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EU CALLS FOR SUMMIT TO END BRETTON WOODS
French President threatens tax havens.
The current turmoil is severe enough that the world's politicians are questioning the fundamental arrangements that have undergirded the world financial system since World War II, notably the Bretton Woods agreement which formally established the United States dollar as the one currency to rule over them all. There have even been some dark mutterings about reestablishing some kind of quasi-gold standard.
It is hard to see any of the high-muck-a-mucks letting go of their central banking ring of power voluntarily. Their financial puppet string pullers would not be amused.
The European Union is "Pushing to Overhaul the Post-World War II Financial System":
European Union leaders pressed for an overhaul of the global financial system to prevent a repeat of the credit crunch that sparked the biggest stock-market selloff since the Great Depression.
EU leaders called for a global summit as soon as next month to rewrite the 1944 Bretton Woods accord that paved the way for Europe's post-World War II reconstruction and set up the institutions that oversee the world economy today.
"We had the emerging market crisis, we had the Internet bubble, now we have this massive crisis," French President Nicolas Sarkozy told reporters after chairing the first session of an EU summit late yesterday in Brussels. Europe insists on the "re-foundation of the international financial system."
U.K. Prime Minister Gordon Brown, author of the British bank-bailout plan that was copied across Europe and in the U.S., called for an end-of-year deadline to place each of the world's top 30 banks under the supervision of a panel of regulators from the countries where it is active.
"We now have global financial markets, but what we do not have is anything other than national and regional regulation and supervision," Brown said.
Treatment of tax havens such as the Cayman Islands and Monaco may be overhauled as part of any new global financial framework, Sarkozy said.
"It will be part of discussions Saturday in Washington," the French leader said. "Will we continue to work with tax havens? It is a valid question. We have passed into a new era. It is a question we will put on the table and immediately."
"There needs to be a new Bretton Woods," Italian Prime Minister Silvio Berlusconi said. "The consensus is very strong and it keeps growing stronger."
The European initiative is likely to face headwinds from the U.S., which has used its dominance of international financial institutions to promote a brand of capitalism that has come into at least temporary disrepute.
"The U.S. got what it wanted in 1944 and, I suspect, will do so again simply because the Europeans will not be able to decide what they want," said Martin Weale, director of the National Institute of Economic and Social Research in London.
We all know that the major EU governments all hate the tax havens. First we had the Liechtenstein scandal this year. Now the current turmoil will undoubtedly give them another avenue of attack. Sarkozy's little statements are fair warning.
Bloomberg is reporting "Trichet Urges Return to 'Discipline' of Bretton Woods":
European Central Bank President Jean-Claude Trichet said officials reshaping the world's financial system should try to return to the "discipline" that governed markets in the decades after World War II.
"Perhaps what we need is to go back to the first Bretton Woods, to go back to discipline," Trichet said after giving a speech at the Economic Club of New York yesterday. "It is absolutely clear that financial markets need discipline: macroeconomic discipline, monetary discipline, market discipline."
At Bretton Woods, nations agreed to fix exchange rates, establish the International Monetary Fund and start the process of rebuilding Europe's economy in the aftermath of World War II by encouraging coordinated economic policies. Brown said national regulators must coordinate their work and banks should be pushed to disclose more trading positions.
"If we do not have discipline, then we are putting into question the functioning of the market economies and the functioning of our financial markets," Trichet said.
Gold’s Honest Discipline
I certainly agree with Trichet about the need for discipline. When Nixon tossed aside gold convertibility, all fiscal discipline went out the window. On my reading list on the left is a fine book by Vincent R. Locascio called The Monetary Elite Vs. Gold's Honest Discipline.
Locascio argues that it is not impossible in theory to devise an honest monetary system based on something other than gold, but in practice it is unlikely to happen. It is a good book that those in favor of a return to a gold standard would enjoy.
What I think needs to happen is 4-fold:
Numbers 2-4 are redundant actually because a sound currency system could not have the likes of a Fed micro-mismanaging things or the FDIC guaranteeing anything. And certainly no one would trust banks who made reckless or excessive loans in a free market system unhindered by FDIC.
- Formulate a basis for a sound system of currencies
- Eliminate central bank setting of interest rates
- Eliminate fractional reserve lending
- Eliminate FDIC
Instead the summit participants will likely bicker over regulation without agreeing to do anything until the current system blows sky high. That might not be too much longer at the current rate of progress.
ARMAGEDDON OR A BUMPY LANDING?
Not a disaster, but the end of a perilous high-altitude balloon ride.
Last week we posted an article which argued that the Dow Industrials at 8,500 represented a "return to normalcy." At around that price it was selling at its historical average multiple of normalized earnings. By contrast, for the whole 1996-2007 period the Dow sold at a prodigally high multiple which exceeded the P/E it sold for in any year from 1935 through 1995. The 1995 liftoff coincided, not merely by chance, with the Greenspan Fed's initiation of a super-easy monetary policy -- a policy which continued nonstop through last year.
Now the "high-altitude balloon ride" has come to an abrupt end. Martin Hutchinson explains why this is truly a Good Thing™. "The implications of stocks finally returning to some reasonable long-term value are highly positive," he says, "so much so that it may be difficult for this column to remain appropriately bearish."
There is one small obstacle: The "bad public policy that governments feel entitled to inflict on us whenever market crashes occur." ... "[W]e are left with the danger that the crash on Wall Street, caused largely by government's incompetent meddling with the nation's money supply, will result in still more Socialist restrictions on the free market together with gigantic subsidies to politically-connected crooks. Should this happen, the market decline will truly turn out to have been the first phase of Great Depression II."
How you view the stock market crash of the last week depends on your understanding of the last 13 years. If you thought the Dow Jones Industrial Average at 14,000 reflected real values, you doubtless think the crash is an appalling event, leading to a depression of 1930s dimensions. If like me you believed the progress of the Dow from 1995 on was part of an enormous and destabilizing monetary bubble, you are relieved and thankful that it is finally drifting back to terra firma, even if the landing is a bumpy one.
In the early part of 1995, the DJIA was trading just below 4,000. The U.S. economy was in its 4th year of recovery from the 1990-91 recession and inflation was low. A mild Fed tightening had raised bond yields more than 1% and bankrupted a number of foolish derivatives speculators including Orange County, California. On 23rd February, Fed Chairman Alan Greenspan appeared before Congress in his biannual Humphrey-Hawkins testimony and announced that he had finished raising short term rates; his next move would be towards easing.
What he did not tell Congress was that the policy of easier money would be in force for the next 13 years, during which time MZM (the St. Louis Fed's Money of Zero Maturity that can be used as a proxy for the more generally followed M3, discontinued by the Fed in 2006) would rise by 8.8% annually compared with a 5.1% annual rise in nominal Gross Domestic Product. Normally, a rapid and continued rise in money supply would result in inflation. In this case, it coincided with the effects of the internet in permitting cheaper international outsourcing, so resulted only in asset price inflation. The stock market took off in late February 1995 into the stratosphere, and has never looked back.
In the very long run, the price of stocks should move approximately in line with the rise in nominal GDP. If stock prices move far out of line with nominal GDP, the ratio of stock prices to GDP increases to a level at which the stock market is clearly overvalued, and eventually it corrects itself. In early 1995, the stock market was if anything rather high. It was 40% above the 1987 peak that had seemed at the time an unsustainable bubble and had led to a famous one-day crash. Thus, inflating February 1995's Dow Jones Industrial Index of just under 4,000 by the 95% increase in nominal GDP since 1995 gives a current "rather high" stock price guideline of Dow 7,800.
The stock market has never traded at its 1995 value, inflated by nominal GDP, from that day to this. It got down to 7,800 briefly in early 2003, but at that time the early-1995-inflated value was only around 6,000. Thus stock prices have been consistently overvalued for the past 13 years. The drop in the last few months has not been a sink into depression that would rival the 1930s disaster, but the end of a perilous high-altitude balloon ride, taking in several thunderstorms, that is now returning to earth. The collapse in stock prices last week suggests it will make a bumpy landing, but on the plus side, once the Dow gets down to 7,800 it will again be decent value.
Most important, the long-term value of real returns on holdings of U.S. common stocks will reassert itself. If you buy a broad portfolio of stocks at Dow 7,800 and hold it for a decade or more, it will on average return you around 8% or so in real terms. That comforting equation is definitely untrue for those deluded optimists who brought stocks at around the twin peaks of 2000 or 2007. They may well not see a positive real return on their money on a consistent basis until well into the 2020s or even the 2030s.
7,800 is a reasonable estimate for a "midpoint" of where stock prices should be. To see where a "low" might take us, we should perform the same exercise for the growth in nominal GDP since the Dow's low of 776 in mid-1982. Since that date, nominal GDP has risen by 340%, so an equivalent of the 1982 stock price low would be 3,421 on the Dow. That gives a very pessimistic outlook for the future Dow trend from a current level that is still well over twice that.
