.7% gain.

To his credit, Rosen is uncomfortable with the attention this performance has drawn. He lives in fear of Mr. Market and stresses that his returns do indeed fluctuate. After some cajoling, he agreed to discuss how he trades.

Rosen sells volatility. He sells richly priced index options and hedges them with cheaper options. He is disciplined and does not guess market movements, focusing only on actual trading and hedging volumes. He looks at implied and realized (also called historical) volatility. Discrepancies are found between options expiring in one month or three, and at-the-money or out-of-the-money. Everything is hedged to neutralize stock-market swings.

Since 2003, he has focused on Standard & Poor's 500 index options. Consider July's trades. At the month's beginning, Fannie Mae's and Freddie Mac's stocks were eviscerated by the financial crisis. The Bank Index (BKX) fell to its lowest level since 1996. Citigroup, AIG and Merrill Lynch shares plummeted.

Options premiums surged to their highest level since Bear Stearns's collapse. Investors bought hordes of puts to protect stocks, and Rosen sold options. Realized volatility increased to about 18% to 20%, while implied volatility, as measured by the Chicago Board Options Exchange's Market Volatility Index -- the VIX -- surged to about 30%.

"Options traders were paying a 50% premium over fair value, which is an unusually high differential," Rosen says. "On average, implied volatility trades at a 25%-30% premium to realized volatility."

At July's end, the VIX closed down 4.22%. In August, Rosen cut his positions and changed his approach as volatility contracted. He is trading only options that expire within 20 days or less to monetize rapid time decay, the phenomenon by which options lose some value each day as expiration approaches. He is waiting for better trading conditions.

"It is really important not to trade all the time," says Rosen. "When there are opportunities, they are there; and when they are not, they are not." The faltering commodity boom and the U.S. presidential election could cause large swings in stocks and options prices. He is patient: "You can't be afraid to build large cash positions. Opportunities will always come. Don't try to predict. Just take things as they are."

August 26, 2008

Japanese banks have capital again – and they are spending it.

Of all the major stock markets in the world, one would think that Japan's would be the most likely candidate for a decent bull market going forward. It is still far below its peak set in 1989, which makes the U.S. bear market (in real terms) of 1966-82 look like a catnap vs. the Japan bear's hibernation. Not withstanding this extended underperformance, Byron Wien "just does not see" the Japanese market doing that well from here (see below).

There are sound analytic reasons for the Japanese stock market's extended underperformance. For starters, 1989 was the culmination of a Japanese bubble economy which led to simultaneous bubbles in stocks and real estate. The real estate valuations of the time make the U.S. property valuations of 2005-06 look tame. Some adjustments in the the country's real economy and asset valuations were inevitable. But rather than let nature take its course, Japan's central bank and politicians engaged in a slow-motion looting of the public's substantial savings in order to protect the guilty. Massive public works projects, including the country's own version of "bridges to nowhere," kept employment at politically acceptable levels. And a zero (or close) interest rate policy by the Bank of Japan enabled companies to slowly restructure by gradually writing off bad assets without the pressure of paying anything on their debt -- at the expense of savers (not to mention being a major contributor to a worldwide credit bubble).

Whatever the prospects of Japan's overall stock market, this article claims that the Japanese banks are an opportunity. Most of their bad loans have been written down. This leaves them with strong capital positions, which will enable them to take advantage of the weak positions most other banks around the world find themselves in. Looking at the low price-to-book ratios cited, a case can be made there is some non-negligible upside just from correcting the undervaluations. In the longer run, the well-managed Japanese banks could achieve growth rates that would lead to a run comparable to U.S. bank stocks during the 1990s (before things got out of hand and then blew up this decade).

This month, Mitsubishi UFJ Financial (ticker: MTU) bid for the 35% of UnionBanCal (UB) it does not own, valuing Union at $8.8 billion. Mizuho Financial (MFG) injected capital into Evercore Partners, after participating in a Merrill Lynch bailout last winter. Sumitomo Mitsui Financial (8316.TO) supplied capital to Barclays.

All are among the world's largest banks, but have suffered from a paucity of topline growth, owing to Japan's near-zero rates, sluggish lending, and retail aversion to Japanese stocks. Lengthy post-merger integrations sapped earnings. Regulators did their bit by curbing returns on consumer loans. And lately, bankruptcies are on the rise among smaller companies and real-estate firms. Thus, HSBC recently downgraded the megabanks, citing a shrinking topline with "devastating" effects on profits.

There is scope for Japanese banks to lag near term, but value is also building. Much depends on whether the Bank of Japan will normalize interest rates. It is postponed lifting rates because the economy took a turn for the worse.

Japan's banks -- after paying back government bailouts from the late 1990s -- are busy piling up capital, and higher-returning opportunities, either abroad or at home, will lift profits. Potential targets are certainly fetching cheaper prices. Meanwhile, Japan's banks are trading at massively cheap valuations, particularly as returns rise.

Consider Mitsubishi UFJ, or MUFG, as it is known. One of Japan's better banks, it missed earnings in the first quarter ended June, with a steep increase in credit costs related to subprime and asset-backed investments. It is still expecting full-year net profit of ¥640 billion, little changed from the previous year. Today, it trades at 15 times earnings, but 1.2 times book. Compare that with 1.4 times for troubled UBS. Mizuho trades at 1.9 times, SMFG at 1.8.

Says Camille Carlstrom, a Putnam Funds analyst who is expert in global financials: "This is one of the largest banks in the world, and it is trading on one times price-to-book, while earning returns in excess of its cost of capital in a tough operating environment."

Next year, earnings will improve as MUFG completes the merger that made it Japan's largest bank. Michael Peterson, director of research at Pzena Investment Management, reasons that the stock is worth much more than the ¥793 (roughly equal to $7.17) it fetched last week. Its return on equity was a low 6% in the fiscal first quarter, about half its sustainable return on equity (ROE). If ROE doubles, then it ought to trade at twice book -- or double the current price.

How about a share of Bank of Japan, which trades by appointment, for a little over $100,000?

Want another play on Japan? Look up ticker 8301.JP, which happens to belong to shares of the Bank of Japan. That is right. They are down 33% over the past 12 months, versus 22% for the benchmark Nikkei 225 index. They are thinly traded -- a round lot is 100 shares each worth ¥111,000 [apx. $100,362 -- a Berkshire Hathaway-like price per share], and only a few units trade daily.

They are nearly impossible to value. There are no shareholder meetings or voting rights. The Japanese government owns 55%, and you need its permission to own the shares. There is a measly ¥5 dividend, putting the yield at 0.38%. The central bank does not release earnings per share. Bloomberg bravely puts the market cap at ¥111 billion (about $1 billion).

