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ROCKY ROAD (BARRON’S ROUNDTABLE PART 2)
Bill Gross, Felix Zulauf, Archie MacAllaster and Abby Cohen take center stage to promote their investment picks and pans for 2008.
Part 2 of the Barron’s annual Roundtable features several well-known market pundits and some less well-known veteran Roundtable stalwarts, and picks up where Part 1 left off.
Are we there yet? Are we there yet? “There,” in case you are wondering, is a genuine stock-market bottom, not a temporary low before the next tsunami of selling. It is the point (and price) at which it is safe to jump back in the market, with plans to stick around for a while. And no, we are not there yet, not by a long shot after the unprecedented events of the past year, say the wise men and women of Barron’s 2009 Roundtable.
Yet, attractive investments – and trading ideas – surface even in grizzly bear markets, and our panelists have found quite a few. As usual, they were eager to share them, along with their typically trenchant views about the economy and financial markets, when the Roundtable convened Jan. 5. In this week’s installment, the second of three, we’re pleased to pass along the picks, pans and prophecies of Bill Gross, Archie MacAllaster, Felix Zulauf and Abby Cohen, along with observations from the rest of the crew.
Bill, founder and co-chief investment officer of Pimco, needs no introduction, but here goes: He is only one of the most influential guys in the bond market, give or take a Fed chairman or two. So, when he says something is the most “incredible” or “remarkable” thing he has seen in all his years in the business, as he does several times in the pages ahead, you had best sit up and take notice. Bill hopes to exploit today’s stranger-than-fiction anomalies by investing alongside Uncle Sam in bank preferred shares. He is also a fan of TIPS.
Archie, head of MacAllaster, Pitfield, McKay, should be classified as an endangered species. After all, the man says he is an optimist about stocks. Archie, who knows his way around financials like no one, and around bear markets, too, sees dirt-cheap bargains everywhere. He is especially keen on the prospects for Hartford Financial, Franklin Resources and Delta Air Lines.
When Felix talks, everything should sit up and listen. His 2008 Roundtable picks ... made him and all who took his advice a bundle. For better or worse, his bearish macro forecast also came to pass. As founder and head of Zulauf Asset Management in Switzerland, Felix sees the forest and the trees. What he does not see is a quick resolution to the problems bedeviling the global economy and financial markets, which is why he is sticking with gold.
Abby changed hats about a year ago at Goldman Sachs, but it is what is under the hat that matters. No change there – just the usual triple-A-rated mind (in this case, the rating means something), and an enviable eye for financial facts and figures. This year Abby has got a keen interest in interest, which leads her to a trio of high-yielding corporate bonds and a utility, among other stocks culled from the list of those recommended by Goldman’s analysts.
So, buckle up, and read on.
Barron’s: What grabs you in the bond market, Bill?
Gross: The government has issued hundreds of billions of dollars of Treasuries, but with yields of 2.5% on 10-year bonds and 0.8% on 2-years, who wants to buy them? The market is beginning to address that question. Treasuries do not make sense at these levels. It will be at least 2010 before we see a hint of the Fed moving interest rates higher, simply because they are aware of the Japanese experience. They know the Japanese raised rates prematurely [after Japan’s economy went into a tailspin in the 1990s].
Because of their low yields, government bonds are a trap. First the government lowers interest rates to the point where the investor receives a negative real return. That is where we are now. Second, the principal is depreciated through inflation. That is a hidden tax. The combination takes away any advantage Treasury bonds have, except under a deflationary scenario.
This crowd seems a lot more worried about inflation.
Gross: There is a 10% possibility that government policy will not work and the U.S. will experience deflation à la the 1930s. That is not our prediction but it is more than a thin tail [low probability]. In that circumstance, long-term Treasuries yielding 3%-plus might make some sense.
Schafer: Doesn’t a little inflation help us out of the current mess?
Gross: The entire capitalist system is based on a little inflation. A little, but not a lot.
Zulauf: How do German government bonds compare with Treasuries?
Gross: They are monitored by the ECB [European Central Bank], and inflation in Euro-land looks to be lower. If you had to buy government bonds, you would want German bunds over U.S. Treasuries.
The cost of insuring the U.S. Treasury against default has been rising. Is this just a hedge-fund game, or does it mean we are a worse credit than, say, Germany?
Gross: We are a worse credit than Germany, and at least a few other countries. That said, the CDS [credit-default-swap] market in Treasuries is relatively illiquid, and an anomaly. Countries default in a number of ways. They default by inflation. They default by devaluation, and, yes, sometimes they default and do not pay their coupons. But to go the third route through actual default would be a “black swan” [extremely rare and unpredictable]. It will not happen in my generation.
Faber: From whom would you buy such credit-default swaps? If the U.S. government goes bust, the sellers of such swaps would go bust, too.
Black: Bill, it is one thing when the Treasury prints money and issues bonds. It is another when the Federal Reserve expands its balance sheet from $750 billion to $2.2 trillion. Is this a ticking time bomb?
Gross: The Fed is expanding its balance sheet because the private sector is contracting its balance sheet. If it is one for one, it is not a problem. The Fed is trying to gauge how much is disappearing, versus how much should be put into the system, which is difficult.
Zulauf: How far can they go? Ireland has guaranteed its whole banking system, which is five times GDP [gross domestic product], and in a currency [the euro] over which it does not even have sovereignty.
Gross: Ireland and Iceland are examples of economies that have gone too far. The U.S. has had the benefit of being the world’s reserve currency. How much longer can we abuse it? Probably not too much longer. If asset reflation works and the real U.S economy kicks back into gear, the dollar can hang on. If it does not work, it is a new ballgame. Perhaps the biggest question for the next few years is whether the dollar can hang onto its reserve-currency status.
Cohen: This is a function not just of the dollar but of the currencies that might be able to step in. One thing that has disappointed but not surprised many people is how long it has taken for the euro to assume a larger role as a reserve currency.
Gross: In Asia the yen cannot take the mantle because China eventually will be the dominant economy. But it is not ready financially.
Zulauf: The euro has problems. The eurozone is not a homogenous economic bloc. There are weak economies and structurally strong ones, and stress in the system. It is questionable whether the euro can survive in its current form long term. There may need to be a euro A and a euro B.
Cohen: We talked this morning about the state of the U.S. banking system. The European banking system by many measures started out in a much more levered state, and still is much more levered than the U.S.
Zulauf: European banks have approximately one-third less equity capital than U.S. banks. In general, the banking system in the industrialized world is still fragile, and not equipped to handle what is ahead in corporate defaults and loan write-offs.
MacAllaster: Bill, what is your view of the quality of the assets the Fed is taking on? A lot depends on whether the government will get anything back when it tries to sell these assets.
Gross: Up until this point the government has been buying primarily triple-A-rated paper. Its plan to start financing asset-backed securities such as student loans and credit-card receivables theoretically and technically will involve triple-A assets. I am skeptical that every triple-A-rated assets is in fact triple-A in quality. The Fed, though, is very careful and not likely to make mistakes in this area.
Zulauf: The Fed may go down the ladder and buy lower-quality assets.
Gross: [Federal Reserve Chairman Ben] Bernanke made that clear in 2002 with his helicopter speech, in which he said the Fed would be willing to buy almost anything in order to prevent deflation and support the economy.
Hickey: Has Pimco detected any reticence among governments in the Middle East and Asia about continuing to buy U.S. Treasury bonds at these low rates?
Gross: No. There is a reticence to take risks, including an unwillingness to buy even mortgages backed by U.S. government agencies like Fannie Mae and Freddie Mac. There is an anathema toward corporate bonds. Foreign central banks and others do not want any part of risk.