You can cheer yourself up by performing the same calculation on the 1932 Dow low of 41.22, which gives a potential bear market low of no less than Dow 10,032. You should however remember that the Dow's 30 stocks represented a far greater portion of the economy in the heavy-industry-oriented business world of 1932 than they do today. The New Deal itself was pretty destructive of stock market values. As late as 1949 the Dow at 167 was equivalent to only 8,924 today, below its 1932 low when adjusted for the intervening growth in the U.S. economy. Apart from reminding us that the 1982 low was well below that of 1932 in real terms, that should caution us against taking these calculations too seriously. Nevertheless it suggests that if the Dow gets down to 5,000 in this bear market, it should bounce well back up again thereafter, and not stay down at that unpleasant level. For holders of U.S. stocks, that should be reassuring.
The implications of stocks finally returning to some reasonable long-term value are highly positive, so much so that it may be difficult for this column to remain appropriately bearish. For investors, dividends will now be a substantial part of their return, so they will no longer be prepared to allow management to goose stock prices artificially by a combination of huge stock option grants and buybacks. For the economy, projects will get financed based on a true cost of equity capital, not on an artificially low equity cost. For those saving for retirement, returns will be both higher and more assured, reducing the risk of suddenly finding themselves on the point of retirement with a devastated portfolio and no way to replenish it.
For the United States as a trading economy, equity costs worldwide will increase, and it will no longer be possible to finance major investment projects in low wage economies on the basis of 20 or even 30 times earnings. Consequently, the true costs of outsourcing will be clear, including the additional cost of capital from investing abroad. The result will be more jobs remaining in the U.S., as lower U.S. capital costs offset higher U.S. wages.
There are however three problems. First, there is a legacy from the decade of overvaluation. Just as the housing bubble left many people worse off than they should have been, by trapping them in a house they could not afford bought at the top of the market, so the equity bubble has sucked many retirement savers into believing that they would have enough funds for retirement, when in fact their savings had been inadequate. In terms of public policy, this is particularly a problem for money purchase pension funds, which were around 97% funded in aggregate at the end of last year, and must now have a funding gap of 20% or more. This will result in more corporate bankruptcies throwing pension funds on the Pension Benefit Guaranty Corporation, and bankruptcy of the PBGC itself, requiring yet another bailout by the hard-pressed taxpayer.
Second, there is the damage done by the sharpness of the fall itself -- more than 20% in under two weeks. This is particularly a problem for market professionals, who will have believed themselves hedged using the "Value at Risk" system or one of the other discredited Wall Street hedging metrics. In reality, risk management as practiced on Wall Street is wholly incapable of dealing with such sharp movements, which occur not "once in a million years" but about every two decades or so. There will be further bankruptcies.
Finally, and most insidiously, there is the bad public policy that governments feel entitled to inflict on us whenever market crashes occur. The idea that no bank should be allowed to fail is pure moonshine (though by all means, small depositors, but not large ones should be protected). The idea that $700 billion should be diverted from productive use into propping up the price of detritus from the last bubble, at prices above those prevailing in the market if Ben Bernanke were to have his way, is utterly disgraceful. It demonstrates that neither President George W. Bush himself, nor Treasury Secretary Hank Paulson (who was conflicted owing to his Goldman ties and should have recused himself) nor Bernanke are fit to be left in charge of a free market economy.
Neither Presidential candidate has covered himself in glory during this crisis. Democrat Barack Obama has been as vague as possible, leaving cynics like myself worried that he really does intend to appoint ex-Weatherman William Ayres as Treasury Secretary, while Republican John McCain has expressed himself mainly by senile rantings against Wall Street, together with a proposal to pour yet more public money down the rathole of dead investments. Thus we are left with the danger that the crash on Wall Street, caused largely by government's incompetent meddling with the nation's money supply, will result in still more socialist restrictions on the free market together with gigantic subsidies to politically-connected crooks. Should this happen, the market decline will truly turn out to have been the first phase of Great Depression II.
Overall however one can remain optimistic that Obama, the likely winner in November, will turn out to be an intelligent and reasonably sensible moderate. Thus in a week when the whole world has turned bearish, not to say frightened out of its wits, it behooves this column to take a more rational approach. The stock market has finally come to its senses, and with the above political caveat the U.S. economy will be the better for it.
STILL HOLDING BACK: JEREMY GRANTHAM WARNS AGAINST BUYING TOO SOON
“The broad, typical opinion that we would muddle through this crisis ... just shows you what a dangerous optimistic bias the advisory business has built into it.”
Veteran money manager Jeremy Grantham has been bearish for several years now. Like most people who saw the historical credit bubble as it was happening and were pessimistic about the eventual outcome, he was early. At long last he has been proved to be correct.
What does he see now? He believes his investment company's next major move will be on the buy side, but demonstrates no anxiety to jump in just yet. He thinks overseas stocks, particularly emerging market ones, are absolutely cheap; however, experience teaches him they could well overshoot on the downside now. His concluding remarks from this interview in Barron's well sums up his overall perspective regarding the workout of the current situation: "It is just so intricate that all I can conclude, by instinct and by reading the history books, is that it will be longer, harder and more complicated than we expect."
For three years, he has cautioned investors to avoid risk. Jeremy Grantham, chairman of institutional money manager GMO in Boston, was early, but eventually right.
Grantham told Barron's in February of 2006 that "housing is a classic bubble" and that "this feels like the end of a cycle." Known for his insights on global investing, Grantham, 70, co-founded GMO, which has a value framework combining quantitative and fundamental analysis. It oversees assets of about $120 billion.
For Grantham's latest views on the fallout from the financial crisis and what investment opportunities he sees, please read on.
Barron’s: How much will the recent $700 billion bailout plan approved by Congress help stabilize the economy and the financial markets?
Grantham: It certainly does not hurt. It is an amazingly complicated situation. But I do believe we have passed the point where we have to worry about moral hazard. When Bear Stearns was in trouble, I used to worry about moral hazard.
What is your sense of how this crisis has been handled by those in charge?
It has been a haphazard response, and the next time something happens, you cannot be sure what will happen. In one deal they protect the bonds, while in the next deal the bonds go. Then in the next deal they protect the foreign bonds but not the domestic bonds. My guess is that people will be nervous that they will be at the bad end of one of the tough deals, rather than one of the more gentle deals.
Everyone is shaking in their boots. The awareness of risk has come back with a terrifying surge, and it is not going to go away too quickly.
With the Fed and other central banks lowering rates last week, are you worried about inflation?
My view is, "Forget inflation, guys." This is serious, the real McCoy, and you do not have to worry about little things like inflation. Global growth will slow down, commodities will be weaker for a while, and inflation is a thing of the past. Now we are talking about getting the financial machinery to work and just keeping [gross domestic product] grinding along.
What was at the core of what got the financial system into this crisis?
It was the belief by a lot of people who counted that financial bubbles did not have to be addressed. The thinking was that ... you could step in and, by scattering a bit of money around, ease the downside consequences. Therefore, you could let the tech bubble run amok and wait for it to burst and step in. And you could let the housing bubble run amok and step in.
At the center of this crisis was a bubble in risk-taking. The risk premiums dropped off the cosmic scale, the lowest ever recorded. On our 7-year forecast data, we reckoned that between June of 2006 and June of 2007, people were actually paying for the privilege of taking risk. Our constant theme for the last three years was avoid risk, avoid risk, avoid risk.
How much further do we have to go to get through this downturn?
Great bubbles like the one in 2000 take a long time to wash through the system, and you should not really expect a low much before 2010. The fair value on the [Standard & Poor's 500 index] is about 1025 [versus 910 late last week].
This was not only a monetary event, but it coincided with the first truly global bubble in all assets. You had inflated housing in almost every country in the world, except for Japan and Germany. You had overpriced stocks in every country in the world. And you had too much money and too-low interest rates. I was confident about very little, but I was confident that this would be different from anything we had seen before, and potentially more dangerous. It should have been treated with more care.
Is this crisis playing out the way you thought it would?
No. I threw in the towel three months ago, and wrote a quarterly letter saying I thought I was the bear around this joint.
But this is much worse than I thought. All the fundamentals are turning out worse than I thought they would. All the competencies of the senior people at the Fed, Treasury and [firms like Merrill Lynch and Lehman Brothers] have turned out to be much less than I had expected; that is very disappointing.
And, therefore, how could one's confidence that the senior people would get us through the storm be very high? Prior to three months ago, we were investing in emerging-market equities. Then we battened down the hatches, and I changed my view from avoid all risk except emerging markets to avoid all risk, period.
The terrible thing -- after all this pain -- is that the U.S. equity market is not even cheap. You would imagine that, given the amount of panic, that it would be. But it started from such a high level in 2000 that it still has not yet worked its way down to trend, although it is getting close. But the really bad news is that great bubbles in history always overcorrected. So although the fair value of the S&P today may be about 1025, typically bubbles overcorrect by quite a bit, possibly by 20%. That is very discouraging.
What about equities outside the U.S.?
Things are getting cheaper. We score the EAFE [the Europe, Australasia and Far East Index] as absolutely cheap, and it is offering a 7% real annual return over seven years. Emerging-market equities are a bit cheaper, and we see a 9.5% annual real return over the same period.
The problem, though, is that we have so much downside momentum, so many financial problems and so many interlocking relationships, that it is hard to imagine this crisis subsiding because stock prices are digging in their heels and approaching fair value.