The last analyst's report -- which may be urban legend -- was said to be written in the early 1990s. One well-connected Japanese broker scratches his head when Barron's contacts him. "When I was in retail sales, I might have sold a couple. But it was to wealthy individuals, who like to frame the certificates." Next year, Japan abolishes these anachronisms.

Masakazu Takeda, manager of Sparx Japan (SPXJX.Japan), claims: "The sole reason for their listing is to ensure the BoJ's independent status." Most of the central bank's balance sheet, he cautions, is in government bonds (JGBs), which it buys to inject liquidity into the system. As Japan's rates creep higher, "the balance sheet will deteriorate significantly."

Still, the BoJ does have other assets: Gold, carried at ¥441.2 billion but which is not marked to market, and foreign currency worth ¥5.2 trillion. When the yen goes down, the value of these investments rises sharply. And it can set rates by itself. Says Ed Merner of Atlantis Investment in Tokyo: "It's a leveraged play on the general trend of the market."

Ben Sontheimer, who runs hedge-fund Vault Partners, sees things this way: "With the return of inflation, domestic investors are likely to reallocate some portion of their considerable savings out of low-yield deposits or JGBs into equities. If you are a believer in a return to inflation in Japan, it is an elegant way to participate."

August 28, 2008

Elliott Wave International Senior Bonds Analyst Bill Fox wonders whether the U.S. Treasury will become the buyer of last resort of Fannie Mae and Freddie Mac's maturing debt, now that foreign buyers are finally losing interest. And it that happens, will Treasury debt start to because as questionable as all the crap it is willing to back?

In the summer of 1868, Mr. George Hull of Binghamton, New York, decided to pull off a hoax. No, not about Bigfoot -- but close. He had a gypsum block carved into the shape of a giant dead man and buried at a farm near Cardiff, New York. And then later, he had it dug up. Keep in mind this was a gypsum statue. Nevertheless, thousands of people flocked to pay and see "Mr. Hull's giant."

Soon thereafter, a syndicate paid $30,000 (in 1868 dollars) [on the order of a 750 thousand of today's dollars] for a majority interest in the giant. A member of the syndicate, a banker named David Hannum, raised the admission price. Not long after that, a renowned sideshow promoter and politician P.T. Barnum offered $50,000 dollars for the giant.

It was later said by Mr. Hannum (talking about P.T. Barnum, but it is a quote often incorrectly attributed to P.T. Barnum himself) that, "There's a sucker born every minute."

Here we are, 140 years later. We have just uncovered a giant leveraged debt mess, but there are still suckers out there willing to buy this paper. As we move into the later innings of this credit crunch, one of its untold stories is the recapitalization that has taken place in the financial industry -- despite the writedowns that have persisted at record levels for two full quarters.

Without the sale of assets, equity dilution, vulture capital, hostile takeovers and bailouts this leverage bubble implosion would have been at least a recessionary event -- or a far worse one. Some of these deals have been astute transactions, others ... have not. Either way, though, the pool of available suckers appears to be shrinking.

Market values of both Fannie Mae and Freddie Mac have declined dramatically -- to $6 billion and $2 billion, respectively. Both are paying penalty spreads over Treasuries to sell debt while demand is rapidly in decline. The question is, how high will yields have to go to generate demand?

Each of these two GSEs have more than $100 billion in debt maturing before October, and foreign buyers -- typically a reliable well of demand -- have been scarce of late. That leaves us with the buyer of last resort: the U.S. Treasury, which may have to buy more than $30 billion of GSE preferred shares just to get us through Q4.

The forthcoming supply of Treasury bonds could weigh more than Mr. Hull's giant -- and be worth less.

August 27, 2008

We have never been fond of high-yield, aka "junk", bonds -- at least those bonds that were created as junk at birth. (Those that fall from investment grade into junk status are a different story, and used to offer opportunities in the formerly obscure corner of the investment world called "distressed securities analysis" -- back when "distressed" was a less universally applicable adjective.) The constituents of a junk bond's return can be adequately constructed using standard debt and equity issues, with an occassional warrant thrown in, so why complicate things? As far as we can tell junk bonds exist to take advantage of tax and regulation arbitrage opportunities, e.g., the tax deductibility of interest. Or when savings and loans bought Michael Milken's creations using their newly-obtained freedom to buy anything that was nominally interest-bearing, with the option to put their purchases back to the taxpayers if things went wrong, in a last desperate attempt to stay alive.

The justification for buying junk bonds was that the higher yields more than compensated for their higher default rates. This is a fancy way of saying that what became a major asset class was inefficiently priced, apparently no matter how low the yields got. As long as the economy was expanding and -- maybe more importantly -- in another instance of Ponzi finance, as long as money was moving into the asset class, thus bailing out previous investors, the theory worked. (That was a microcosm for the whole post-1982 financial world.) Now the economy is going downhill and credit is contracting. Yet, junk yields are still low both absolutely and relatively, as this piece from Barron's delineates. It is a conundrum but, then again, it is not the only one out there.

Neither history nor logic has been a guide for junk-bond investors throughout the credit crisis. There is a natural assumption that when risk aversion in the financial system increases, the riskiest investments suffer the most. That simply has not proven true for junk bonds.

The higher-quality bonds in the market -- those rated double-B and B -- are trading nearly 300 basis points, or three percentage points, over their historical norms, according to Marty Fridson of Fridson Investment Advisors. The interminably risky triple-C bonds, in contrast, are trading right around their historical averages, even though risk aversion remains as high as ever.

Investors have a variety of theories as to why the lower-quality part of the market has not sold off as much as the higher-quality parts. For one, the triple-C part of the market comprises many companies that were taken over during the leveraged-buyout boom, in sectors like health care and utilities, that will not be as hurt by a traditional downturn as, say, as companies in the retail industry.

Another theory is that investors think the lower-quality issues offer safer yields. They are buying up the triple-C part of the market at a time when the rate of corporate bankruptcies has yet to rise to where the risks would outweigh the rewards of double-digit yields.

That is an eerily similar rationale to the one that was cited when much of this triple-C issuance came to the market before the credit crunch began. The low default rate -- below 1% in the bull market days -- created an environment where it was possible for a company with a triple-C credit rating to issue a large amount of debt to yield-starved investors. As a result, the triple-C part of the junk- bond market now accounts for a record 23% of the overall high-yield bond market, according to Moody's Investors Service.

To be rated in the triple-C bucket means generally that a company has about a 25% chance of defaulting on its debt within a given year. With this in mind, rating agencies expect an aggressive spike in bankruptcies in the coming year. Moody's measured the default rate at 3% in July and forecasts its reaching 7.2% a year from now.

Though the default rate is already rising, investors think it will take a major uptick in bankruptcies for the triple-C part of the market to price in additional risk.