Hickey: Are they losing faith in the U.S.?
Gross: They recognize markets here are illiquid, and there is a possibility, be it 5% or 10%, that not just the U.S. but the global economy will enter a mini-depression. Isn’t that what you see, Abby?
Cohen: Between January and October 2008, total foreign holdings of U.S. Treasury securities rose from $2.4 trillion to more than $3 trillion. The most significant change by country had to do with the U.K., where Treasury ownership rose to almost 12% of the total from 6.7%. The additional purchases came from two types of buyers: petroleum-producing nations whose investment offices are based in London, and global asset allocators who manage money for pension plans and others whose security of choice in recent months has been U.S. Treasuries.
Zulauf: The $600 billion increase is just about equal to the U.S. external-account deficit for that period, so it means foreigners recycled those dollars into the U.S. Treasury market.
Didn’t risk-aversion peak in late November?
Gross: It did, as evidenced by stocks, credit spreads, oil and currencies. But that is not to say it peaked for foreign central banks and foreign investors. They continued to buy Treasuries and forced them to overvalued levels.
The bond strategy we have followed for the past 12 to 18 months is to go where the government goes in terms of its purchasing power. The government is going to buy $500 billion in the next six months of the $3 trillion in agency mortgages outstanding. We have been buying agency mortgages. Through the TARP [Troubled Assets Relief Program], the government has bought several hundred billion dollars of preferred stocks and attached equity warrants. The Treasury has accepted a 5% coupon on the preferred. Treasury Secretary Hank Paulson has decided 5% is a decent compensation for bank preferred, but the private market affords 11%, 12%, 13% yields on the same bank preferred stocks, which is remarkable. We are buying bank preferreds.
As for specific names, the best example of partnering with the government in the bond market is the case of AIG. Some of us might agree it was a mistake for the government to bail them out, but it happened. The Treasury basically has taken $60 billion of troubled assets off AIG’s books and extended it a $50 billion credit line. It has extended a commercial-paper program to one of its major subsidiaries, International Lease Finance, worth another $2.5 billion. The government has given or guaranteed AIG close to $200 billion. The outstanding debt of the United States is $10 trillion, so 2% of everything the U.S. government has issued has gone to AIG. But here is the most incredible thing.
You mean, that was not it?
Gross: In the past three months, AIG bonds that are senior to the Treasury’s $40 billion in preferred could be bought at 14%, 15%, 16% yields. You can buy them now at 11% and 12%, under the cover of nearly $200 billion of guarantees, or 2% of the outstanding debt of the U.S. Normally you cannot have a bond yielding 14% without significant potential to default. It is the most incredible example of value I have ever seen in the bond market. AIG has a 10-year bond that can still be bought at 12.5%. Technically it is A-rated, but realistically it is close to triple-A. We own a lot of them.
My next pick is Treasury Inflation-Protected Securities, or TIPS. Here is an example of deleveraging at work. Theoretically TIPS should have performed like Treasury bonds. Instead they went down in price while Treasuries have been going up. TIPS now sport real yields of 2.5% in an economy that is growing nowhere close to that. And that is before you tack on the inflation kicker. [The principal of a TIPS increases with inflation and decreases with deflation, as defined by the consumer-price index. TIPS also pay interest twice a year, at a fixed rate applied to the adjusted principal.] When an economy deleverages, almost every asset goes down. As Abby discussed this morning, hedge funds, levered institutions, sold what they could when they had to raise funds. TIPS were the most liquid thing in many levered portfolios, and the hedge funds have been spitting them out billions of dollars at a time. Yet, the potential for inflation five to 10 years from now is high. You can buy TIPS via the iShares Barclays TIPS Bond ETF [exchange-traded fund].
Maybe the problem with TIPS was marketing. They were sold as an inflation hedge. If inflation no longer is a problem, people feel they do not need them.
Gross: But they are getting the inflation insurance for free. That is the opportunity. Nothing is totally safe from the ravages of inflation or deflation. In a deflationary environment TIPS are not going to work. Pimco will be a substantial buyer of TIPS in the next few months. There are few more attractive investment alternatives, except for municipal bonds. You can get a double-A-rated muni bond these days that yields almost twice as much as Treasuries.
Schafer: TIPS will not pay off for a number of years under your scenario.
Gross: That is not true. The big payoff comes in the next six months if this deleveraging cycle is halted and asset managers are reliquefied. TIPS bottomed in November. They are a risk asset without much risk. They can go up 10% or 20% in price simply on the basis of optimism that deflation has been averted.
Cohen: TIPS do not have the issuer risk associated with municipal securities. So, while municipals look appealing, there are concerns related to the budget problems of specific state and local governments.
Gross: Pimco is not a fan of the high-yield market. It is a little early to be buying high-yield bonds. Defaults are on the rise, but in recent months our closed-end funds, and others’, have been subject to selling and to regulations that force such funds to delever. If assets fall by 20% or 30%, closed-end funds that typically are levered by 50% have to delever. Several Pimco funds, including Pimco High Income, were forced to suspend dividends for a month, which sent a confusing signal to the market that something was wrong. We had to reduce leverage somewhat by paying off adjustable-rate preferreds. The dividend suspension was a temporary regulatory fix.
Gabelli: You did not need to build up capital. You had to reduce leverage.
Gross: Exactly. No one should have a favorite child, but this fund was my, and our high-yield desk’s, focus every morning. It is not a high-yield fund any more; 40% of its assets are high-yield, but 60% are investment-grade. Yet, while junk-bond funds in general yield 14%, the Pimco High Income Fund yields 23%.
Schafer: When it pays the dividend.
Gross: The fund sells for about net asset value. It has doubled in the past month, so somebody sees something. It has about $1 billion in assets. It is about as good a deal as any in the bond market today.
Bill Gross’s Picks Company 1-2-2009 Price 1-2-2009 Yield Preferred stock issued by banks AIG 8.25%,due Aug. 15, 2018 $75.91 12.6% iShares Barclays TIPS Bond ETF (TIP) $97.38 6.3% Pimco High Income Fund (PHK) $6.16 23.4% Source: Bloomberg
What is the status of Pimco’s closed-end municipal-bond funds that ran afoul of regulations? Have dividend payments been restored?
Gross: We hope to restore them quickly. It is a matter of ensuring leverage is in line with the rules. The muni market is doing better since late November. Munis are another non-risky asset that investors sold because they had to. Given the fiscal problems state and local governments face, there may be a bailout for munis. When you see a single-A or double-A-rated California muni yielding 6% to 7%, you should anticipate Uncle Sam will bail out Dear Arnold [Schwarzenegger, governor of California]. We might not support bailouts philosophically, but as Bob Dylan said, you have to know which way the wind is blowing. We have been buying munis for several months.
As an aside, the size of government programs to date is staggering. The FDIC [Federal Deposit Insurance Corp.] will now insure bank deposits up to $250,000 [through December 31], versus a previous $100,000. People assume that is where it stops, but it does not. The FDIC has guaranteed many more liabilities of the banking system through a program called TLGP, which extends the insurance temporarily, at least to checking accounts. In addition, there is the TARP, which guarantees a significant portion of the equity capital of banks. The banking system in effect has been nationalized. If you can buy a corporate bond issued by a bank at a 5% or 6% yield, as opposed to a Treasury bond that yields 1% or 2%, you have got a good deal. If you can buy bank preferred shares that yield 11%, 12%, 13%, you have got an even better deal. Hopefully, the government will have an exit strategy.