What happens to hedge funds in the wake of this crisis?
A year ago, I said that half of all hedge funds would go out of business in five years, and I would certainly stand by that today. Unfortunately, like a lot of my dire projections, that may turn out to be conservative.
I also said that at least one major bank will fail. I got a lot of grief for that, and now it looks like I could have said at least a dozen major banks will fail.
As for the broad, typical opinion that we would muddle through this crisis, it just shows you what a dangerous optimistic bias the advisory business has built into it.
Do you think we will learn anything from all of this turmoil?
We will learn an enormous amount in a very short time, quite a bit in the medium term and absolutely nothing in the long term. That would be the historical precedent.
Let's talk about your asset allocations.
In a nutshell, we are as conservative as we can possibly get. One bet that has been very successful for us, touch wood, has been long high-quality, blue-chip stocks, particularly in the U.S., and short risky companies. We have been screaming against risk-taking for a long time, and in recent weeks, it has paid off enormously.
What about looking ahead in terms of asset allocation?
Going forward, you can think about slowly moving back into the cheapest pockets of global equities. So the next move that we make will be back to moderate neutral in emerging-market equities and small-cap international value. I cannot say we are going to be in a great hurry, but that will be our next move. We had finished selling almost everything except emerging markets two years ago. We finished selling emerging-market equities three months ago.
But the next move will be buying, and we are encouraged that there are a few pockets that are cheap on an absolute basis. We are not encouraged that they will rally immediately. But we will be looking to buy the cheap pockets of global equities as our next move some time in the next several months.
Why emerging markets and small-cap international value?
Just value and because they have been hit the most. Emerging equities are down almost 50% since late last year, and some of small-cap international is down more than 40%. That big a drop has this wonderful effect of making these categories look cheap pretty fast. You can buy, but it does not mean it is their low, and I strongly suspect it is not.
The great trap is to buy too soon and, in the big move, to sell too soon. I have been saying since 1998-99 that my next major-league error will be buying too soon -- but we will not buy quite yet. But when we do, I suspect it will be too soon again.
What do you see ahead for commodities?
Commodities have a great long-term future, now that the long-term trend has shifted from falling commodity prices to rising commodity prices. Having said that, the next couple of years will be quite different. We are in a global slowdown, which I think will be worse than expected even today, and it will be longer than expected -- so this is not a healthy environment for commodities. Over a shorter horizon, I would be getting out of the way of commodities or I would be short commodities. I am personally short oil; the firm is short copper.
What about some other trades?
I am speaking for the asset-allocation unit at the firm. We have been substantially long the safe-haven currencies. We have been very long the yen and somewhat long the Swiss franc and short sterling, which is one of our favorite bets. We have been short the euro for three months, and slightly long the U.S. dollar. One of the paradoxes is, if the world is worse than people expect, the U.S. dollar will outperform.
Why are you shorting the euro?
It just ran too far. It went from 85 cents on the U.S. dollar to $1.60. It more or less doubled, which I do not think reflects reality. But the biggest lay-up of any idea over the last three or six months was shorting the pound.
The U.K. housing market was dreadfully overpriced. I felt nearly certain that the U.K. housing market would come back to a more normal multiple of family income, which is a very big decline of 40% if you did it in a hurry -- or you can sit back for many years and wait for income to catch up. But you should really count on that market coming down over a couple of years painfully.
Do you have any closing thoughts about how we got into this financial state?
I ask myself, "Why is it that several dozen people saw this crisis coming for years?" I described it as being like watching a train wreck in very slow motion. It seemed so inevitable and so merciless, and yet the bosses of Merrill Lynch and Citi and even [U.S. Treasury Secretary] Hank Paulson and [Fed Chairman Ben] Bernanke -- none of them seemed to see it coming.
I have a theory that people who find themselves running major-league companies are real organization-management types who focus on what they are doing this quarter or this annual budget. They are somewhat impatient, and focused on the present. Seeing these things requires more people with a historical perspective who are more thoughtful and more right-brained -- but we end up with an army of left-brained immediate doers.
So it is more or less guaranteed that every time we get an outlying, obscure event that has never happened before in history, they are always going to miss it. And the three or four-dozen-odd characters screaming about it are always going to be ignored.
If you look at the people who have been screaming about impending doom, and you added all of those several dozen people together, I do not suppose that collectively they could run a single firm without dragging it into bankruptcy in two weeks. They are just a different kind of person.
So we kept putting organization people -- people who can influence and persuade and cajole -- into top jobs that once-in-a-blue-moon take great creativity and historical insight. But they do not have those skills.
Where do you see all of this going?
I want to emphasize how little I understand all of the intricate workings of the global financial system. I hope that someone else gets it, because I do not. And I have no idea, really, how this will work out. I certainly wish it had not happened. It is just so intricate that all I can conclude, by instinct and by reading the history books, is that it will be longer, harder and more complicated than we expect.
Sobering thoughts. Thanks, Jeremy.
TALES FROM THE BUBBLE: GOING DOWNEY IN FLAMES
How did a bank that tried so hard to be good end up in so much trouble?
The founder and head of Downey Savings & Loan, Maurice McAlister, was well aware of the perils of making mortgage loans in a bubbly real estate market. He did everything he could to avoid getting caught in the downdraft he feared was coming, to the extent that the bank's chief lending officer and a third of the bank's staff quit.
For all the good it did, McAlister could just as well of spared himself all the hard preventative work. Downey is on the verge of going under. Real estate overvaluations in Downey's main markets had gotten so high that when they returned to earth, the equity cushions on the Downey loans disappeared ... and then went negative. Now 1 in 7 of its loans is delinquent.
As technology stock buyers in 1999 who played it "cautious" by sticking to "solid" companies that sold real products and actually earned profits, like Cisco and Sun Microsystems, had already learned, being careful in how one participates in a bubble misses the point. You have to sit it out entirely. There are no bargain-prices in a bubble-fueled asset class.
At first glance the turmoil at Downey Savings & Loan looks depressingly familiar. After issuing exotic mortgages all over California, it finds 1 in 7 of its loans delinquent. Its shares trade at 7% of book value. Downey is one misstep away from becoming the 14th bank -- and the 3rd biggest after IndyMac and WaMu -- shut down by regulators this year.
Yet Downey was hardly like the reckless lenders that inflated the housing bubble. Maurice (Mac) McAlister, Downey's 83-year-old founder, weeded out speculators and excommunicated dodgy appraisers and mortgage brokers. So strict were his rules that at one point many of Downey's mortgage officers threatened to quit en masse, sick of seeing their customers and commissions going to banks with looser lending rules.
For 50 years McAlister kept tight control over Downey and its money. Not one to waste his own dollars, he sometimes pocketed the breakfast rolls from meetings to take back to his hotel, recalls one former executive. Grandfatherly to employees, he was difficult to outsiders. He cultivated a deep indifference to Wall Street, packing the board with family and friends and eschewing conference calls with analysts.
Under McAlister, Downey sailed through the s&l crisis of the late 1980s. As the housing boom took off in the late 1990s, larger, laxer banks jumped in, stealing away borrowers who wanted traditional 30-year, fixed-rate mortgages. McAlister turned to adjustable-rate loans, which carried twice the profit margin but made a few concessions to lure customers when interest rates were rising. He approved negative amortization loans, which give borrowers the option to let their mortgage balance run up for a few years.
Still, McAlister always insisted on higher credit scores and sizable down payments from borrowers -- 20% or more -- to protect Downey if a loan went bad, according to S.E.C. filings. They rarely did. Even borrowers who took negative amortization loans were never allowed to let the loan value exceed 88% of the property value. "If my broker lied to me I'd cut them off," says a former Downey account executive. "We didn't play that way."
Downey's rivals did. In 2003 Wall Street began securitizing adjustable loans. Big firms like Merrill Lynch invaded Downey's negative-amortization niche, waiving requirements to document a borrower's income, financing a home's entire value, paying out huge commissions. "The problem was competitors were doing so much more," says Timothy Kepler, the bank's former head of wholesale lending.
Paid on commission, Downey's loan officers pleaded with executives to loosen standards. Instead, McAlister tightened rules. In 2005 he barred appraisers from working outside their home counties to prevent the inflated values popping up at rival banks. In late 2006 Downey's wholesale division, which made nearly all the bank's loans, mutinied. The bank's chief lending officer quit, followed by 1/3 of the staff. Kepler and many others defected to a subsidiary of Chevy Chase Bank run by former Forbes 400 member B. Francis Saul.
As the housing crisis metastasized last year, it seemed that McAlister's conservative style had saved the bank. Downey maintained a 28% cushion on its loans' collateral. Executives even lowered reserves for bad loans. Last fall, as he accepted a lifetime achievement award from UC, Irvine's business school, McAlister answered a question about the mortgage bust with a cocky: "We have a little bit of a problem -- but not very much."
He had miscalculated. The real estate run-up had carried values so high, especially in southern California, that when home prices crashed, they quickly tore through the bank's fat equity cushion. As delinquent loans soared, Downey started going after customers, filing at least 31 suits since January 1, accusing borrowers and brokers of lying on loan applications and appraisers of inflating home values. McAlister resigned from the board in July. His stake in the bank, worth $400 million a year ago, is now $12 million. When we called him in early October he was out hunting elk and not available for comment.