It used to be that triple-Cs traded as much as, if not further outside of their historic averages than Bs and BBs, Fridson says. These days, triple-Cs are trading just 8% above their averages whereas Bs and BBs combined are trading 70% beyond historic norms.

Perhaps it is simply a case of no two credit meltdowns looking the same. But this disparity may be leaving the junk-bond market vulnerable to further deterioration if the credit crunch persists. The market is already down more than 3% year to date, according to Merrill Lynch's index.

"I do not think we are going to recoup much of the losses," says Christopher Munck, high-yield trader at B. Riley & Co. "Here we are in early August; if we go into the first few weeks of the third quarter and people feel a little bit better about housing and the financial sector, then maybe, maybe high-yield has a chance of getting back some of the losses, but I think there is too short of a time frame between now and December 31 for that to happen."

The consensus seems to be that either the high-yield bond market stagnates at this level, or even more struggling companies file for bankruptcy, dragging down the triple-Cs and ultimately, the overall market.

"We're still pretty early here in the credit cycle," says Mike Difley, portfolio manager at American Century Investments. "Clearly, defaults are picking up and it is going to make for a pretty tough high-yield market, at least in the near term. ... You can't just simply look at the ratings, you have got to do your research. At the end of the day, it is like stocks; bond selection is the key."

August 27, 2008

A writer attempts a Maria Gabelli-style "private market value" analysis of websites based on recent site transactions, and finds huge discrepancies between large and small website acquisition valuations. Such valuation descrepancies between large publicly held companies and smaller privately held ones have driven countless growth-by-acquisition strategies and stories over the years, many of which worked out quite well for those who got in early.

But the observational data here is too scattered to draw any quick conclusions about opportunities in the website business, in part, we suspect, because the business models are still evolving. The author does not have access to actual profitability numbers, so that hamstrings his analysis as well. But for those hoping to start up a website and blow in out at a YouTube-like revenue or user multiple in a couple of years: have an alternative exit strategy before you start.

We all read on TechCrunch about the huge Internet acquisitions that are seemingly made every week. YouTube sold for over a billion dollars, Bebo sold for $850 million, etc. While those big acquisitions get all the headlines, there is a very active market in buying and selling smaller websites that does not get nearly as much notice. For every YouTube that has tens of millions of users, there are hundreds of thousands of websites with smaller, but attractive audiences.

While looking into the market for buying and selling smaller websites (generally with price tags under $1 million) I have noticed that there is a huge discrepancy in valuation metrics that smart investors will take advantage of.

Revenue multiple

With some notable outliers (YouTube being one of them), larger, established websites generally have been valued at anywhere from 3X to 10X annual revenues. Take the recent acquisition of Pluck, for instance. Pluck's reported revenues were $10 million a year and the company was sold in March for $75 million -- 7.5X annual revenue.

Now let us compare this to revenue multiples found on Sitepoint, one of the largest, most active marketplaces for smaller websites. According to a recent Sitepoint analysis, sites sold on Sitepoint go from 10X to 24X monthly revenues, i.e., a revenue multiple of just 0.83X to 2X annual revenue. A typical recent sale was the celebrity gossip blog celebparasite.com which sold in July for $90,000 -- a multiple of only 8.6X monthly revenue (0.71X annual revenues), which was listed at $10,500.

Cost per user

The disparity in valuation metrics of large vs. small website acquisitions becomes even more glaring when you look at the cost (or sales price) per user. For sites without much revenue, price per user can often be a more accurate gauge of a site's value than revenue multiple. Let us first look at some large website examples:

eBay acquired StumbleUpon for $75 million last May. At the time, StumbleUpon had 1.4 million unique users per month, so the price per user was $53.57.

Discovery Networks acquired HowStuffWorks.com for $250 million last October. At the time, HowStuffWorks had 3.9 million unique users per month, so the price per user was $64.10.

If one looks at a number of larger acquisitions, the price per user ranges anywhere from $20 to over $200.

Smaller websites go for much, much less. An analysis I did of 27 recent sales on Sitepoint reveals that the average price per user was just $0.34 ... Of those 27 sales, only 2 sites were sold at a valuation of more than $1 per user. Going back to our CelebParasite example, that site was sold at a price per user of just $0.11.

Now one can certainly argue that the value of a HowStuffWorks user is worth more than a CelebParasite user, but are they really 58 times more valuable? Future posts will explore various ways of taking advantage of these valuation discrepancies.

August 28, 2008

This fund’s specialty: unearthing little-known companies.

The venerable Barron's financial newspaper, bless their souls, has a penchant for fundamental value analysts and fund managers. This article features a value mutual fund, the Keeley Small Cap Value Fund, whcih focuses on companies going through restructurings and spinoffs. Several studies in the 1990s found that spinoffs on average outperform the stock market for three years following their spinout (see, e.g., here and here). We are not sure what an updated study would show, but there are several institutional factors which might cause the phenomenon to persist.

In any case, the Keeley fund has outperformed the S&P 500 by 12 percentage points annually over the last five years while outperforming 99% of its peers. These guys know their stuff. Success has bred the typical influx of assets, so whether they can keep that up warrants careful analysis before taking the plunge oneself.

"What makes us different is where we look." That is the way John Keeley Jr. explains his firm's distinctive approach to stock-picking, and its excellent returns. The 15-year-old Keeley Small Cap Value Fund (ticker: KSCVX) searches for little-known companies going through restructurings or spinoffs, trading at significant discounts and not included in popular indexes.

Such stocks, many of them operating in unusual circumstances, are likely to be under-followed by Wall Street. And spinoffs in particular frequently end up getting acquired.

One recent example: Keeley Small Cap Value's largest holding, metallurgical coal maker Alpha Natural Resources (ANR), spun out of Pittston Coal in 2002, is being taken over for $10 billion by Cleveland-Cliffs (CLF). The shares are up 206% this year.

Keeley's methods clearly have merit. Small Cap Value returned 4.95% for the 12 months ending August 6, beating the Standard & Poor's 500 by 15.26 percentage points. Over three years, the fund has averaged 11.8% a year, trampling the benchmark by 8.1 percentage points. Its 5-year numbers are even better: The fund has typically posted a 20.0% annual gain, 12.1 percentage points ahead of the S&P 500. The Small Cap Value Fund beat 98% of its peers in the 1-year and 3-year periods ending August 6, and 99% of them over the 5-year period.

"With more than $7 billion under management, it is not a one-man band anymore," says Keeley, 68, who got his B.A. at Notre Dame and his M.B.A. at the University of Chicago. He created Keeley Asset Management in 1982 with the aim of managing money for high-net-worth individuals and institutions. As recently as 2000, it had just $340 million. Today, it handles $11 billion.