Agreed, and thanks. ... Archie, your turn.
MacAllaster: I am an optimist about the stock market. There are not many of us. It is going to be slow going, but bargains are out there. If you can find them, you may do well. I have a few, starting with Franklin Resources, another California money manager. The stock is 66, about 50% below its high for the past year, 133. The low was 45.50. The company pays a dividend of 84 cents a share, and yields 1.3%. It has about $4 billion of net cash, equal to $15 to $17 a share. Total book value is $30 a share; cash is half of that, or more. Franklin, which manages mutual funds, bought up Templeton and Mutual Shares, and seems ready to buy other assets, which are cheap right now. Over the years the company has bought in a lot of stock. They have indicated they will not be buying in so many shares in the future, which tells me they are going to use their money to buy assets.
Templeton invests mostly in foreign equities. Mutual Shares invests in U.S. equities, and the original business was primarily tax-exempt investments in the U.S. In the fiscal year ended September, it earned $6.68 a share. Like other fund companies, it has had redemptions. It has $450 billion or $460 billion of assets under management, down $50 billion or $60 billion on the year. Therefore, earnings could be lower this year, at perhaps $4.75 to $5 a share.
With people exiting mutual funds in droves, is this not a bit like buying straw hats in winter?
MacAllaster: My view is long-term. Franklin’s success goes back a long way. This year the company will earn less than last year, and it may earn less next year, too. But it is going to end up a much bigger company because it will use its cash to buy assets. In two years it will be making more money than ever before. And remember, the stock was as high as 133 last year.
That does not mean anything. Everything was higher last year. The important thing is where it is going.
MacAllaster: It is going higher. My second stock is Supervalu. It closed Friday [January 2] at 14.88. The 12-month range has been 35.91 to 8.59. The company runs both wholesale and retail grocery operations. They have got the 3rd-largest grocery chain in the U.S., after Wal-Mart Stores and Kroger. Supervalu pays a dividend of 69 cents and yields 4%-plus. Book value per share is $29, just about double the stock price. [The company wrote down goodwill and intangible assets when it reported earnings January 7. Book value is now around $16 a share.] Sales are flat to down in retail and positive in wholesale. Earnings were $2.76 a share in fiscal 2008, ended February, and should be about $2.75 for fiscal 2009. The stock sells for five times earnings. Debt is high due to the purchase of the Albertsons grocery chain in 2006, but the company has been paying down between $400 million and $500 million a year. [It announced January 7 that it would pay down $600 million in fiscal 2010.] Sales are about $45 billion.
My third stock is Williams Cos., which produces and transports natural gas. The stock sells for 15.23. Once again, the range is 40.75 to 11.69. The dividend is 44 cents a year for a yield of 3%. They have raised the dividend in each of the past four or five years. Book value is about $15 a share, so the stock sells right around book. The company earned $1.40 a share in 2007. Last year’s earnings have not been announced yet but should be around $2.25 a share. This year they will earn somewhat less – $2 a share – in view of the lower price of gas. But Williams has hedged a lot of its gas production, so its average selling price will be more than $7 per thousand cubic feet. Gas sells now for $5.50.
Where is their natural gas?
MacAllaster: All through the West. Natural gas is the place to be in energy production. It is clean. It is domestic. It is cheaper than oil, and it looks like we will use all the natural gas we can find in this country. Williams sells for about seven times earnings. The company raises its dividend every year. I suspect they will raise it by a penny a share this year. In the past two or three years Williams has increased reserves by 20% to 22%. The balance sheet is strong, with debt down from $12 billion to about $7 billion, a 40% drop over five years. They have about $1.1 billion of cash and equivalents.
Next, Hartford Financial Services. It was trading for 17.09 Friday [January 2]. The range has been 85.11 to 4.16. How about that? The yield is a little under 8%. Book value is $41 a share. Earnings in 2007 were $8.25 a share. Recently Hartford raised its 2008 earnings estimate to $4.70 to $4.90 from about $4.30 to $4.50. I think they will make better than $5 and maybe $6 a share in 2009. The company has given itself all kinds of flexibility.
MacAllaster: They raised a couple of billion dollars in Europe. They bought a savings bank in Florida. They got some money from the TARP. They will not have any financing problems. Hartford will be 200 years old in 2010. It has $350 billion of assets, and in five or 10 years will have a much bigger net worth than today. Meanwhile, you are buying it around four times earnings.
Archie MacAllaster’s Picks Company Ticker 1-2-2009 Price Franklin Resources BEN $66.60 Supervalu SVU 14.88 Williams Cos. WMB 15.23 Hartford Financial Services HIG 17.09 Delta Air Lines DAL 12.13 MetLife MET 35.97 Prudential Financial PRU 30.77 Source: Bloomberg
Delta Air Lines, my next pick, trades for 12.13. The range is 18.99 to 4. After merging with Northwest in 2008, it became the largest U.S. carrier. It is fresh out of bankruptcy court with a relatively clean balance sheet and about $35 billion of revenue. It is a speculation on continued low fuel prices. Delta should produce earnings of as much as $2-plus in 2009. Some energy hedges are working against it now, and in the last quarter of 2008, but that will end. In the next two or three years Delta could earn much more than $2 a share. Cash flow next year could be about $4 billion. The only thing is, if you are a long-term investor in airlines, you are bankrupt, so you have to buy this carefully.
Black: As Warren Buffett said, the Wright Brothers destroyed more capital than communism.
MacAllaster: Here are some one-liners: MetLife and Prudential Financial. MetLife is 36 a share; the range is 65 to 15. It yields a bit over 2%. Book value is $42 a share. The company raises the dividend every year. Any time you can buy MetLife under book value, you should.
Prudential is somewhat more speculative. It sells for 30.77. The range on the stock has been 92 to 13. Book is about $44 a share. Earnings for 2008 are estimated to be $3.50 a share. In 2009 they could earn as much as $7. The dividend yield is 2%. In a few years this company, too, will be worth more.
Thank you, Archie. Felix?
Zulauf: Last year saw the most severe bear-market decline since 1931. The instant reaction is to be bullish after such a decline, but the situation is more complex. The watershed events of 2007 and 2008 lead to a different world in many ways. The household sector is traumatized by a 20% drop in net worth, as the worst year prior to this saw a loss of just 5%. The corporate sector is traumatized by a slump in earnings, and refinancing problems. Thus, everyone will turn more cautious, not just for 12 months but several years. Deleveraging is a structural process, not a short-term process.
Fiscal policy and other interventions may stabilize the economy later in the year and into 2010, but economic growth will be anemic and disappointingly low once things start to improve. Less leverage means lower growth, lower profit margins, a lower return on equity, lower valuations and such. But the market is slow at pricing that in. During the energy crisis of the 1970s, it took the market six years to stop extrapolating 6% annual growth and get in line with reality.
We are still in a secular bear market that started in 2000 in the industrialized economies. It has several more years to run. This is a transition year after the first slump, and we will see some corrections to the upside.
We have just seen one.
Zulauf: The current rally will peter out sometime in the first quarter. It is the Obama hope rally. Obama is dangerous for the market in the sense that expectations that he can change the world are too high. He is a charismatic person, but a charismatic person with no track record. Eventually the market will grow disappointed that he cannot change things as quickly and to the degree people hope.
The market will have a setback after this rally ends, with the next rally starting sometime in the second quarter. It will be more powerful and a bit more sustainable because some of the economic numbers will show positive momentum, and it will start from a new low. But you cannot buy and hold equities for the long term. Investors will turn away from equities. They are fed up with negative returns over 10 years. In that period, as I said earlier today, risk was high and perceived risk was low. Now risk will be low, due in part to support from the world’s central banks. But investors will perceive risk as high, and price financial assets accordingly.