VALUE AMID THE STORM
The current maelstrom provides opportunity for Sound Shore Management, which hunts when everybody else has headed indoors.
Sound Shore Management follows a straightforward investing strategy. It looks among the large company universe for stocks with low P/E's relative to the rest of the universe and relative to the company's trading history. Then they look for some catalyst that might bring the company back into the market's good graces.
This has made for a solid long-term record achieved with low risk. Over 20 years it has outperformed the S&P 500 by 1.2% a year. Not spectacular, but where only a minority of money managers actually beat the S&P at all it is very respectable indeed.
This Barron's piece covers a few current favorite of Sound Shore analysts. The money management firm's top 10 holdings may be seen here.
When Sound Shore Management made its antediluvian move to Greenwich, Connecticut, from lower Manhattan way back in 1982, clients and colleagues "thought we were crazy," laughs Harry Burn, who along with T. Gibbs Kane founded the investment firm 30 years ago. Long before that quiet Connecticut suburb morphed into today's tony financial hub, the two saw its possibilities.
The move to "the sticks" was consistent with the money managers' focus on a contrarian value-investment strategy. "Rather than own what everyone else loves, we try to buy things that are on sale and sell things people are clamoring to own," says Burn. That approach has served 17-person-strong Sound Shore well. With nearly $7 billion under management, it has built a long record of outperformance by picking well-known stocks with large stock-market values.
As an independent fund manager with a stable management team, one strategy, a low 0.92% expense ratio and no load, Sound Shore is an increasingly rare animal. Though down in the 12 months ended September 30, the Sound Shore Fund (ticker: SSHFX) has outpaced the S&P 500 over just about any period measured, no small feat in the past 12 months. It is up an annualized 11.2%, 10.4% and 6.9% for the 20, 15 and 10 years ended September 30, respectively, versus 10%, 8.4% and 3.1% for the S&P. Perhaps it is no surprise, then, that 60% of its clients have been with Sound Shore for 10 years or more.
While a value shop, "we are not interested in significant turnarounds," Burn says pointedly. Sound Shore's four portfolio managers and three analysts look at businesses with a history of quantifiable margins, balance sheets, strategy and growth rates, "as opposed to problematic companies. That is why we have not been in a big rush to go back into financials, just because the [stocks] are down." Indeed, Burn notes, the fund has benefited from underweighting financial stocks over the past 18 months or so, and avoiding the spectacular blow-ups "like Lehman, Fannie Mae, Freddie Mac and AIG."
Sound Shore portfolio manager John DeGulis, whose father was a money manager, adds that financials in 2006 were the "classic" example of a value trap. They looked cheap, with a price-earnings ratio of 10 times or so, but at the time returns on equity and leverage were at all-time highs, while price-to-book ratios were "at best fair."
DeGulis, 42, a 20-year industry veteran with 13 years at Sound Shore, says its investment process begins by sifting through the roughly 1,250 stocks that have a market capitalization of more than $3 billion. The list is whittled to around 250 by screening for shares that are in the market's lowest price-to-earnings quintile and sporting P/Es at lows relative to the stock's history.
Afterward comes a "value check" to weed out shares that are not really bargains, notes Sound Shore fund-manager James Clark, 46, a former head of equity research at Credit Suisse First Boston. An example, Clark says, would be a coal stock trading at just six times earnings when coal prices and returns on capital are peaking, and the issuer is outspending cash flow because it is hell-bent for growth.
The screening trims the universe to about 80 to 100 names. From there, says DeGulis, "we do the math. ...We do not take Wall Street analyst numbers or what the management team tells you for granted." Sound Shore models the income statement, cash flows and balance sheet, searching for an earnings driver for the next 18 months.
A largely equal-weighted portfolio of 40 names is culled from this list. Sound Shore looks for solid companies that the Street has lost interest in, but that have good earnings power and could surprise investors positively over one to two years.
The firm does not get emotional about its winners. "When we reach the target, it is a candidate for sale, and typically they get sold," says DeGulis. "A typical holding is about three years," adds Clark, who grew up talking stocks at the dinner table with his father, who was in the brokerage business.
The current maelstrom presents an opportunity for Sound Shore, whose annual portfolio turnover is a modest 33%. Says co-founder T. Gibbs Kane: "Our job is to stay in the duck blind. When the weather is inclement, you tend to have more ducks. When everybody else is in the lodge, staying warm and dry, the opportunities will be better for us."
Among some of Sound Shore's current holdings are Cardinal Health (CAH), Royal Dutch Shell (RDSA), Pfizer (CAH), Credit Suisse Group (CS) and Aon (AOC).
Credit Suisse should emerge as a winner from the capital-markets crisis, DeGulis maintains, because of the capacity that has been taken out of investment banking and private-wealth management businesses. And it has a strong balance sheet and a management team battle-tested by the Swiss bank's own restructuring in 2000-2002.
Since the end of 2006, Credit Suisse has sold some assets and hedged others to cut exposure to toxic investments. It is positioned to take wealth-management share from wounded rival UBS, he says. Its private-banking business, DeGulis argues, "alone is worth the entire stock price of 37." DeGulis thinks it is worth over 70.
As for Royal Dutch, Clark says, it is the only major integrated oil company that probably will have meaningful reserve and production growth over the next three or four years, after having positioned itself in unconventional hydrocarbons, like liquefied natural gas -- now 15% of its business and soon to be 20%. Royal Dutch also is big in other growing plays, like the heavy oil reserves in Canada, and has a "nice shale natural-gas play" in the U.S. Royal Dutch, which sports a 6% dividend yield and a solid balance sheet, is worth about 75, using a normalized multiple of 10 times an EPS of $7.50 in 2009, says Clark. [Stock is now around 48.]
Another pick, Pfizer, is clearly out of favor, in part because its blockbuster anti-cholesterol drug, Lipitor, goes off-patent in 2011. (Lipitor will produce about $1 of the company's $2.40 earnings per share in 2008.) But, DeGulis says, the market is valuing the rest of Pfizer, with a 7% dividend yield, at 11 times on non-Lipitor earnings, "and we think that those earnings will grow." Given what has happened in the world, cash and the value of a powerful balance sheet has just gone up immeasurably, he adds, and Pfizer has $25 billion in cash -- $10 billion net of debt. Sound Shore's target for the stock is the high 20s; it has recently been around 18.
Another holding, Aon, with its arch rival, Marsh & McLennan (MMC), forms what is almost a duopoly in insurance brokering for the world's largest 1,000 corporations. Says DeGulis: "This is a business that is not capital-intensive, so returns are high." Aon trades at 13 times expected 2009 EPS, is taking market share, has a balance sheet that is a fortress, and is buying stock back. "There is cyclical risk, but at 13 times we like Aon," he says, and think it is worth about 55, versus a recent 38.
Cardinal Health is one of a handful of restructuring candidates in the fund's portfolio. Growth has slowed in its branded and generic drug-distribution business, but the industry has consolidated, with only two other major players, AmerisourceBergen (ABC) and McKesson (MCK). Cardinal has restructured the drug operations, which are improving. "We think the drug-distribution earnings are stabilizing in the next six months, and will begin to grow again. The other half of the business, medical products, has been growing and will continue" to do so at double-digits.
Cardinal Health recently said it would split its drug-distribution and medical-products units. "It is undervalued, and the two parts are worth more than the whole," says DeGulis. Sound Shore has a mid-60s target price on the stock, recently near 44.
On the bear side, he observes, Sound Shore is wary of companies that provide "any consumer item that requires a loan for purchase: autos, appliances, homes. We think the unwind there is multiyear."
STOCKS TO SURVIVE ON
Ken Fisher: I am still big. It’s the markets that got small.
Ken Fisher has been steadfastly bullish in his columns this year. He was wrong. To be fair, he never advocated buying his stock recommendations because he though the market was going up, but he hardly admits his previous incorrect calls at all. Instead he resorts to the age-old fallback of advocating that everything will be fine in the long run. That would be the long run in which John Maynard Keynes famously said we would all be dead.
Of course Fisher is basically right. Unless your time horizon is short and your portfolio is in liquidation mode you will be buying more stocks than you sell over the next 10 years or more. In that case it is good that stocks are cheaper, so be glad.
We are not crazy about the stocks Fisher advocates below. On the other hand, they are not objectionable. You will not get in trouble buying them. In the long run, anyway.
Though I walk through the valley of the shadow of death I fear no evil. Seems that almost everyone else does, though. Most investors need their investments to last them a long, long time, yet they are acting like the next few months are everything. The shadow of death is an illusion. In the long term equities always do well. They will now, too, even if they fall further first.
My firm has 25,000 high-net-worth clients. A typical account would be that of a couple aged 65 and 60 who need their money to last the rest of their lives, 25 to 35 years. They have a long time to go, and they accomplish nothing by getting in and out of the market from fear now. Yet such folks are so overloaded by the doom and gloom they hear around them that many must be re-reminded of their primary purpose and long-term needs.