Keeley's sons, Mark, 45, and John, 47, went to work for him in 2002, and Kevin, 41, came on board in 2005. They have since been joined by several senior managers and analysts. Dick Kindig, 72, an energy researcher, came out of retirement three years ago ("I was getting under my wife's feet") and reports to research head Robert Becker, 66. Mark Zahorik, 46, covers financials and David Woodyatt, 65, focuses on health care. Brian Leonard, 29, tracks utilities, while John Keeley Jr.'s nephew Brian, 38, works on transportation and industrial stocks, which are now among the fund's chief holdings.

Small Cap Value, which carries a stiff 4.5% front-end load and an expense ratio of 1.33%, holds a total of about 180 stocks. It is low on technology, media and telecom offerings, and stays away from big, concentrated bets. Since it does not automatically boot out any stock based on a market capitalization threshold, the average market valuation has grown to $2.5 billion, which is on the high end for the small-cap blend category. Turnover is a modest 18%, since the fund keeps most stocks four to five years.

Right now, the ailing U.S. economy may provide some interesting bankruptcy plays, according to Keeley's analysts and portfolio managers. "Bankruptcies are great, because a company has to tell the judge what it is going to do over the next five years -- and it is impossible to get that information any other way," says researcher Becker. Financials hold the most promise, but right now too many have such opaque balance sheets that they do not make Keeley's cut.

"We are not looking to go into controversial situations," Keeley says. "In the example of bankruptcy, we wait until it is all adjudicated, so that we can see what we actually get."

The goal is to cut as much risk as possible by keeping a sharp eye on metrics, such as return on equity and sales per share. The firm does not keep hard and fast benchmarks for these figures because they can be so variable in the midst of a spinoff or restructuring. However, academic studies support the idea that spinoffs tend to outperform, and once the entities are off on their own, they are more transparent to outside analysts and portfolio managers.

One area of recent interest to Keeley and his team is savings-and-loan and insurance conversions, since they allow the Small Cap Value Fund to buy a new stock without an underwriter. They bought Home Federal Bancorp (HOME), a Nampa, Idaho-based former mutual savings-and-loan that just completed a conversion in December 2007 at $10.

"The proceeds of the conversion give Home an equity-to-assets ratio over 27%, among the highest in the country," according to Zahorik, who does not rule out that the company will be acquired at two times book value, or 23.50 per share, after three years. It recently was at 10.80.

"While many community banks and thrifts are thinly capitalized, Home is heavily overcapitalized, yet still trades at just 87% of tangible book," Zahorik says. "In late December, Home will be permitted to deploy capital in the form of stock buybacks. Given the high level of excess capital, these buybacks could be substantial." Earnings estimates are 24 cents a share for this fiscal year, and 26 cents a share in 2009.

One would think you could value Home Federal by looking at the size of a special dividend they could declare and still remain well capitized afterwards, and then try to value their deposit gathering franchise (we doubt they have any special loan generating competitive advantage). That will no doubt generate a value estimate greater than the current price, but we doubt it would be twice current book value.

In April, Keeley picked up Batesville, Indiana-based Hill-Rom Holdings (HRC), formerly Hillenbrand Industries, in the mid-20s following a spinoff and renaming. Hill-Rom manufactures and provides technologies and related services for the health-care industry, including patient-support systems like multipurpose beds that can also be used as chairs and as transportation. Earnings estimates are $1.25 a share for this fiscal year and $1.47 for the next.

Some spinoffs that undergo additional restructuring are also are of interest to Keeley. The firm bought Louisville, Kentucky-based PharMerica (PMC), which was created in 2007 from the merger of two leading institutional pharmacy businesses -- PharMerica Long-Term Care and Kindred Pharmacy Services. PharMerica Long-Term was spun out from AmerisourceBergen (ABC), a drug wholesaler. It then was merged with Kindred. The new company operates 115 institutional pharmacies that service 340,000 beds. "So in addition to the benefits of a spinoff and restructuring, you have a demographic play as the population ages," says health care specialist Woodyatt. Small Cap Value bought it in April at around 15. It has since risen to about 24. The Street estimates earnings of 78 cents a share this fiscal year and $1.04 next year.

Most of the fund's largest holdings are in energy, which Kindig helped identify as undervalued three years ago relative to the price of oil and natural gas.

The firm acquired shares of Houston-based Petrohawk Energy (HK), an independent oil and natural-gas company, via Petrohawk's merger with KCS Energy, a Keeley holding. The new company found significant natural gas in the Haynesville Shale along the U.S. Gulf Coast, which may hold twice the reserves of the entire country.

"This is an example of higher energy prices and new technology producing a significant supply response," Kindig says, adding that the potential is so huge that nobody has a good estimate on what will come onstream in the next five years.

Keeley bought KCS at about 12 in 2003 and continued to add to the position after the merger. Petrohawk, which has been under significant selling pressure in the past three weeks as the price of natural gas has fallen along with the price of oil, was recently near 31. Kindig puts earnings at $1.28 a share this year and at $2.15 in 2009, which is considerably higher than the Street's estimates.

One favorite is Tampa, Florida-based Walter Industries (WLT), which has a booming coal business. It is also an on-the-lot home builder, which used to finance buyers and has a low loan-delinquency rate. Keeley was buying Walter at 21 in 2007, and the shares recently traded above 90. Earnings estimates are $5.58 a share for this fiscal year, jumping to $15.44 for next year because of high metallurgical-coal prices and the prospect of a new mine opening.

After more than a quarter-century tracking down these sorts of stocks, Keeley says he will close up shop when the team cannot find new things to do. But with all the restructuring about to occur in the U.S. and elsewhere, that does not seem likely any time soon.

The top 10 holding of the fund are listed here.

August 28, 2008

This is the first bear market I have failed to call, says Ken Fisher.

Forbes columnist and relentless optimist Ken Fisher admits he was wrong to be optimistic all along while the market fell 20%+, while professing puzzlement at how different this one has been from the others of the last 36 years. Usually bad news comes out, gets discounted, and capital markets move on to the next bad news, or, run out of bad news at the end of a bear market. In this one the same old stuff about credit problems keeps getting rehashed.

It may be that Fisher has never seen a real end-of-a-genereral-credit-bubble bear market, a la 1929-1932, before. As Bryon Wien says below, we did not get into this mess in the usual way, so the old rules may not apply. In any case he thinks it is too late to get out now, and recommends investing in large multinationals.

The stock market's drop since last November is enough to qualify it as a bear market. I am not sure there is a meaningful distinction between being down 19% and being down 22%, but 20% is the normal definitional cutoff, and the big indexes have pretty much all pierced 20%. Wrongly, I have been upbeat throughout.

There have been three other bear markets since I started this column 24 years ago: 1987, 1990 and 2000. This is the first time I have not anticipated the fall. I hate that. I let you down.