Witmer: They already have.
Zulauf: In a few years’ time there will be some fantastic long-term buying opportunities, but we are not there yet. The Standard & Poor’s 500 easily could fall into the 400 to 600 range over 2010-11, after a bounce that takes it to 1,050 or so. But the upside is limited because the fundamentals are not there.
Gabelli: So it is up 10% and down 50%.
Falling oil prices are central to what has happened in the markets, if not the economy. You are a commodities man in some ways. Where do you think oil is headed?
Zulauf: The price of oil has tumbled much more than I expected. I thought it might be cut in half in this cycle, which would have meant a price of around $75 a barrel, not $35-$40. Oil will bump along around $40 for a while, with rallies up to $70 or so. It will build a range for some years, until demand and supply get back into balance. So far, producers are behind in adjusting production to weak demand. Buy oil for a trade but not for an investment. Lower oil prices are one of the big pluses in the economic equation, because consumers will pay less for gasoline and fuel.
Is OPEC pretty much out of the picture?
Zulauf: It is cutting back. There was a struggle within OPEC [the Organization of Petroleum Exporting Countries]. The Russians did not behave as the Saudis wanted. The Iranians did not behave as the Saudis wanted. Now the Saudis are playing hardball with other OPEC members. But OPEC, as announced, will cut production. It is not interested in having oil prices get too low or too high. It thinks a price of $60 a barrel or so is reasonable.
Gross: We always root for lower oil prices because they restore consumer purchasing power. But cheap oil also impacts oil-producing nations and the global economy.
Zulauf: It plays havoc with their budgets. The boom in the Middle East is over. Government finances in the region will go into deficit. These are not politically stable countries. A large part of the population in the region is dependent on government finances. A drop in oil prices could further destabilize the Middle East.
Cohen: Is there a policing mechanism to make sure OPEC members cut production? So far, it has not worked.
Zulauf: Swing producers like the Saudis can cut back as they bring other OPEC producers in line. But it takes time to cut production by three million or four million barrels.
Faber: Some people say they have to cut by seven million barrels.
Gabelli: Either way you have a demand problem, even as oil companies have invested in new production. Petrobras [ Petroleo Brasileiro ] has spent hugely on its new field off Brazil.
Zulauf: At current oil prices, you can forget it. A lot of projects around the world have been postponed or canceled altogether, and that’s true in all commodities markets, including metals.
Gross: Does extracting oil from tar sands make economic sense, with oil at $45?
Zulauf: You need a price of $60. Getting back to equities, dividends will be cut in the next few years, but dividend yields will be higher than today, despite the cuts.
Zulauf: Investors should keep their powder dry. Sit in fixed income. Buy five-year investment-grade corporate bonds in less-risky industries that service daily necessities, such as telecoms, oil and food, and blend them with medium-term government bonds. Check company balance sheets. I would not buy long-term government bonds, except maybe German bonds. My one recommendation for the longer term is physical gold. Consider the basic set-up: World economies are so weak that we are seeing government stimulation of historic proportions. At first this is deflationary, but it will become inflationary. Gold is the only currency that will not get devalued. It will be revalued.
If the Fed’s liabilities had to be covered in gold, it would sell for more than $6,000 an ounce. We are not going back to the gold standard, but the markets will not trust the central banks anymore. Gold is in a very slow bull market. The year-end price has been higher each year since 2001. The gold market could have a shakeout in the next six months, and the price could fall back to $700 an ounce or below from today’s $850. But two years from now it will be a lot higher. It is one of the few commodities that held up during the forced liquidation of almost everything else. We have talked about the risk of currency devaluation. If you were a citizen of Iceland and your currency went down by 50%, consider how gold performed in your currency. Gold functions as a protection against your central bank doing stupid things.
Schafer: Did gold hold up because it was not a part of leveraged structures?
Zulauf: To some degree. You do not own it in a leveraged way. It was helped by the forced liquidation of other things. There was some forced liquidation of Comex futures contracts, but at the same time there was a massive move into physical gold. Gold will stay in a bull market. It cannot be manipulated like a currency you can keep printing.
What about central-bank sales of gold?
Zulauf: You can sell it, but unlike a currency, you cannot make it out of thin air. You have to dig hard to get it out of the ground, and there is a limited quantity available. Historically, jewelry accounted for about 70% of the demand for gold. That will decline as hoarding increases.
Gross: How many years will it take for gold to double?
Zulauf: Two, but do not blame me if it takes three. If you are a little more adventurous, you can buy gold stocks, but put the core of your holding in physical gold. Gold-mining stocks have underperformed physical gold for more than a year, due to rising production costs. Production costs should decline slightly because of lower energy prices.
Fred recommended the Market Vectors Gold Miners ETF. Do you like it, too?
Zulauf: Yes. It is a diversified portfolio of major mining stocks. The total market capitalization of the industry is only $150 billion.
Last year I recommended shorting both sterling and the Swiss franc against the U.S. dollar. These trades worked well. Now short the Hungarian forint against the euro. All the Eastern European countries, excluding Russia, are running large current-account deficits. A current-account deficit is basically a loan from the outside world. In a credit crisis, credit gets pulled and the economy and currency adjust downward. Because all these countries want to join the European Union, they are all trying to defend their currencies.
Why pick on Hungary?
Zulauf: Among European countries, it has the largest percentage of public and private credit – 57% – denominated in foreign currencies, largely Swiss francs. That is public and private credit. Probably 70% of mortgages in Hungary are Swiss-franc denominated because of the interest-rate advantage. The Hungarian central bank is trying to defend the currency and does not want to devalue it, which would create more pain. They raised interest rates from 8% to 12% in the fall in the midst of the worst economic recession in modern times; rates are now down to 10%. When the pain eventually becomes too great, they will cut rates and the currency will decline.
The forint is not in the worst shape, but it is the most liquid among Eastern European currencies. The currencies of the Baltic states and Romania are much worse fundamentally, but more difficult to trade. Hungary has made good progress since the Berlin Wall came down. Per capita income is about 70% of the average income in the European Union. The Hungarian economy was stabilized in the late 1990s and inflation brought under control. Short-term interest rates declined from 35% in the mid-1990s to a low of 6% by 2005. It has risen since, due to inflation. The currency has been stable since 2000 in a trading range against the euro.
What is the current exchange rate?
Zulauf: The forint has traded between HUF235 and HUF275 to the euro. The current price is HUF266. The forint could move out of its trading range in 2009. I would have recommended shorting the forint against the Swiss franc, but I have some concerns about the franc due to the banking situation in Switzerland.
Here are some trading ideas for 2009: Trade beaten-down commodities like oil, which has a shot at rebounding to $70 or so, after which it will retreat. You can trade energy stocks, the big integrated oil companies, via the Energy Select Sector SPDR, or XLE. It sells for 50, and my expected 12-month range is 40 to 60. Oil has come down 75% from its high, and the XLE is down 60%.
Another good trade is Asian equities. Asia is in a severe recession that will not end for a while. But Asian stocks are cheap. They offer good dividend yields and are a good way to have a foot in these markets. Buy the iShares MSCI Hong Kong Index, or EWH. It is selling at 10.79, and I expect a range of 9 to 13-14. The iShares MSCI Singapore Index, or EWS, trades for 7.25.
What do you think of housing?