If you have a time horizon that long, even a 9% minicrash, such as we had on September 29, is something you can take in stride. Over long periods equities have always done well compared with other liquid alternatives. Even if you have a shorter time horizon, such as a decade, you know that stocks are more likely than not to recover from a market decline.
I hear 60-year-olds say nonsense like, "I won't be able to retire because of the market's downturn." That is ridiculous. History has seen many similar bear markets. Yet folks have kept retiring. The next bull market more than makes up for what we lost in the last decline. The average bull market, of which there have been 10 since World War II, takes stock up 150% before the cycle turns. The average 12-month rebound from the bottom is 36%. No, I do not know where the bottom is. I just know that stocks do not go down and stay down.
We can argue about where stocks are headed, and there are always two sides to the argument. But put that aside. Think longer. Unless you are in your late 80s and were an adult as World War II ended, stocks are cheaper, adjusted for tax rates and interest rates, than they have been at any time in your adult life. That is a simply stunning statement looking forward. You are walking forward. Stop myopically looking at your feet and focus on the horizon. Just buy great franchises at cheap prices now and be patient. Here are some long-horizon stocks I like now.
Looking past all the immediate hysteria, focusing several years ahead, it is hard for me to see cheaper oil. Hence simple, strong holdings like Norway's StatoilHydro (24, STO) seem logical. As a vertically integrated oil and gas firm with $220 a share of proven reserves, this $89 billion (in revenue) business will keep growing steadily. It sells for 10 times likely earnings in 2009 and one times revenue. It offers a 3.75% dividend yield.
The world believes McCain or Obama, and Congress, will beat up on the drug stocks. Hence they sell like nongrowth stocks. I suspect that, as happened when the Clintons were terrorizing the health care industry, the antipharma movement will generate more rhetoric than action. How can Congress curb drug companies without hurting the baby boomers who need their products?
You do not need Viagra to get excited about Pfizer (18, PFE). It is the world's largest drug producer, with such blockbusters as Lipitor for cholesterol, Celebrex for arthritis and Lyrica for epilepsy. As these come off patent, Pfizer will be drawing new revenue from Sutent for cancer and Chantix to help smokers stop. Pfizer sells at less than 10 times likely 2009 earnings, with a 7% dividend yield.
Another buy is Bank of America (34, BAC). Built on acquisition and consolidation, Bank of America is the world's largest consumer bank. It has used the credit meltdown to make smart and cheap acquisitions of Countrywide, to make it the largest mortgage lender, and now of Merrill Lynch, to give it the largest securities distribution force. Having made fewer mistakes than its peers, it is marvelously positioned looking a few years out, yet it sells at 10 times next year's earnings, with a 7.6% dividend yield.
Celanese (28, CE), though much smaller, is a globally diversified second-tier chemical company. Its chemicals are used to make industrial colorants, paints, adhesives and complex polymers for most basic industries. It is not exciting, but it is fundamental and cheap. Its markets will not go away. If you buy now at 70% of revenue and six times 2008 earnings, you have got to win a few years out.
Carpetmaker Mohawk Industries (67, MHK) has seen its stock sink for four years because of the collapse in housing. But the much larger nonresidential construction market should pick up the slack. It sells at 60% of revenue and 15 times depressed current earnings.
Fellow value-oriented Forbes financial columnist and fund manager John Rogers discusses, here, Wall Street systematic thinking errors such as "mental anchoring" and "recency bias." In the later case, recent news and trends are given an unwarrantedly high weighting over cumulative past results. For example, a bad recent earnings report can cause an outsized stock price decline even where the company is sound and has historically reported consistently good results.
Stocks which Rogers thinks are being unfairly tarnished by some bias or other include Royal Caribbean Cruises (RCL), consultant Accenture (ACN), and advertiser Omnicom (OMC).
SMALL STOCKS, NO LEVERAGE
Ron Baron wants to own somewhat expensive companies growing very fast. His performance history says he is worth a listen.
The latest issue of Forbes, dated October 27, is their annual "America's 200 Best Small Companies" issue. The 200 sorted by rank can be found here. The universe of companies considered have sales between $5 and $750 million and a stock price of $5 or more. These are ranked on a combination of returns on equity, sales and profits growth, and stock performance versus comparable companies, and then are run through a human qualitative filter.
Since the 200 Best Small Companies are growing faster than most while earning higher returns on capital, they naturally tend to sport higher earnings multiples. However justified in many cases, and whatever studies may say, small growth companies with high P/E's have never been in our comfort zone. Thus we would look to specialists in the domain with good long-term records, a strong fundamental orientation, and some price discipline for wisdom there. Ron Baron, 65, founder of Baron Capital Group, is one such example. His flagship Baron Growth Fund (BGRFX) has substantially outperformed the S&P 500 since its 1994 inception, although its NAV has fallen about as far and fast as the S&P's over the last year.
This article covers those from among the Best Small Companies that are held in the porfolios of one or more of the Baron funds. The P/E multiples can reach nosebleed territory at 40 or more, but Baron is willing to pay up when 5-year growth rates are 25 or 30%.
Every man has his limits, and Hollywood is clearly beyond those of Ronald Baron. When the founder of Baron Capital Group hired Jerry Seinfeld to entertain his funds' investors a few years ago, the comedian quipped, "The man who picks your stocks didn't think I was a good investment." Seinfeld was referring to Baron's personal verdict years earlier that the stand-up comic's routine was amusing but too parochial for the national stage.
Fortunately for his investors the founder of Baron Capital has a far better record picking stocks -- like the Best Small Companies members profiled below -- than entertainers. Baron, 65, oversees $19 billion among 17 funds, which puts him on The Forbes 400 with a net worth of $1.4 billion. He has also personally managed the flagship Baron Growth Fund (assets: $6.2 billion) since its 1994 inception. During that 14-year run the fund has returned 14.2% annually after fees, which is 5.3 percentage points ahead of the S&P 500. The fund carries no load, but it is not particularly cheap at 1.3% a year in expenses.
Baron has delivered his impressive performance by digging up well-run small companies that are leaders in their industries and enjoy high barriers to entry. He wants firms that have a decent shot at doubling their earnings in five years by dint of their business growth rather than using leverage. Less than 1/10 of Baron Growth holdings have a debt-to-equity ratio above 67%.
"The use of leverage is the principal reason small businesses go out of business," says Baron. "Read the papers."
Baron is patient for a growth guy. His annual turnover of 21% is less than 1/5 that of the small-company growth fund average. He hangs on to his best picks until they reach $10 billion in market capitalization, at which point he will usually sell. Baron also eats his own cooking, with more than $250 million personally invested in his firm's funds. (The rest of his wealth is tied up in the funds' parent company, real estate and art.) He scoffs at the notion small caps are best shunned amid economic uncertainty.
"I constantly tell my analysts, 'I don't want you thinking about the stock market, interest rates or the economy,'" he says. "'I want you on the phone with great companies, visiting them, bringing them to visit us.'"
Which of the Forbes Best Small Companies are attractive enough to find their way into a Baron fund portfolio? Among them are these five.
Blue Nile (NILE). This online diamond and jewelry merchant (#42 on our list) says it can sell a 1-carat engagement ring for 20% to 40% less than what you would pay at a walk-in store. Since 1999 Blue Nile has been signing exclusive contracts with big diamond suppliers to list their stones exclusively on its site. Blue Nile is thus able to give customers access to 55,000 certified diamonds while maintaining negligible inventory; its suppliers benefit from fast inventory turns.
To leverage its supply chain, Blue Nile focuses on the fragmented $4.5 billion market for engagement rings. With only a 4% share, it has already surpassed Tiffany & Co. (TIF) as the largest unit buyer of high-end domestic diamonds. Blue Nile already controls 50% of online jewelry sales and should be able to weather rocky economic times by taking additional sales from more expensive offline sellers, as well as by moving abroad.
Baron bought Blue Nile in June 2004 at $36; he still likes it at $42.50, despite its lofty price/earnings multiple of 43. It has little debt.
Copart (CPRT). Ranked #79 on the Best Small Companies list, Copart, has expanded from a lone junkyard into the industry's largest chain. Its 130 North American yards handle a million scrap vehicles a year. Cars are stripped for parts, rebuilt or scrapped for steel. Baron first bought Copart in January 2005 at $24; now, at $37.64 (with a P/E of 22), it makes up 1.9% of the Baron Growth Fund. The firm has no debt.
Some cars live long, productive lives; some die young. But almost all of them eventually end up in a junkyard. Zoning restrictions make it hard to set up new yards, keeping barriers to entry high. Copart is buying smaller lots.
With demand for recycled auto parts strong, the company just pushed through a 19% price hike. VB2, Copart's online sales network, is drumming up buyers around the globe. It ships a third of its vehicles abroad. The company last year bought the first of its 15 junkyards in the U.K. Its next markets: Continental Europe and Asia.
Genesee & Wyoming (GWR). A locomotive can haul a ton of cargo four times as far on a gallon of gas as a truck can. So costly diesel is great for Genesee & Wyoming (#94), which owns 10,000 miles of railroads in the U.S. and Australia. Three things make this short-haul outfit stand out in the railroad business. One is that it is, in a sense, family run. Chairman Mortimer Fuller III is the founder's great-grandson. Another is the industry's high barrier to entry; replacement track costs $1 million per mile. Third, half of Genesee's workforce is nonunion.