I also admit confusion. In my 36 years as a professional investor I have not seen a period like this. Investors are afraid, journalists are morose, and the same old stories keep replaying endlessly. That is not normal. In the world I have known most of my life, old stories quickly lose their power over capital markets and get replaced by new surprises. That which everyone fixates on gets priced into the stock market quickly and cannot drag on. But here, 19 months after we first started hearing about subprime mortgages, housing woes and weak financials, the stories moving stocks are little changed.

Normally the market peaks before bad news emerges. That is what happened in 1929, and that is what happened in 2000. In the latter crash global stocks had fallen by 16% over nine months before the Federal Reserve's first interest rate cut. This time multiple cuts of the discount rate and the bad news about the housing sector came before November's market peak.

The fact is, the global economy is not so bad. We have very low growth, with deep pockets of weakness, but last year's consensus held that the pockets would ripple out everywhere, and they really have not. Slow, erratic growth continues. The U.S.'s first-quarter GDP was up 0.9% at an annualized rate, despite expectations that it would be down. The experts said the number would later be revised down, but it was revised up. They said the second quarter would show a decline in economic activity, but now it is showing an increase of 1.9%. This is the recessionless bear market.

To me it still seems more like a long, big correction than a bear market. But technically I am wrong. Either way, what do you do now? Well, if you have not gotten out yet, it is a bit late. Of the 10 bear markets since World War II, six went down less than 30%. Another, in 1987, lasted just a few months. Now is nothing like 1968-70, 1973-74 or 2000-02, which were entangled with broad global recessions.

I would bet we are most of the way through to the end of this bear market. And after bear markets end, the initial upswings come fast and steep. It would be risky to get out now and end up being whipsawed -- that is, exposed to most of the decline but absent for most of the recovery. Now is the time for patience.

The shares of big, market-leading companies should be materially higher 12 to 24 months from now. There is too much pessimism and gloom for those shares not to pay off. Here are five stocks to consider.

Anglo American (27, AAUK), an international mining giant run by the able Cynthia Carroll (profiled in Forbes), has 40% of the world's platinum market. It also produces iron ore, nonferrous base metals like nickel and zinc, industrial minerals like lime and also coal and diamonds. Unless there is a rollicking recession, the company will earn more than $2.60 a share this year, and the stock, at 10 times that sum, is a buy. It is rare to find such quality trading so cheaply.

Hewlett-Packard (44, HPQ) has great management, great product lines and great market share (19% of the world's volume in desktop computers, for example). You can buy it at 11 times this year's earnings and 1.1 times annual revenues.

Notwithstanding oil's pullback from $140 a barrel to $120, I believe the long-term trend in energy prices is up. Italy's giant Eni (65, E), is well positioned with massive reserves (the equivalent of $385 worth per share) and broad diversification within the energy field. At less than eight times 2008 earnings and with a 6% dividend yield, this stock allows investors to be patient.

The agricultural world continues on a tear, and among smaller companies, CF Industries (144, CF) looks appealing at six times 2008 earnings. It provides nitrogen and phosphorus fertilizers to midwestern corn growers. The recent decline in the price of corn (from $7.61 to $5.25 a bushel) does not take away CF's growth prospects.

The Dutch firm CNH Global (34, CNH) makes farm equipment like tractors, balers and combines, as well as light-construction equipment like forklifts, backhoes and mini excavators. In the latter category, strength overseas is more than making up for U.S. housing weakness. CNH's brands include Case, New Holland, Kobelco and Steyr. It sells at 50% of annual revenue and nine times my estimate of 2008 earnings, which will be up. Its market capitalization is $8.3 billion.

August 28, 2008

Value mutual fund manager and Forbes columnist John Rogers, like Ken Fisher above, also finds the current market to be exceptionally difficult. He finds some solace in the words and life of the recently deceased John Templeton, who counseled to buy when pessimism is at a maximum. Following that advice, he finds some high quality stocks selling at enough of a discount to attract his buy interest.

If the stock market and the economy in general do not have you on edge this year, either you have an iron stomach or you have not been paying attention. It is one of the toughest years I have seen in a quarter-century of investing. At such a time I am compelled to swim in the pool of value investing knowledge. I talk to other experienced contrarians, and I head to the bookshelf to revisit the writings of the giants of value investing.

One of them just died. Sir John Templeton launched his 70-year career at the beginning of World War II with $10,000 in borrowed money, which he audaciously invested in every stock trading for $1 or less on the New York Stock Exchange. This contrary move generated quick profits, and out of 104 companies, only 4 became worthless. It is a wonderful reminder of the difficulties and eventual rewards of diverging from the crowd.

Templeton's message is more important than ever in this market, because there has been such a push to conform. The market has appeared to be a one-trick pony named Commodities. If you did not pick that horse, you finished out of the money. Normally when a bull market ends and a bear market starts, market leadership reverses course quickly, but that clearly did not happen this time -- at least until the last week or two. Commodity issues, especially energy-related ones, have beaten the odds in recent years, for all their volatility and unpredictability. Before the market came undone last November, shares of commodity producers had quadrupled in five years. Six months into this bear market those same high-octane issues were up another 12%, while the overall market was down 20%.

Sir John taught that it is crucial to maintain a contrarian discipline in tough investing environments. He warned against submission, saying, "It is extremely difficult to go against the crowd -- to buy when everyone is selling or has sold, to buy when things look darkest, to buy when so many experts are telling you that stocks in general, or in this particular industry, or even in this particular company, are risky right now." After World War II, when Japan, still hobbled, represented only 4% of the world's economy, he had more than 60% of his Templeton Growth Fund in Japanese stocks. His rationale was clear and successful, and it still holds: "The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell."

I frankly do not know whether this bear market has hit bottom, but I do know that pessimism is at an extreme. So I have been taking that advice and buying where the fear has been greatest.

With people defaulting on mortgages, falling behind on home equity loans and skipping credit card payments, the market has been punishing bank shares with little regard for quality. So I am adding to an existing position in PrivateBancorp (29, PVBT). The market sees it as a bank chain based in Chicago, but really it is a private wealth manager. That is, it seeks wealthy households with more than $1 million in net worth and $150,000 in annual income. Private Bank's clients are not people about to default on subprime or adjustable-rate mortgages, and their deposits at the bank are growing, not shrinking. By my measure, the company is worth 79% more than its share price suggests.

With the streets and casinos of Las Vegas a lot less crowded lately, gaming stocks were down 40% in the first half of 2008. I have gone looking through the wreckage and found an old favorite, International Game Technology (22, IGT), which I have owned twice before. It is the largest maker and operator of computerized gaming machines, starting but not ending with slot machines. The presumption is that in the short term gamers will be putting less money into the slots. I am focused on the long-term reality that casinos have to replace their games regularly, both because they wear out and for the draw of new products. Whereas the market thinks the company is worth $22 a share, I think it is worth $35.