Zulauf: House prices in the U.S. will reach a low in 2010, some 10% to 15% below today’s level. Housing in other nations, particularly in Europe, has much more downside. Prices in Spain or the U.K. could fall 30% from here. The housing bubble has been a global phenomenon, and it has involved leverage and low homeowners’ equity not only in the U.S. Countries like Germany that did not have a housing bubble are in better shape.
Felix Zulauf’s Picks Medium-term government paper blended with five-year investment-grade corporate bonds issued by companies in defensive industries, such as telecom, food and oil. German government bonds Investment 1-2-2009 Price Gold* $875.40/ounce Short the Hungarian forint against the euro €1=266.10 HUF Trading Ideas (Ticker)** Crude Oil $46.34/bbl Energy Select Sector SPDR (XLE) $50.15 iShares MSCI Hong Kong Index (EWH) 10.79 iShares MSCI Singapore Index (EWS) 7.25 * Buy after price drops back to $600-$700 range. ** Buy after selloff to new lows. Source: Bloomberg
About 45% of U.S. home owners do not have a mortgage, which means 55% do. Almost half of those have no equity or negative equity in their homes. The National Association of Realtors’ Affordability Index is a theoretical number, because the appetite to buy a house is so different now, even if you could afford it.
Gross: I agree but offer a counter-argument. To the extent that the 30-year mortgage rate acts as a discount-pricing mechanism, if you can bring it down to 4.5% to 4% to 3.5%, you have a theoretical basis for supporting housing.
The ITB, or iShares Dow Jones U.S. Home Construction index, is up 50% from the lows. What do you make of that?
Cohen: In the U.S., we are three years into the housing correction. The home-building stocks got very cheap.
Zulauf: When you go down 95%, it is easy to have a 50% bounce.
Thank you, Felix. Abby, let us hear more of your views.
Cohen: With regard to the economy, chances are we are seeing the worst numbers now on production and consumer demand. The official recession may be over before the end of 2009, but growth rates afterward will be sluggish. A good deal of this ugly scenario already has been priced into stocks. Using a dividend-discount model or a price-to-book-value basis, our sense is fair value for the S&P 500 may be 1,100 or 1,200 in 2009. There is notable upside, but that does not mean the market goes back to its highs. Because consensus earnings expectations are too high, the market may come under some pressure again. But in the next several months we expect share prices to be higher, not lower.
What is your S&P earnings estimate?
Cohen: About $55. The 2008 number was about the same. The consensus is about $10 higher than we are for 2009. S&P earnings could see some recovery in 2010.
Valuation is not a timing device. Also, even though the market offers value, valuations across the market are uneven. In the past six months, better-quality names often went down more than lesser-quality names because they were easier to sell. As a consequence, we are looking primarily at larger-capitalization stocks for 2009. In addition, we are looking for companies with a domestic orientation. The U.S. moved into recession earlier than other countries, and we may move out of it earlier. The incoming Obama administration will provide greater detail shortly on plans that may be viewed as positive in terms of economic growth. These may focus in the short term not just on job creation but the prevention of additional job losses. The administration also will be working on things that have an impact two to three years out.
One peculiar thing in the markets last year was very high correlations. Everything was correlated to everything else. The single exception was U.S. Treasuries. Correlations will move lower this year, and differences in fundamental performance and valuation will come to the fore. That creates opportunities for security selection both in the equity and fixed-income markets. Finally, the public markets really took it on the chin in 2008 because they were open for business and that is where the liquidity was. There could be some big snap-backs.
Will there be more consolidation in banking and financial services?
Cohen: We are going to see consolidation in many industries. Companies with strong balance sheets will be in a much better position, regardless of industry. Even though the credit situation will be improving, there is still a lot of operating duress. Companies under duress could be involved in strategic mergers and acquisitions.
Regarding specific ideas, I will pick up where Bill left off in talking about distorted valuations in the fixed-income markets. There is general agreement around this table that U.S. Treasuries do not offer good value now. We would rather look at corporate bonds. I have three, all single-A-rated, all trading at significant spreads over Treasuries, all in financial services. Investors should stick with the senior securities within the capital structure. The Bank of America 5.65s of 2018 are trading at a [yield] spread of 325 basis points [3.25 percentage points] above Treasuries. The JPMorgan 6s of 2018 are selling at spread of 275 points over Treasuries. The Travelers’ 5.75s of 2017 are selling at spread of 345 points.
Schafer: Treasuries have a negligible yield because they have become a safe haven. An analysis of yield spreads is less relevant than usual.
Cohen: My next comment was going to be that spreads are expected to narrow. That could occur as Treasury yields rise, and as the absolute yield on these securities falls. Not just the coupon but the potential of price appreciation is available here.
Bank of America common equity is interesting, as well, from a valuation perspective. It yields in excess of 15% because investors are nervous about it. The stock is down 65%. We all know about the banking sector’s problems, and credit-cycle issues will take a while to play out. In Bank of America’s case, there are three phases to the credit cycle. The first was problems related to mortgages and home equity. The bank had 43% of its loans in the housing sector. The next phase of concern will relate to construction and commercial lending, and the third phase to losses related to consumer loan books, such as credit cards. The bank has material consumer exposure and delinquencies are increasing, but it becomes a question of what is priced in.
Zulauf: Does it yield 15% after they cut the dividend?
Cohen: Yes, and they may cut it more. This is a controversial stock, and it is priced as one. [Note: According to government and company announcements Friday morning, Bank of America, which already has received $25 billion in TARP money, will get additional funding and a loss-sharing agreement on impaired assets because of problems at Merrill Lynch, which are worse than had been expected when BofA struck a deal last fall to acquire Merrill. As a result, BofA’s capital position has been significantly weakened. Bank of America also is cutting its dividend to a penny a share. According to Abby, Goldman Sachs analysts say BofA may have other capital options available as it seeks to reduce leverage. It could reduce stakes it holds in other financial institutions, such as CCB, BlackRock or Itau. Pro forma tangible book value is about $10. Extensive government involvement likely will mean current shareholders are not a top priority.]
Duke Energy, an electric utility, offers good income potential. It yields about 6%. We are not expecting much if any earnings growth because of the weakness in the economy. We are forecasting GDP will fall 1.6% in 2009. On the other hand, with a 6% yield and long-term earnings growth of about 5%, Duke is not a bad place to be. Along with some other utilities, Duke has been proactive about energy efficiency, sustainability and such. It may get some attention as a consequence, with a new administration coming to Washington and talking about the need for infrastructure spending, and a new national grid.
What else looks good this year?
Cohen: Pharmaceutical companies are facing significant concerns about a lack of innovation and, at the same time, major patent expirations. There are also concerns about health-care reform and what it might mean for these companies. Wyeth is a good place to be in this industry. It has less exposure to patent expirations than other large U.S. pharma companies. It has a significant biotech initiative. The company’s vaccine and biological division is growing at about a 20% annualized rate and generating strong cash flow. There is a potential for a dividend increase; the current yield is about 3%. The P/E is 10.3. The pharma industry could see consolidation. Given its biotechnology endeavors and strong cash flow, Wyeth might be an appealing candidate for some other companies.
Next, I have got some stocks that could benefit from a better economy. I began by saying we are in a recession, but the equity market is a discounting mechanism. At what point do we feel comfortable looking at these names? ITT looks appealing over a 12-month horizon because of its special products. It has a strong defense business, which will account for more than 50% of earnings. It is involved in aircraft avionics and such.
The water business is attractive. Longer term, the Obama administration may focus on the water and waste-water infrastructure in the U.S., and ITT is a leader in the category. Earnings could grow 10% to 12% long-term. The P/E is about 12 times earnings.
On this year’s or next year’s earnings?