This gives Genesee advantages over big rails like Burlington Northern, CSX and Norfolk Southern, which tend to be unionized. A Genesee train engineer can make $75,000 to $100,000 per year, comparable to that of the big railroads. But the Genesee worker is more flexible, a jack-of-all- trades able to tackle different jobs and shifts. Genesee shares have nearly tripled in four years and are now at 20 times trailing earnings.
Strayer Education (STRA). When the economy turns down, vendors of post-high-school education turn up. Unemployment, or the fear of it, drives people to hit the books. That is good news for Strayer Education (#20), a $354 million (sales) outfit that provides college degrees to 37,000 working adults annually.
Strayer, with a $2.9 billion market value and no debt, is adding 9 campuses this year to the 57 it already runs. Since 2001 Strayer has been expanding enrollment by 18% and tuition by 5% a year. Earnings and the company's share price have tripled over that same period.
Under Armour (UA). A pioneer in athletic clothing that wicks sweat away from the skin and regulates body heat, this company (#28 on our list) has expanded into pants, gloves, socks, hats and footwear. It has managed to do so while remaining virtually debt-free.
UA has developed a cult following. That explains how it manages to get more than $100 (retail) for cross-training shoes. It may also explain how UA can get away with something that not too many apparel companies can, which is to compete with its retailers. Since its inception in 1996 it has been selling goods to consumers over its Web site.
There is room for UA to grow, Baron says, in women's apparel (now 20% of the business) and in Europe. This stock has more than doubled in the past three years and will cost you 38 times trailing earnings.
MIDSTREAM MLPS CRASHING, PRESENT OPPORTUNITY
Master Limited Partnerships are publically traded United States LPs. In exchange for escaping double taxation (profits at the corporate level and dividends at the personal level for a regular publicly traded corporation), MLPs are required to pay out most of their operating profits. As with a private limited partnership, MLP profits get passed through to the partners, who then include that income in their tax reporting. Fearing a major loss of corporate income tax revenue if too many companies chose the MLP legal structure, Congress restricted its use to certain industries, namely natural resources, commodities, and real estate. (The feared loss of tax revenue from corporations has happened anyway. See this posting.)
When a company pays out most of its profits then if it wants to finance growth it needs to go to the capital markets. But as long as maintenance capital spending approximately equates to depreciation or depletion, the company can continue operating indefinitely without resorting to external financing. The most important question for an investor then concerns the stability and possible growth of the profit payouts.
A U.S. Treasury bond has an extremely reliable nominal payout, but zero growth possibilities. The nominal payout is susceptible to real depreciation via inflation. On the other hand, an oil and gas producer's payout will vary with volatile output prices and uncertain drilling results if it tries to maintain production and avoid shrinking. This article covers an interesting subset of MLPs focused on the gathering, processing, storage and distribution of oil, natural gas, and refined petrochemical products, aka "midstream" MLPs (as opposed the upstream producers and downstream refiners and wholesaler/retailers). These operations have the following characteristics:
Along with almost everything else, midstream MLPs have crashed in price. Some sport yields of well over 10%, which sounds enticing if everything else lines up.
A downside an individual taxpayer should be aware of is that MLP payouts consist of distributions from income and often a return of capital (presumably when reinvestment requirements are less than accounting depreciation) as well. The returns of capital reduce the cost basis of the MLP shares. This can all mean putting on the green eyeshades come tax forms time.
Worth pointing out is that there is an inherent reason for MLPs to attract less than average following from Wall Street, and thus to be inefficiently priced to an individual's advantage from time to time. If a mutual fund holds MLP shares the complicated tax accounting treatment has to be passed through to the fund investors. This involves a substantial paperwork on the fund's part and we imagine that most will just decide to forget the whole idea. And otherwise tax-exempt entities such as pension funds will owe a tax on "unrelated business income" once LP distributions reach a certain level, so they too mostly avoid investing in MLPs. (The same rules militate against putting them in an IRA.) The result is low institutional ownership and Street coverage.
As we all know, the entire market has been crashing in recent weeks. The price action in the MLP sector has been no different. However, unlike many sectors that have been crashing, the businesses of Midstream MLPs are very defensive in nature. Midstream MLPs can be characterized as having stable cashflows that are backed up by either fees based on the volumes of oil, gasoline or natural gas moved through pipelines or hedges that are used to stabilize the fairly stable cash flows of processing plants.
Under even a severe recession people will still need to drive to work, heat their homes and turn on their lights. Midstream MLPs will continue to serve this need by transporting the energy we need to survive. This idea was recently confirmed by the management of Crosstex Energy LP (Nasdaq: XTEX) on October 2 during their conference call to discuss the impacts of Hurricane Ike. Below is management's statement on the matter:
We think that we have a great set of assets in a diverse area in the best of producing areas and those assets are going to continue to perform well. We are still serving a necessary piece of the industry. We are getting gas to market. The market is going to continue to demand this gas supply with a link to the source. So we feel good about that.
The one Achilles heel of midstream MLPs is that they are highly dependent on the capital markets to finance growth projects. But midstream MLPs are not dependent on capital markets to operate their assets. This was recently confirmed by management of Crosstex. Here is what Crosstex's management said about this issue.
We think Wall Street is doing a poor job of distinguishing between companies that need capital to execute a growth plan versus those that need capital to survive. We are clearly in the former group.
Once pipelines, processing plants or storage tanks are in place the amount of capital required to operate them is very low. Most midstream MLPs continue to have significant amounts of their credit lines undrawn but they will nonetheless likely be deferring growth projects in the current environment as the long-term credit markets are no longer functioning. Nevertheless, there will continue to be a large need for new midstream infrastructure in the United States, as significant new infrastructure is needed to support the production growth of the North American shale plays.
Midstream MLP cash flows fall into one of two groups. Fee-based contracts and price-based contracts. While both groups are defensive in nature, some types of midstream assets produce cash flows that are more secure than others are. Pipelines with fee-based contacts are oil pipelines, gasoline pipelines and large interstate or intrastate natural gas pipelines. These fee based contracts charge based on the volume of product that they transport, not the price. These fees are raised every year based on the Producer Price Index. These companies can be considered the toll roads of America's energy infrastructure.
Oil and refined product pipelines have a little economic exposure as the consumption of gasoline has dropped between 3%-4% over the last year. Whether this trend continues now that gasoline prices have dropped is unknown but a recession certainly will not help gasoline consumption. Fortunately, the annual rate increases have more than made up for the slight drop in volume. Under normal circumstances, rate increases result in steadily increasing cash flows. Under these circumstances rate increases are keeping cash flows stable for oil and gasoline pipelines. My favorite pick in this area is NuStar GP Holdings LLC (NYSE: NSH) with a 10% yield. Under normal circumstances, I would expect NSH to be able to grow distributions at 20% per year for the next few years.
Intrastate natural gas pipelines are the most stable type of asset in the midstream MLP universe. Natural gas consumption is still rising as the U.S. slowly migrates towards generating more of its electricity from natural gas and less from coal. There is a shortage of this type of pipeline in many areas of the U.S. as natural gas is essentially trapped in producing basins with a lack of pipeline capacity to transport it out. Interstate natural gas pipelines also have annual rate increases based on the producer price index so this type of asset should continue its cash flow growth even during a severe recession. My favorite pick in this area is Energy Transfer Equity (NYSE: ETE) with a 12.5% yield. Under normal circumstances, I would expect ETE to grow its distribution 20% per year for the next few years.
The final area within fee-based contracts is storage assets. Oil or gasoline storage cash flows are very similar to that of oil or gasoline pipelines. Natural gas storage cash flows are similar to those of natural gas pipelines. Storage assets also have rates that adjust for inflation. Even during the best of economic times, storage assets typically have little growth.
The third type of assets are natural gas gathering and processing assets. These assets have some commodity exposure as cash flows are tied to the price of natural gas or natural gas liquids. Gathering pipelines charge a percent of the value of the natural gas they move, as a result they are long natural gas. While processing plants burn some natural gas (methane) to extract the natural gas liquids (propane, butane, isobutane, etc.), which they keep and sell, processing plants must then purchase the amount of natural gas (methane) they burned during the processing. So processing plants are long natural gas liquids and short natural gas. The pricing of natural gas liquids is highly correlated with oil prices. Midstream MLPs hedge the cash flows of gathering and processing assets with derivatives for what is typically a rolling 3-year period. If gas and oil prices are significantly lower three years from now, these assets will continue to be profitable, as the costs of operation are very low but they will be less profitable than they are today. My favorite pick in this area is Markwest Energy Partners (NYSE: MWE) with a 14.8% yield. Markwest Energy Partners has been guiding for 15% to 20% distribution growth over the next 12 months.
Recently Warren Buffett purchased preferred shares of General Electric and Goldman Sachs that yield 10%. The median Midstream MLP yield is somewhere around 12%. Given their general stability, I view MLPs as better defensive holdings when compared to these two companies. Typically, midstream MLPs retain a portion of the distributable cash flow to ensure stable distributions and most MLPs only distribute between 70% to 90% of their available distributable cash flow to ensure that they have this margin of safety. In addition, it is important to remember that if inflation picks up in the future MLPs may do much better than Buffett's GE or Goldman preferred shares as MLPs have the ability to pass any inflation through to the rates they charge, whereas Buffett's preferred shares have fixed dividends.