The wave of fear is hitting even traditionally defensive health care. Investors are worried about everything from managed-care contract renegotiations to hard-pressed Americans forgoing doctor visits. So look at Laboratory Corp. of America (70, LH). It is the nation's second-largest clinical lab company. Management runs it conservatively, maintaining a solid balance sheet while using a healthy free cash flow (net income plus depreciation, less capital expenditures) to make share repurchases when the stock is cheap. Here is what the market is missing: Blood and other tests are becoming more common, and outside lab companies are growing as hospital labs shrink. I believe LabCorp is trading at a 38% discount to its intrinsic value.

August 29, 2008

As mature economies, the United States and Europe are unlikely to grow in excess of 3% in the next five years.

Former Morgan Stanley U.S. chief investment strategist Byron Wien started his own hedge fund in 2005. A renouned "big-picture" guy, he duly notes that the credit bubble and globalization make things different this time, and not in a good way for the U.S. and other mature economies, but his expectations for the bear market's resolution are not cataclysmic.

This interview from Barron's touches on just about every major issue and market: the bear market, stocks, bonds, commodities, inflation, recession, overseas markets, the financial sector, Japan, Brazil, China, India, you name it.

Byron R. Wien, chief investment strategist at Pequot Capital Management, a Westport, Connecticut, hedge-fund outfit with $5.5 billion under management, is a big-picture guy. He travels frequently and widely -- most recently to Brazil -- to gain first-hand insights into global markets. A lucid writer, Wien has a knack for distilling a lot of information into concise monthly notes to clients. He started his Wall Street career in 1965 as a securities analyst, then worked as a portfolio manager before becoming U.S. chief investment strategist at Morgan Stanley. He joined Pequot in late 2005. To probe his latest thoughts, Barron's recently spoke with him in his midtown Manhattan office.

Barron's: What has been the biggest surprise for you about the market and the economy so far this year?

Wien: How far things went both up and down. Commodity prices went much higher than I thought they would. I thought oil would go to $115 a barrel, for example.

I was a bull on oil. And I thought it would go down at the beginning of the year, which it did. Then I thought it would go up -- but to $115 -- and it went to nearly $150. All other commodities went to extremes, including corn. I was bullish on agricultural commodities, but their prices went up much further than I thought they would. I certainly did not expect that Bear Stearns would fail. So the problems in finance turned out to be more severe than I had originally expected.

The underperformance of large-cap stocks has been a surprise.

Anything else?

At the beginning of the year, every strategist thought large-capitalization stocks would outperform small-caps. That has not happened. We probably should have known it was not going to happen, just because everybody thought it would. The fundamental reason behind that prediction was that large-cap stocks had a higher percentage of foreign earnings. That turned out to be right, but large-capitalization companies just have a tough time being flexible.

Would you not think that in this kind of market, investors would seek more dependable earnings growth?

Investors look for companies that do something new that is going to have a big impact. A big company does something new, and it just makes up for something that is going bad somewhere else.

Globalization has changed the nature of investing.

How do you compare this market with others you have seen in your career?

This market is different because globalization has changed the nature of investing. When I started as a securities analyst, I was focused on U.S. equities alone, and I did not know much about what was going on around the world, and I could do my job very well; today, you cannot.

In 1965, the United States was the unquestioned economic, political and military leader of the world, a position it achieved in 1945 and maintained until 1980. But in 1980, Japan started to become a factor and Europe was back on its feet. I do not think, I or most other American investors, globalized enough. And then in 1990, after Communism failed and China became a factor and India entered the world economy, we did not understand fully enough that these were not only potential customers of the United States -- but very real competitors.

The U.S. and Europe (and Japan) are going to have a tough time growing going forward.

As a global strategist, you spend a lot of time visiting other countries. What has caught your eye lately?

The biggest new thought I have related to my travels is that the U.S. and Europe are going to have a tough time showing real GDP growth in excess of 3% in the next five years, maybe the next 10. That means that the market, which did so well from 1982 to 1999, may be slow in coming back.

In January, you wrote, "I worry that the problems in housing and credit are more significant and longer-lasting than the usual market-adjusting events." What raised those concerns?

An idea was evolving: that we did not get into this mess in the usual way.

Usually when we are in a recession, the Fed eases and then we come out of the recession. Business gets good. Inflation picks up. The Fed tightens. And then we go back into recession. But this was not anything like that. Interest rates were not high. Inflation was not a problem. We got into this because of an excess of credit, both in the financial system and in housing. There was too much leverage in the financial system, and housing had gotten out of control.

Leverage and salaries in the financial services industry are going to be wound down.

Is there a sign of a bottom in financials?

The leverage in the financial-service industry is going to be wound down a lot, and I do not think the return on equity for these companies is going to be as great as it has been in the past. So the earnings for these companies in the next up-cycle are not going to be as good. Maybe the financials have gone down as far as they are going to go down, but I do not think they are going up with any verve.

And it sounds as if you see the business model changing for these firms, and becoming less profitable in the post-credit-crunch world.

When I came into this business in the mid-1960s, what a doctor made or what I made as a securities analyst or what a lawyer made working at a big firm was all the same. Five years out, our compensation had increased -- pretty much in parallel.

But in the period from 1982 to 1999, the compensation in financial services expanded much more rapidly than it did in any other field. I do not know that a securities analyst is a whole lot smarter than a lawyer at a major law firm, and I do not see why securities analysts or investment bankers should be paid so much more. So I think there is going to be a convergence of compensation.

He is no longer as worried about inflation, but more there is more to this recession.

One of the topics you have written about in your notes to clients is the possibility that stagflation, which combines inflation and stagnant growth, will rear its head again as it did in the mid-1970s. What is your assessment of that possibility?

I am probably not as worried about it as I was in the beginning of the year. In other words, I understood the "stag" part of it better than I did the "flation" part of it. So I was more worried about inflation at the beginning of the year than I am now. I am buying into the idea that maybe the slowdown around the world is going to take pressure off inflation. But I am concerned that growth is going to be harder to come by.

What is your take on the U.S. recession?

We are in a recession, but there are two parts of it that you have not seen yet.

The first part is an increase in unemployment, and the second is a collapse in consumer credit.

You have seen it in housing, which is a form of consumer credit, and in finance. But we are in a recession, and we are not going to come out of it until sometime next year at the earliest. The market will discount that by six to nine months. I have said that the market low on July 15 was a very significant low. I am not saying it will not be tested, but I do not think it will be severely penetrated.

Oil and commodities went up too far, but prices will continue to rise. Commodities have always been volatile, and that is not going to change.

Let's go through some of the key market and economic indicators, starting with oil.

Oil got ahead of itself. It has now stabilized. I do not think it is going back to $50 a barrel. I think it will stay in the $100 to $115 range, but, tax bill for that longer-term, oil prices are headed higher because China and India are consuming.