Cohen: This year’s. The yield is about 1.4%. To the extent that there is increased spending on defense and water infrastructure, ITT fits these themes. I am sitting next to Fred, so I would love to hear his comments on my next pick, Applied Materials. You have to believe in this case that the economy will turn up in 12 months. This is an early cyclical. The semiconductor-equipment industry does not look attractive right now. However, orders are likely to trough in the first half of 2009 and things will look better in the second half. The company has a backlog of $4.85 billion, including $1.5 billion in solar thin-film used on solar panels. The solar area was hyped a few years ago, and it could become more important now. With this backlog, there could be some cancellations.
Hickey: There will be a lot of cancellations.
Cohen: Applied has $4.2 billion of net cash, equal to 25% of its market cap of $13.7 billion. The yield is 2.4%.
Black: Even though Applied Materials is the big Kahuna in semi equipment, estimated earnings of 20 to 25 cents a share for this year are not enough to justify an $8 or $9 stock in the short term.
Schafer: If you take out the cash, $9 is $7.
Cohen: This is a transition year. You have to look at 2010.
Abby Cohen’s Picks Corporate Bonds 1-5-2009 Yield 1-5-2009 Price BofA, 5.65% due 2018 $99.50 5.7% JPMorgan 6%, due 2018 105.50 5.2 Travelers 5.75% due 2017 98.75 5.9 Company Ticker 1-2-2009 Price Bank of America BAC $14.33 Duke Energy DUK 15.40 Wyeth WYE 38.39 ITT ITT 48.79 Applied Materials AMAT 10.67 Hess HES 57.25 Source: Bloomberg
Hickey: It is too early. This is the biggest disaster we have seen, and we have seen a lot of disasters in the semiconductor market, particularly in the companies driving that backlog. Taiwanese DRAM and flash-memory makers are near-bankrupt. There is no cash available. Everyone is canceling everything. The turnaround might take well into 2010, and then you could lose market share.
Black: Applied Materials is a great company with great technology. There is just no customer demand to drive the stock.
Cohen: My final name is intended to be controversial. Assuming oil averages $45 a barrel this year and $70 next year, companies like Petrobras and Hess could benefit. Hess has demonstrated significant leverage in earnings and share-price performance to rising energy prices. At $45 a barrel there is not much earnings growth. If crude goes higher, earnings growth could be significant. There is not much of a yield – 0.7% – so it is really a play on higher oil. The stock has jumped to 57 from 50 in the past few days. Maybe the move is over and I should have pulled it from my picks folder, but if you see some light at the end of the tunnel in terms of economic activity and energy prices move up, Hess could do well.
Zulauf: Some European energy stocks offer fantastic yields, even if earnings go down. Italy’s ENI [ENI.Italy] yields 8.5%, and the payout ratio is probably 30% or so. Royal Dutch Shell is yielding 5.2%.
Cohen: The U.S. equivalents would be ExxonMobil and some others. They performed well from the end of October through the middle of December. But if the economy starts looking better in the second half of this year, you want something more leveraged to the price of oil.
Thank you, Abby.
BACK IN VOGUE: EUROPE’S HIGH-PAYOUT COMPANIES
As dividend payouts come back into vogue, the Continent is the place to be.
Investors are returning to basics and focusing on dividends as a major source of the total return from stocks. This has always turned out to be a good idea, studies show. As expressed below: “Though historically the dividend was a more important ingredient of total return than capital gains, for many investors it had become almost an afterthought. High-payout companies were considered stodgy, with slow profit growth.”
With capital gains suddenly a far-from-sure thing, and with U.S. blue chip stocks yielding more than Treasury bonds for the first time since the late 1950s, the emphasis on dividends has reemerged with a vengeance. But do not confine your searching to the U.S., this piece advises. Some European stock markets are yielding twice that of the U.S. Overall, “the trailing yield of European stocks is about 5.6%, compared with about 3% for U.S. stocks and the yield for 10-year German Bunds.”
A convenient ETF, the SPDR S&P International Dividend ETF (DWX), tracks the S&P International Dividend Opportunities Index, a worldwide (not just Europe) benchmark for income-seeking investors.
In the long bull market of 1982 to 2007, the rapid and steep gains of equity prices from earnings growth overshadowed the appeal of dividends. Though historically the dividend was a more important ingredient of total return than capital gains, for many investors it had become almost an afterthought. High-payout companies were considered stodgy, with slow profit growth.
“It’s been the most amazing environment in the past 20 years, but it is not necessarily normal,” argues Graham Secker, a European equity strategist for Morgan Stanley; in the future, “stock appreciation [from earnings growth] will be more limited.”
So dividends should regain their rightful place in stock-picking. U.S. companies tend to use more of their earnings to fund growth or buy back shares, notes Vincent McBride, manager of Lord Abbett International Dividend Income fund [LIDAX]. But for reasons ranging from U.S. tax policies to the preferences of local investors, many international firms pay out a greater portion of their profits in dividends, says McBride.
Among developed markets, Europe is the place to be, with some country indexes sporting a dividend yield twice that of the U.S. In fact, the trailing yield of European stocks is about 5.6%, compared with about 3% for U.S. stocks and the yield for 10-year German Bunds.
So far, however, among European equities, the traditional switch to high-yielding stocks during bear markets and recessions has been somewhat muted. Last year, the European food-and-beverage, telecom and utilities sectors returned a negative 30%, 37% and 38%, respectively – better than the broad market’s 43% drop, but not by much. Only health-care shares gave better protection, but even they fell 18%.
Stocks were pricing in a severe economic downturn. “But what people forgot,” says Jorik van den Bos, senior portfolio manager at Kempen Capital Management, “is that those boring, strong, mature companies, that grow earnings 5% [annually] and pay dividends, still grow and pay dividends” during recessions. And, he notes, dividends give clear signals about the health of a business, provide generally stable income and are a decent long-term valuation tool. Dividends may grow more slowly than earnings, but they slide less than earnings when profits fall.
The recession means there will indeed be dividend reductions, notes Morgan’s Secker, but “studies have shown that over the long term, the majority of the total stock returns come from reinvested dividends....In a world struggling for growth, the dividend yield becomes a larger proportion of the total return of stocks.”
Morgan Stanley has made a list of names with a high dividend yield and low risk of a dividend cut [see table] ... And, while some high-dividend stocks have outperformed, the conditions causing that – a poor global macroeconomic picture, plunging earnings, stresses in the financial system – have not gone away, despite the stock rally seen since November 20 lows.
Rajesh Shant, who is head of European equities for Newton Capital Management, says that when picking high-dividend payers, “you want a dividend that will be maintained or increased, and it does not have to be a big increase. Middle-single-digit EPS and dividend growth can be particularly attractive in today’s environment.” Combine such a dividend payout with modest stock appreciation, and total return can approach double digits.
Among the high-dividend payers he likes, Shant lists Deutsche Telekom (DT), with a 2009 expected yield of 7% and cash flow this year that will cover dividends a strong 4.5 times. Its ratio of net debt to earnings before interest, taxes, depreciation and amortization (EBITDA) is 1.7 times. At French oil giant Total (TOT) the respective ratios are 5.8%, 3.7 times and 0.3 times.
Nigel Bolton, head of European equities at money-manager Blackrock, cautions that investors should not forget the risk of dividend cuts, and should focus on dividend cover, cash flows and balance sheets. Bolton begins with stocks that have 1.5 times dividend cover for a stable business, meaning the company’s profit could pay the dividend 1.5 times. He recommends seeking a higher dividend cover for a cyclical company, to ensure more of a cushion if profits should fall.