So, you are probably asking if midstream MLPs are so stable and defensive why are their yields so high and why have unit prices declined with the rest of the market? Citigroup Global Markets addressed this question in a recent report on October 8. Here is Citigroup's statement on the subject:
This type of volatility in a sector with defensive characteristics leads us to believe that fundamentals and valuations are being completely ignored in the near term as fear and forced liquidations by distressed hedge fund investors seem to be the primary drivers of recent unit price performance.
Wachovia Capital Markets and Lehman Brothers (now owned by Barclays) have also reached the same conclusion. Jim Cramer has also recently recommended Kinder Morgan Energy Partners LP (NYSE: KMP) and Enterprise Products Partners LP (NYSE: EPD) as defensive stocks that pay high dividends in comparison to their underlying asset value. On October 8, Kinder Morgan Energy Partners raised its distribution 3%, suggesting that MLPs truly are defensive investments in difficult times. Here is what the firm's Chairman and CEO Richard Kinder had to say about the business environment.
While no company is 100% immune to external conditions, KMP continues to demonstrate that our diversified portfolio of stable assets is capable of generating consistently strong cash flow even in extremely difficult market conditions.
ONEOK Partners LP (NYSE: OKS), TEPPCO Partners LP (NYSE: TPP), Enterprise Products Partners LP (NYSE: EPD) and Global Partners LP (NYSE: GLP) have all raised their distributions and made similar comments in the past week.
As I write this there have only been five midstream MLPs to announce distributions so far this quarter and all have increased their distributions. In the coming days I expect announcements of distribution increases and similar comments from virtually all midstream MLPs as the economic downturn should have little effect on cash flows in the sector.
Also see this article from Barron's, which suggests some approaches to valuing MLPs that interested parties should consider. One metric is total enterprise value, calculated as the market value of a partnerships equity plus the book value of its debt, divided by earnings before interest, taxes, depreciation and amortization (EBITDA). Such a calculation should be made with a sideways glance at such old-style statistics like debt/equity ratios, interest coverage, and such.
The article also suggests this possibility for those allergic to involved tax-related pencil-pushing:
For individual investors averse to filing the tax forms required annually of MLP owners, another option is owning the MLP general partner, says Timothy Call, chief investment officer at ... Capital Management Corp. Call thinks that demand for U.S. natural-gas pipelines will increase, boosting returns for interstate operators like those controlled by OneOk Partners (OKS). But Call prefers shares of its general partner, OneOk (OKE), the Tulsa, Oklahoma, natural-gas utility with a large stake in OneOk Partners.
The bigger fish, OneOk, buys, transports, stores and distributes natural gas. It yields 6.4%, which is not too shabby, and its shares recently fell to a 52-week low near 26. Despite the gloom in the financial markets, analysts' 2009 earnings estimates are $3.49 a share, giving the stock a price/earnings ratio of just below eight times expected profits.
Another option: exchange-traded MLP funds. Two trade at a discount to their net asset value. The BearLinx Alerian MLP Select Index (BSR) has a 10% yield. The other, the MLP & Strategic Equity Fund (MTP), which holds a basket of energy MLPs and dabbles in forward contracts, yields near 14%.
Of course, even if the stock market stabilizes, sentiment against MLPs could stay negative if oil and gas prices waver. But the partnerships mentioned here look inexpensive, generate steady income and offer upside potential even amid fluctuations in oil and natural-gas prices. And the idea of being paid while waiting for the stock to rise should energize some investors.
Ah yes. Back to the days when current income was a stock investor's first consider and capital gains were icing on the cake.
A FRESH LOOK AT SHIPPING COMPANY STOCKS
Shipping stocks have always been highly volatile, concommitant with their highly volatile profitability. Lately they have been killed, with many falling 50% or more, as the rates shippers obtain have fallen far and fast along with the commodities they transport.
Have any babies been thrown out with the bath water? The author of this article thinks perhaps. Among other considerations, those shippers who have long-term contracts will only feel declining spot rates after a lag. Also, those whose ship portfolios feature oil tankers rather than freighters and container ships have seen lesser rate declines.
Investors who know their way around the industry have some enticing yields to investigate right now. If those yields hold -- big "if" -- the total returns available are noteworthy.
[This article from Wall Street Journal] started me thinking about the ongoing prospects for the shipping related companies I follow. The gist of the article is that container shipping rates have fallen up to 75%, reaching unprofitable levels. The Baltic Dry Index has fallen by 2/3 over the last several months, hitting the bulk shippers. The Claymore/Delta Global Shipping ETF (SEA) has fallen by 50% in the two months since it was launched. The three shipping stocks I follow here have also fallen so I wanted to revisit each and look at the prospects going forward.
First up, oil tanker company Nordic American Tanker (NAT). NAT leases all of its Suezmax tankers on the spot market. The company has kept its expenses very low and pays out virtually all of its free cash flow as quarterly dividends. Dividends fluctuate with the spot tanker rate and vary wildly from quarter to quarter ranging from 40¢ to $1.88 during the last 4 years. Over its 10 year history the dividend has provided a greater than 10% yield. NAT share price has fallen from over $40 in late July to the current $27. The company has given guidance that 3rd quarter dividend will be in the same range as the 2nd quarter's $1.60. Earned Suezmax tanker rates for NAT averaged $64,900 for the 2nd quarter and I calculate rates for Q3 will come in near there. Early October spot rates are still in the $60k per day range, so tanker rates have not fallen like the cargo shipping. Since the future dividends of Nordic American are unpredictable, I consider this stock an accumulate proposition when share prices fall.
Ship Finance International (SFL) has exposure to both the dry bulk and container shipping sectors. Of the current 73 ships in the company's fleet, 11 are dry bulk and 13 are container vessels. These ships account for 14% of the asset value of Ship Finance. Over 80% of SFL's revenues are derived from their oil tankers and offshore vessels. Ship Finance leases their vessels to shipping companies on long term, bare boat leases. They get the first dollars their ships earn and should continue to get their lease payments unless one of their customers goes completely under.
For the 2nd quarter, SFL had $1.57 in free cash flow to easily cover their 58¢ dividend. About $1.20 of the cash flow is from their long term leases and the balance is from the profit sharing agreement with Frontline (FRO). A recently announced deal to buy and lease back a pair of deep sea drilling rigs with SeaDrill will add an additional 90¢ per quarter starting Q2, 2009. I believe the current 16% dividend is secure and will grow over the next several quarters. The only problem I foresee is possible difficulty obtaining financing for future deals. The graphic below shows the different banks that Ship Finance does business with and we are all guessing as to when access to additional funds for companies like SFL will be possible. Please note, they are in no need of any additional financing at this time. I think SFL is a great value at the current share price.
Star Bulk Carriers (SBLK) is a much more speculative pick in this sector. Star Bulk is a year-old start up with a fleet of 12 bulk carriers. The company plans to keep all of their vessels on longer term contract and are currently booked 90% through 2009 and 60% through 2010. The current 35¢ quarterly dividend appears to be well covered by earnings. Of course, any kind of hiccup in their contracts would kill this company's cash flow. If earnings have been maintained when the 3rd quarter results are announced, the current stock price is going to look like a great value. This is a high risk opportunity that may end up with a 24% yield plus stock price appreciation if the company's contracts are solid.
SFL and NAT are components of my site's Income Portfolio. NAT and SBLK are included in the Opportunities Portfolio. These portfolios are for the hypothetical tracking of stocks I am interested in.
Baltic Dry Shipping Collapses
Mike "Mish" Shedlock uses the decline in shipping rates -- the Baltic Dry Shipping Index has fallen 80% this year -- as a convenient stepping off point for a discussion of rapidly declining aggregate economic activity, prudent bank lending practices, and the consequences of credit bubbles.
The Baltic Dry Shipping Index covers dry bulk shipping rates and some view it as a proxy for general economic health. The index continues to collapse. Notice that the indicator is back at levels not seen since 2005 and is below levels seen in 2004.
Bloomberg is reporting "Shipping Lines Say Tight Credit Cutting World Trade":
Pacific Basin Shipping Ltd., Hong Kong's biggest dry-bulk carrier, and Precious Shipping Pcl. said demand for moving coal, iron ore and other commodities will fall because banks are guaranteeing fewer loads.
"Letters of credit and the credit lines for trade currently are frozen," Khalid Hashim, managing director of Precious Shipping, Thailand's second-largest shipping company, said in Singapore yesterday. "Nothing is moving because the trader does not want to take the risk of putting cargo on the boat and finding that nobody can pay."
Khalid Hashim has this backwards. Nothing is moving because demand is falling like a rock. Who in their right mind is not cutting back production in the face of the biggest consumer led recession in history?
The lack of letters of credit, in which banks guarantee payment for merchandise, could become a "big issue" for world trade, according to Klaus Nyborg, Deputy Chief Executive Officer at Pacific Basin. Tighter credit has contributed to this year's 80% drop in the Baltic Dry Index, a measure of commodity-shipping costs. About 90% of world trade moves by sea.