What do higher oil prices bode for the U.S. economy?

Europe has been operating and growing with much higher energy prices. Gasoline is much more expensive in Europe than it is in the United States. I am not saying it is not a problem. I just do not think it is a problem that is going to force us into a deep depression.

What about other commodities?

The standard of living is rising around the world, and other commodities are going to be rising in price. There is going to be a good corn crop this year, so maybe corn will not go up as much, yet China and India are increasing their standard of living, and their demand for agricultural commodities is going to be intense. When a country starts to do better economically, they eat more protein -- and that means more demand for chicken, meat and corn to feed them, so there is going to be upward pressure on commodities. Even so, commodities have always been extremely volatile, and I do not expect that to change.

The U.S. stock market will end the year higher than it is today, although maybe not a lot higher.

What do you see the S&P 500 -- down 14% this year -- doing for the rest of 2008?

I expect the market will end the year higher than it is today, though maybe not a lot higher. I thought S&P 500 earnings would be down this year. Almost nobody thought that would happen. There were two things that every strategist thought. One was that the S&P would move up and the other was that large-cap stocks would outperform small-cap stocks. Both of those turned out to be wrong.

Earnings have already been very disappointing, and they will continue to be disappointing. On the other hand, the disappointment has primarily been in consumer discretionary and in financials, while the rest of the economy is doing better, especially exporters, where performance has been impressive.

Some take the view that many of the non-financial sectors are doing very well, thereby offering some hope for the overall economy and market. But it does not sound like you buy that.

Finance is important, and whenever a category in the Standard & Poor's 500 gets to be more than 20%, you should probably pay attention, because a reversal is probably in store. That certainly was true of oil in 1980, and it was true of the financials two years ago. So financials are going to shrink as an important part of the S&P 500, and the question is, "What is going to expand?" Two areas that have potential to expand are technology and health care.

Treasury bonds are in a trading range. De-emphasize fixed-income securities and long-only strategies, emphasize alternative investments. The housing price decline is not over. There are opportunities out there, domestically and internationally.

What is your outlook for Treasuries and the rest of the bond market? Late last week, the 10-year was yielding around 3.80%.

Treasuries are in a trading range. There are going to be more defaults, however, and the yield on high-yield bonds is going to go higher. As for the housing market, the inventory of unsold homes is still very high. Prices are still declining. I do not think it is over yet, and we have further pain to go. We are definitely more than halfway through. The question is, "Are we three-quarters of the way through?"

Where do you see opportunities?

There is opportunity in pharmaceuticals, selected biotech companies, oil-and-gas exploration, including natural gas, and in Brazil. I am also positive on coal and agriculture.

Any names?

I cannot mention specific stocks. Once I do, our managers are restricted [in their trading], and in this kind of market, they do not want to be restricted.

So I would recommend the Pharmaceutical HOLDRS Trust [ticker: PPH], an exchange-traded fund. Everybody is concerned about the drugs coming off patent for the big pharmaceutical companies, and a few of them have new products coming on. It is an area that has done so poorly for so long that opportunities have developed. And it is true in certain biotech stocks.

Another ETF I like is the iShares Dow Jones U.S. Technology [IYW], which includes a lot of technology companies such as Microsoft. I am particularly bullish on natural gas, which we are going to use more extensively, and the price has come down. In looking for natural gas, oil and oil-service companies are going to continue to show very good earnings improvement in a difficult earnings environment. I feel that coal stocks will represent good value. If you can clean coal up, you can use more of it, so I am optimistic that the price of coal is going to stay firm, and the companies there are attractive.

You are positive on Brazil but not Japan. Why is that?

I am worried that Japan is in the mature-economy area along with the U.S. and Europe. So I would love to love Japan, because it is the one market that has not performed. I just do not see it, and I still see the economy there struggling.

What about China and India?

I am positive on them. I was negative on them at the beginning of the year, but they have corrected and they are now becoming attractive.

Do you see opportunities in fixed income?

I am not particularly bullish on the bond market. I am on a number of investment committees, and I have de-emphasized fixed-income securities and emphasized alternative investments, because in the slow-growth environment for Europe and the United States, it is going to be a difficult way to make money. From these levels, I think equities will outperform bonds, and alternative investments, such as hedge funds, will outperform traditional long-only investments.

The problems in the financial system could be deeper than he thinks. A convulsive shakeout is a worry.

What do you see for the rest of this year and into 2009?

One of the things I am worried about is that the problems in the financial system are deeper than I think they are, and that the recession turns out to be worse than I expected and the recovery turns out to be disappointing. In other words, the excesses that the United States built up were enormous. I tend to be an optimist, so maybe I assume they could be unwound more gradually than they can be, and maybe there will be a more precipitous decline -- a sort of convulsion is necessary. That is one worry.

The other stems from the notional value of derivatives, which is enormous, and it is a threat to the system. It was considered a threat to the system as far back as the crash of 1987, and nothing bad has happened. But the fact that nothing bad has happened does not mean that something bad will not happen.

Thanks, Byron.

August 30, 2008

Bill Bonner explains why things are likely to go as they have been going for a while yet.

After the biggest spending and borrowing binge in history, Americans need time and money. They need to pay their debts. They need to build savings for their retirements. They need time and money to recover from their mistakes.

What kind of mistakes?

Well, down near the bottom of the ladder, people bought houses they could not really afford to own in places they could not afford to live. And cars they could not afford to run. Those mistakes need to be undone. Which is why there are so many foreclosed houses on the market ... and why house prices generally are falling. ...

Further up on the ladder, the rich are now embarrassed by their own housing mistakes. New Yorker magazine reports that it is the "season of white elephants" in Greenwich, Connecticut. Speculators began huge mansions -- in the "Georgian Stockbroker" style, for example, complete with indoor swimming pools, wine cellars, movie theatres, dozens of bathrooms, even ice-skating rinks -- and now find the buyers have disappeared. Want to buy a $28 million spec house? Go to Greenwich.

At the investment level there were plenty of mistakes too. Subprime mortgage lending dominated the headlines for the last 12 months, but the same reckless spirit found its way into transactions all over the economy. Private equity, IPOs, student loans, shopping malls, fast-food joints -- while the going was good, everyone wanted to go along.

And now, they all need time and money to pay for their errors.

The baby boomers say they are postponing retirement. Some are going back to the office. A county in Alabama says it will have to declare bankruptcy. The FDIC says its "problem list" of banks lengthened by 30% during the second quarter. Bank earnings fell to their second lowest level in 19 years, says Bloomberg.

In London, tens of thousands of jobs have already been lost in the financial sector, says the Financial Times. IPOs, where the City (equivalent to Wall Street in New York) made much of its money, have "fallen off a cliff."