Among the stocks that Bolton favors are Spain’s Telefonica (TEF), which has a 7% 2009 yield and 3.8 times dividend cover, and BP, the British oil producer, which has a 6.9% yield and 2.8 times cover. Falling oil prices are an issue for BP, but he thinks it will try to avoid a dividend cut, owing to bad memories of a prior cut in the 1990s.
There is also the SPDR S&P International Dividend ETF (DWX), which tracks the S&P International Dividend Opportunities Index, a benchmark for income-seeking investors. It is not limited to European companies.
For long-term investors, the allure of income will reassert itself in the post-bull market era, adds Bolton. In other words, it is time for a dividend comeback.
The worst of times in our financial markets in 2008 are producing the best of buys for value investors today.
“Value traps” are stocks which look cheap and attract the attention of value investors, but where the underlying fundamentals are deteriorating. Earnings and asset values fall and what looked like a bargain turns out to be anything but. The margin of safety turns into into a margin of overpayment.
Financial stocks always turn out to be value traps at the top of a credit cycle. Finance is a commodity business – money itself is the ultimate commodity – and the high reported earnings and returns on equity that show up at the end of a credit cycle reflect inadequate reserving for the losses that will happen during the succeeding credit retrenchment. This is true for any credit cycle, not just the credit cycle to end all credit cycles that is now imploding. The market correctly awards low multiples to such top-of-cycle earnings, as it does with any cyclical company, but some value investors cannot resist. Given the huge leverage inherent in most financial services business models you would think they would tread cautiously. Too often not.
Veteran value investor David Dreman fell into the trap of buying “cheap” financial stocks, like Freddie Mac and Washington Mutual last year and paid the price. He has thrown in the towel on all but two of his previous finance recommendations. He has a bevy of recommendations here, with an emphasis on energy and natural resource plays.
I am reminded of the opening sentence to Charles Dickens’s A Tale of Two Cities. For most investors the year 2008 was the worst of times. But this year may turn out to be the best of times for value investors. Stocks are cheap, and value stocks (companies that normally trade at below-market multiples of their earnings or book value) are particularly cheap.
I have not seen a crisis in my lifetime like the one we are facing now, and I think there is a good chance it will get worse before it gets better. Does this mean we are heading into a Great Depression? I do not think so, but there is no doubt that our financial system has become unglued and needs repairing.
Toxic mortgages and their promoters are to blame, but so are our inept regulators. That roster includes two Federal Reserve chairmen (Alan Greenspan and Ben Bernanke), the departing sec chairman (Christopher Cox) and the departing Treasury secretary (Henry Paulson). Under their supervision a collapse in the junk mortgage market spread to the entire financial system. Now the tsunami is threatening to wipe out the U.S. automakers and almost any other company that needs debt financing.
Most of the 49 stocks I recommended in this column in 2008 were unable to escape the damage. If you had bought them all, you would be down 26%, after subtracting a 1% transaction cost on new purchases. Similarly timed investments in the S&P 500 would have lost you 16%. (None of the figures here include dividends.) My mistake: being heavily weighted in financials, and being unable to predict which ones (like Citi and AIG) would get help from the federal government and which would be allowed to sink beneath the waves. I suffered big declines in Fannie Mae, Freddie Mac and Washington Mutual.
Thanks in part to Paulson’s desperate and unpredictable actions, common stocks of good banks and brokers went into death spirals. For the full year the S&P 500 financials index was down 55%, versus a 38.5% drop for the S&P 500 index.
Now we are in a recession which I think will be our worst since World War II. I expect the price of crude oil and other commodities to go lower and unemployment to hit 10% by year-end.
Obama’s economic team faces a Herculean task in turning the economy around. Central bankers around the globe are printing money in an attempt to prevent a deflationary recession. If the bankers are successful, deflation will be contained and the recession abated, but we will pay for this rescue with higher inflation for years to come.
Amidst this Dickensian darkness in our economy I also believe that it is the best of times if you happen to be a value investor like me. I am now seeing buying opportunities that I have rarely seen in my 32 years managing money.
Last year nine of my ten worst stock picks were financials. Of these, I would keep only Bank of America (BAC, 14) and Fifth Third (FITB, 8) for 2009. They are good values.
Among my best-performing 2008 recommendations I would continue to hold are Best Buy (BBY, 31), Carnival (CCL, 25), Target (TGT, 37), General Electric (GE, 17) and Valero Energy (VLO, 25). All are well-managed companies that should survive this recession and go on to prosper.
Other outstanding bargains among 2008’s rubble are from the retail sector. It is as if investors presume that the recent disappointments at the cash register will be permanent. I still like Lowe’s (LOW, 23) and Staples (SPLS, 18). In the oil patch I recommend holding on to Apache Corp. (APA, 85), Devon Energy (DVN, 71), Anadarko Petroleum (APC, 43), Chesapeake Energy (CHK, 19) and Transocean (RIG, 36). The big producers I continue to like are ConocoPhillips (COP, 56), Chevron (CVX, 77) and Occidental Petroleum (OXY, 63).
Two resource companies to hold are the diversified Australian miner BHP Billiton (BHP, 48), whose ADRs went down 40% in 2008, and copper and gold miner Freeport-McMoran (FCX, 30), whose shares went down 77%. Aerospace and defense contractors are still cheap. Keep your shares in Lockheed Martin (LMT, 84) and United Technologies (UTX, 55).
The time to buy value stocks is now. This is not to say that the market will immediately rebound. I do not know where the bottom is, and neither does anyone else. I can simply be confident that value stocks will do well over the long pull and that you are better off buying them when Wall Street is despondent than when it is ebullient. This Dickensian tale could have a happy ending.
BE A BAD NEWS BULL
It is better to be a little early than a little late getting back into stocks.
Ken Fisher may have been chastened in 2008 but he was not silenced. He thinks the bad news, already out and still to come, is fully discounted in current stock prices. He has a bunch of stock recommendations, which include several upper-middle quality companies that have been hammered.
Bad news is good. You can expect more of it. And you can expect the stock market to resume its recovery, which began November 20. Do you find this line of argument perplexing? You have company. A lot of my clients are baffled at the notion that the stock market should be climbing at a time when employment is declining.
But if you look back at the pattern in past stock market recoveries, or think about what the stock market represents, the combination of a bull market and a recession will not seem so strange.
The stock market is a discounter of all known information. It is not a barometer of the current state of the economy but a guess about where the economy (and corporate profits) will be 6 to 24 months in the future.
When we all know that the economy is deteriorating, that is already reflected in prices. The September-to-November crash anticipated the announcement in December that the economy is in recession. Now stocks are starting to climb, in anticipation of an economic recovery that probably will not begin until the second half of 2009.
Do not expect to see any real economic improvement or any good news in the labor market for a long time. In history the evidence is overwhelming: Stock market bottoms happen, and then stocks jolt upwards, while the economy keeps getting worse – sometimes by a lot and for a long time. Take the bear market preceding the roaring 1920s. Global stocks bottomed in June 1921, but global economies did not hit bottom for fully two more years. Or the 1973-74 monster bear, when stocks bottomed in October 1974 but the U.S. economy kept sliding through March 1975.
In the past 12 months the unemployment rate has climbed from 4.7% to 6.8%. It will keep going up for a while. During this time you will see a steady parade of bearish news. There will be a lot of people saying that the stimulus schemes undertaken by the departing Treasury Department were a failure and that the ones from the incoming Administration will not do much better – or work at all.