The Baltic Dry Index dropped 8.5% to 1,809 points yesterday, the lowest since August 2005. Pacific Basin dropped 6.5% to HK$4.75 in Hong Kong and Precious Shipping declined 5.5% to 12.1 baht in Bangkok.
Banks worldwide have curbed lending because of increased concerns about getting their money back. Shipowners are already struggling to obtain funding for new vessels. Precious Shipping took as long as 15 months to secure financing for 18 vessels it has on order, Hashim said.
Those lending who are not extremely concerned about getting their money back are the precisely the ones who will not get their money back.
The maritime sector needs about $300 billion over the next three to four years to fund construction of vessels that are already on order, according to Nordea Bank Finland Plc. At least a quarter of container ships, dry-bulk vessels and oil tankers on order are not financed, according to Seaspan Corp., the Hong Kong-based ship lessor.
The shipping sector is transitioning from huge undercapacity to overcapacity just as housing did in 2005. That is why rates are falling.
Note that the apparent shipping undercapacity was actually a mirage predicated on easy monetary policy by central banks, fueled by insanely low lending standards by banks. Artificial crack-up booms create the illusion of shortages and malinvestment of capital is always the final result. The new supply of ships is coming out at exactly the wrong time is proof.
Swings in the London interbank offered rate, which lenders typically use as a base for writing new loans, have made it difficult to decide what price to charge new customers.
"The banks cannot fund at Libor rates at the moment," said Keishi Iwamoto, head of shipping for Asia at Sumitomo Mitsui Banking Corp. "The question is how do we tackle the additional costs for lenders."
German banks with funds to lend are offering about 200 basis points above Libor, double previous rates, while in Singapore the rate is plus-350 points, according to Tobias Koenig, managing partner of Koenig & Cie. In the main though, shipping lines are not able to borrow, he added.
"There is no rate because all banks are closed for business," he said. "You have a few banks rescuing their best customers, but that is it."
"There is no rate because all banks are closed for business."
The smart banks should be closed for new business. I am sure there are some exceptions in medical businesses, bankruptcy related businesses, or small niche markets in other places, but for the most part, Compelling Banks To Lend At Bazooka Point is exactly the wrong thing to do.
The U.S. is in a recession, consumers are cutting back discretionary spending, there is rampant overcapacity in every sector but energy, and there is no reason to go on a lending spree. Furthermore, there is no reason for any qualified buyer to want to borrow. Why would any responsible party want to expand in this environment? The only people who want to borrow significant sums of money now are the very people banks should not want to lend to. Thus the best thing banks can do with that money is sit on it.
The Other Economy: The Farmer
There are some pockets of strength in the U.S. economy, and the farm sector is one of them, recent major corrections in grain prices notwithstanding.
The heartlands are thriving. Ryan Christopherson, 37, a former Navy fighter pilot who runs a 5,000-acre farm in western Minnesota, is not easily rattled by recent swings in commodity prices. "I don't get too wrapped up around the axle," he says colloquially. If you watch the markets too closely, "you will go nuts or you won't get any work done. Then you will have nothing to sell." Right now there is lots of money to be made in farming. Global demand for food, as well as for corn and other feedstocks used to make ethanol, mean boom times for farmers.
Rich farms mean rich sales for farm equipment manufacturers. Christopherson recently spent a total of $840,000 on three Challenger tractors made by Agco, a Duluth, Georgia successor to the Allis-Chalmers farm equipment brand.
"The strength of the farm economy has us very optimistic about our results," says Gregory Peterson, a spokesman at Agco, which began in 1990 as a management buyout. The company expects to net $360 million on sales of $8.6 billion this year, up from $6.8 billion in 2007. The credit crunch is not a big worry for Agco or its dealers and customers, he says. Agco Finance, which finances sales to farmers, gets its capital not from the commercial paper market but from interbank borrowing, via a joint venture with Dutch Rabobank.
Caterpillar (CAT) distributors who sell Challenger machines for Agco are happy, too. "We had a real strong September -- sales were up 20% over last year," says David Walter, vice president of agriculture sales for Ziegler Cat, which sold Christopherson his tractors. Some dark clouds on the horizon: a slowdown in China and higher costs on things like rent, seed and fertilizer. But Walter's biggest challenge now is getting enough combines, tillage and hay equipment to meet demand in his region, which includes Minnesota, Wisconsin and most of Iowa. Not a bad problem to have.
Convinced the economy's tanking? That is good news for some stocks. At Hormel Foods (HRL), sales of that perennial dollar-stretcher Spam have spiked this year.
Avon (AVP) is another possibility. "If you have lost your job, it is easy to be an Avon lady," says Wendy Nicholson, an analyst at Citigroup. "It actually works out to be countercyclical."
Even TV comic Stephen Colbert is thinking about recession investing. He recently suggested buying soupmaker Campbell (CPB). "It is a good time to be selling meals that cost 89 cents," he said. At 13 times earnings Campbell is not a bad buy. Here are some other cheapskate investments.
The article table lists American Electric Power (AEP), pawnshop chain Ezcorp (EZPW), Family Dollar Stores (FDO), and Ralcorp (RAH), as well as those already mentioned.
Hedge Fund Castoffs
The scales are falling off the eyes of hedge fund investors as they realize that calling a money management firm a hedge fund does not endow it with magical powers. Most are just mutual funds with an extravagant management fee schedules.
The major market downdraft has led to led to hedge fund withdrawls by investors and a consequent forced selling of holdings. This little Forbes piece shows the results of a screen that attempts to discover which stocks might fall more than is justified due to being widely owned by hedge funds.
The credit crunch is turning into a death spiral for a lot of small hedge funds. As the funds' returns suffer, investors pull out money, banks demand more collateral and hedge funds are forced to unload securities at fire-sale prices.
Good stocks get trampled in the stampede -- leaving the little guy a rare chance to profit at the expense of the "smart money" crowd.
Below is a table of stocks screened for four criteria: high concentrations of hedge-fund owners as of June 30, before the selling frenzy began; share prices that have fallen more than industry averages; positive swings in earnings estimates; and low prices relative to earnings growth. A possible added bonus is the likelihood that, should conditions recover, hedge funds will flock back to many of their former favorites.
Real estate has investors spooked. Time to hunt for cheap REITs.
A small story we recall reading long, long ago was that after a major selloff in the stock market a young trade bumped into a veteran trader. "Rough day, wasn't it?", said the young trader. "Not for the buyers," said the veteran.
Now is a tough time in general to be selling real estate, which means it is a good time for buying -- for those that are buying. REITs with low leverage, no large amounts of maturing debt, with a recession-resistant portfolio of properties, and with good, secure yields are buy candidates. Here are a few.
With bank credit getting crunched, this might seem like the worst of times to buy shares of real estate investment trusts. REITs, after all, depend on bank loans to fund new office buildings, malls and apartment houses.
There are some gems out there, however, with low leverage (liabilities as a percentage of assets) and no looming debt maturing. Equity Residential (EQR) has one of the sector's strongest balance sheets and recently secured a $550 million loan from untroubled Wells Fargo, at 6% interest. The REIT need not worry about paying it back for 11 years. Equity also boasts $145 million in cash and a low 45% ratio of debt to total assets.
The Chicago company owns apartments in New York, Los Angeles and Seattle. It is no more injured by the housing crisis than a duck is by water. "More people are staying put in apartments," says Craig Leupold, president of real estate research firm Green Street Advisors.
Washington REIT (WRIT) owns offices in and around the nation's capital. Demand for space in the District is strong and will only get stronger if the government's financial crisis management leads to further hiring. The REIT raised $98 million in equity last month and has a $260 million line of credit. Green Street believes Washington will use the money to pick up distressed D.C.-area assets.
Kimco Realty (KIM)'s strip malls are mostly filled with drugstores, pizza parlors and the like and should hold up well in a downturn. The REIT generates nearly half of its earnings from activities like managing properties for pension funds.
What is not to like? Colonial Properties boasts an 11.5% dividend but carries 60% leverage and has had to sell $200 million worth of buildings since January to raise cash. That fat dividend will not last. General Growth Properties owns high-end malls in troubled places like Las Vegas and has piled up debt building new malls. Its shares have fallen 87% from a 52-week high to $7.59. Still no bargain, says Leupold.
The Rich Get Poorer – Except Buffett
Forbes charts the declining net worths of certain billionaire members of "The Forbes 400" richest people.
September was a rough month for people with large portfolios. Since we locked in prices for our annual survey of America's richest in late August, 17 of the plutocrats have lost more than $1 billion. The biggest loser: casino mogul Sheldon Adelson, who shed $4 billion in September -- on top of $13 billion lost between August 2007 and 2008 -- as his shares of Las Vegas Sands (LVS) fell 34% during that month (and have fallen even further since). The big winner: Warren Buffett, whose shares of Berkshire Hathaway (BRK) rose 17% last month, adding $8 billion to his fortune. Bill Gates lost $1.5 billion in the same period, putting the Oracle of Omaha comfortably in first place on The Forbes 400.
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