We have lived through the biggest credit expansion ever. Ahead is perhaps the biggest credit contraction ever. Why? Because it takes time and money to correct mistakes. The bigger the mistakes; the longer and more expensive the correction. Corrections can be tough on the economy -- and on the individual consumer. Most have no idea what lies ahead ...

When money and credit flow, they tend to raise prices. You get inflation -- first of asset prices ... later, of consumer prices. When money stops flowing, prices come down. As George Soros puts it, the willingness to lend is directly related to the value of the collateral. Both tend to rise and fall together.

Currently, lenders are wary and the value of the collateral is falling. Everyone knows house prices are going down. But U.S. stock prices are going down too. Adjusted for consumer price inflation, they have been going down since the end of 1999. That is, a $50 stock is still worth about $50 ... but the 50 bucks ain't what it used to be. It buys only 1/5th as much oil, for example.

This trend, towards lower asset prices, is likely to last a long time. To protect ourselves, we began buying gold in 2000. So far, so good.


High Prices Cut Demand for Metals

Mike Norman of HardAssetsInvestor.com interviews Miguel Perez-Santalla, vice president of sales for Heraeus Precious Metals Management. Perez-Santalla says that high prices, which he thinks they are "a little bit overvalued at the moment," have led to a decline in demand. For example: (1) Jewelry demand for gold fell off at $900/oz. (2) High platinum prices have led to stepped up efforts to find a substitute for automobile catalytic converters. (3) Investors of various sorts are either getting a little queasy after the substantial gains this decade, or are trading out in order to lock in performance gains.

Boeing an Excellent Contrarian Buy After Stock Drops 40%

If you do not mind owning a company that is a charter member of the U.S. Military-Industrial Complex, then Boeing is an interesting investment opportunity. It dominates the commercial aircraft industry, and an increasing proportion of its orderbook there is from overseas airlines which are in far better shape than their U.S. counterparts. Boeing's next-generation 787 "Dreamliner" has been hit with some delivery delays, but of course that has little effect on the company's true value -- Wall Street's typical overreaction notwithstanding.

The decline in shares of Boeing (BA) has been significant over the last year. The stock has fallen 40% from $107 to $64 as high oil prices force most domestic airlines into heavy losses. The market appears to be acting as though Boeing's only customers are domestic airlines. If that were the case, one could certainly argue near-term earnings growth would be non-existent and the stock deserves the severe haircut it has seen (BA trades at 12 times trailing earnings, 11 times 2008 estimates, and 9 times 2009 estimates).

Investors need to keep in mind that Boeing will get 50% of its revenue from its Integrated Defense Systems [IDS] division this year, with the rest coming from commercial aircraft. The growth in the aircraft segment is coming from overseas, not the United States. With global economies growing faster than ours, much of the 95% of the world population not living in the U.S. are beginning to either fly more or fly for the first time. ...

The company has also been hit due to delays in its new 787 Dreamliner, its next generation plane. Wall Street obsesses over short term events, so a delay of a few months will hit the stock, but in reality, long term investors should feel confident that Boeing has a new product cycle coming. New planes cost more than the old ones and the 787 improves fuel efficiency dramatically, which is a great feature with high oil prices. Even with some delays with a project this big, Boeing's earnings should still accelerate after the 787 starts being delivered.

“Buy, But Sell” – What Are Analysts Thinking?

An investor puzzles over some not unusual Wall Street advice to "sell in the short term/buy in the long term." As the writer points out, this amounts to timing advice ... which we know Wall Street is so very good at.

One has to wonder about stock analyst thinking when one reads releases like the one I have copied below. Please feel free to take the advice of Jeffrey Fan and "sell" shares of Canadian Telecom provider Telus (TU) for the short term, but make sure that you buy Telus shares because they are cheap if you are a long term investor. It would be very easy to interpret this advice to mean "sell the shares now, but buy again later when the stock is still at these low levels." In other words trade/time the stock.

What ever happened to sound, long term investing in quality companies? Easier said than done, I guess ... Hey, at least he predicted a CAGR of the dividend of 10% through 2011.

Few Homers, Lots of Hits

A worthwhile read is a Barron's article on Praveen Gottipalli, Director of Equity Investments at hedge fund company Symphony Asset Management. Gottipalli says of their approach: "We have balanced portfolios long and short. Investors invest with us because they do not want a return correlated with the market." Consistent with this, their funds have not achieved outstanding absolute average returns, but have produced decent gain over the last year where their benchmark fell almost 6% and the S&P 500 fell 11%. Some of his holdings, like Apple, are pricey by our tastes ... to each his own.

We liked Gottipalli's take on the potential of a comeback in financial services: "Someone will end up making a lot of money in financial services if they catch the bottom. But we think it's very difficult to call turns in sectors. The market-timing hall of fame is an empty room."

Yellow Pages publisher’s stock is on the rocks. Is the company?

The stock price of Yellow Pages publisher R.H. Donnelley (not to be confused with printer R.R. Donnelley) had fallen from 68 to around 2 over the the course of a year. Thanks to this article in Barron's the stock rebounded to near 4. The market's valuation of the company fell from $4.8 billion to under $150 million.

As one might have guessed before knowing any facts, the issue has something to do with debt. The company has about $10 billion worth. A little math shows that a 30+% decline in the the gross valuation of the company led to an over 90% decline in the value of its equity. When the value of equity gets this close to zero a certain option-like asymmetry in returns arises. The value of the equity cannot go below zero, but a small change in the gross valuation could lead to a return that is a multiple of your investment rather than a percentage. So is R.H. Donnelley (ticker: RHD) a good speculation at, say, $2 a share? Here is a synopsis of the buy case:

Investors long considered yellow-pages publishers stable, high-margin cash cows capable of carrying high debt loads. That perception has changed dramatically in the past year amid advertising declines and fears about whether Americans are forsaking print yellow-pages books for online searches. Reflecting investor concerns, some of R.H. Donnelley's debt trades for just 50 cents on the dollar, which works out to a yield of over 25%. That may make the bonds a safer play than the shares, which also hold promise.

R.H. Donnelley is far from dead. The company expects to generate $475 million to $525 million in free cash flow this year. It has no major debt maturities until 2010. Thus, investors probably get a two-year "look" at Donnelley's business before possible problems loom in 2010, when it will have $1.4 billion in maturing debt. ...

R.H. Donnelley is in a bind, with debt equal to a stiff seven times annual cash flow. Most companies try to keep this ratio below three. Its stock represents a bet that yellow pages will stay popular in the Cedar Rapids's of America, attracting more advertisers as well as users of the familiar fat books.

If that is the case, the stock could shoot up. And if it is not, it probably will take another two years, at least, before its debt load sinks the company. That probability alone could be worth more than $2 a share.

An intiguing "special situation," as these things used to be called.