Look past the pessimism and remind yourself that it is better to be a little early than a little late in getting back into stocks. The upward move at the beginning of a bull market is almost always huge compared with the vacillations late in the bear market. If you try to pick a bottom, you will miss a good part of the action. Here are five stocks I like now.
Paccar (28, PCAR) makes Peterbilt and Kenworth trucks. It has a 26% market share in the U.S. and 14% in Europe. Earnings will be depressed by the recession. I expect only $980 million, or $2.60 a share, on revenue of $15.8 billion in the fiscal year ending December 2008. But this is a classic stock to lead the market and do well even before its profits hit bottom. It will cost you 11 times trailing earnings and 60% of book value. It yields 2.8%.
Corning (9, GLW) is the world’s leader in specialty glass and ceramics. Among the products contributing to its $6.5 billion in annual revenue are liquid crystal displays found in cell phones, cars and lab equipment. Off 64% so far in 2008, it will bounce back.
Air Products & Chemicals (50, APD) is the largest vendor of gases and the equipment to convey them. Revenues run $10.5 billion a year. The company sells everything from bulk gases for manufacturing to oxygen for respiratory therapy; there are dozens of products serving dozens of industries. It costs nine times next year’s likely earnings and one times annual revenues. Dividend yield is 3.6%.
India’s Wipro (6, WIT) is growing, well run and big in its business, which is selling software and data processing services to 950-plus multinational firms. During the recession its profits will be weak, but its market share will increase. Off 50% in 2008, it sells at nine times my forecast for 2009 earnings.
Research In Motion (37, RIMM) feeds an addiction. You see people in public everywhere who cannot quit. When my BlackBerry is more than a foot from me I get twitchy. Soon you upgrade to more potent stuff. I am on my 6th version. Global cell phone, e-mail, Internet, alarm clock and pocket computer which wirelessly synchs with your PC, the BlackBerry beats the heck out of the iPhone or heroin. The service is cheap at $65 a month for everything. The stock is cheaper; at 10 times the earnings it can deliver in the fiscal year that ends February 28, 2009.
STOCK STRATEGIES: RANDOM PREDICTIONS FOR 2009
Dan Amoss, editor of Strategic Short Report, is happy to see the end of 2008 despite his many trades that worked well. He thinks the indiscriminate and wholesale liquidation of stocks will give way to a stock-picker’s market this year, with stocks backed by good fundamental stories such as energy, commodity, and infrastructure plays doing well.
I am happy to turn the page on 2008. We had a great streak of profitable trades in Strategic Short Report, but it still was a stressful, painful year to be an investor. Even if you are far more patient and disciplined than most investors, you still were punished in 2008.
Dozens of stocks come to mind that were sold down to insanely cheap levels as hedge funds scrambled for cash. That scramble is probably not over, so we may be in for more turbulence. Plenty of stocks come to mind that are still trading too high relative to their earnings potential. We will be looking to bet against those in 2009. Plus, many companies will not make it out of 2009 without going through bankruptcy. I expect to find a few more “short to zero” stocks – like Fleetwood Enterprises (NYSE: FLTW) – in 2009. We sold Fleetwood short in March at $4.43 and covered in October at 27 cents, for a 94% gain.
When asked by family and friends over the holidays what I think about the 2008 stock market and economy, my response has been, “I expected a nasty bear market in 2008, but the carnage since September took me by surprise. The economy will remain weak, but I think the worst of the widespread market carnage is behind us. Future damage should be concentrated in sectors with horrible fundamentals. Thankfully, 2009 should be a year when fundamental analysis should start to matter once more.”
This will be a welcome development, because 2008 was a year when the following strategy worked best:
Clearly, this “deflation trade” strategy is not sustainable over longer time frames – not in an era of worldwide paper money standards. In fact, I would expect that such a shotgun-based investment strategy of short S&P 500/long Treasuries could lead to big losses in 2009.
- Sell short any stock or ETF, without bothering to do any fundamental research
- Invest the proceeds in Treasury bonds, preferably with as much margin as possible
- Repeat Steps 1 and 2, over and over.
I think the key to approaching 2009 markets will be to view everything from the perspective of the Treasury and the Fed. Everyone knows that the real economy stinks and that America is overly indebted. But I doubt everyone realizes just how extreme Treasury/Fed will be in using the deficit and the paper money system to stop the Great Depression II scenario. Theses tactics will be inflationary at some point.
The U.S. banking system became destabilized because its core collateral – houses and mortgage-backed securities – collapsed in 2008. While the authorities may not be able to re-inflate old bubbles in these assets, I am betting they can employ cheap Treasury financing to cushion the decline. This involves refinancing homeowners out of toxic mortgages into conventional mortgages. They will also find some way to deal with the problem of negative home equity, even if it involves highly inflationary tactics like Treasury assuming losses from principal reductions via Fannie and Freddie. And even if foreigners balk at absorbing new Treasuries, the Fed will monetize them, i.e., buy them itself. Again, these tactics would be highly inflationary.
So let me enumerate a few predictions for the New Year:
(1)It is far too easy and popular to be bearish on everything but Treasury bonds, so odds favor a sharp rally in early 2009 – a rally in the S&P 500, led by stocks with the most sustainable fundamentals, including energy, commodities, and infrastructure. Stocks with weak fundamentals may participate, but quickly roll over as economic reality sets in. Many will go to $0 in bankruptcy.
(2) The SEC will suspend mark-to-market accounting, or at least modify it to allow more management discretion in marking values of securities. The era of wholesale shorting of financial stocks is likely over. A massive wave of refinancing is also a backdoor way to recapitalize the banking system; perhaps the most efficient way to increase the value of exotic mortgage-backed securities, (and bank capital) is for many of the mortgages backing these securities to “prepay” upon refinancing. Bankers will re-emerge from their bunkers and look to make new loans to creditworthy borrowers, since a sub-1% cost of funds courtesy of the Fed is too low to ignore.
(3) Oil will rebound to $80 per barrel on lower than expected production, despite weak demand. If demand rebounds, oil could go to $120.
(4) Gold will rally beyond $1,200 on weakness in the U.S. dollar, unprecedented Treasury bond issuance, and tepid foreign demand for U.S. dollar assets. Weaker foreign demand for Treasury bonds will prompt the Fed to step in as buyer of last resort and monetize debt. In its December policy statement, the Fed signaled that if foreign lenders look to sell Treasuries, it would step in as a buyer to keep rates low. If this happens, more savers and bond fund managers will look to invest in inflation hedges like gold and energy.
(5) Many more hedge funds will fold in 2009, but this is good for the long-term health of the market. Most of the new funds should not have been started because they just went “long” everything on margin. Their closure will result in a more efficient – and less volatile – market.
(6) 2009 will be a “stock picker’s market.” Nothing worked consistently in 2008 other than indiscriminate shorting of stocks and buying of Treasuries. The worst of the wholesale liquidation of stocks is likely over, so 2009 will offer lots of opportunities to buy and sell short individual stocks using fundamental analysis.
That is the good news. ... So let us end on that note.
MINDLESS RISK TAKING
Billions and billions of dollars lost on nonsense.
As major bubbles culminate everybody becomes a speculator, trying to take advantage of all the easy money. People quit their old jobs to day trade. Companies try to transform their finance departments into “profit centers.” Asset managers decide that whatever they have been doing for decades is too tame and it is time to reach for the golden ring. Inevitably these ventures prove to be financial disasters come the pop. A lot of the ventures involve leverage, and they all involve people making decisions without knowing what they are doing.
As Chris Mayer expresses it: “The advice I have is not novel, but bears repeating since so many seem to forget it. Stay away from anything you do not understand. (All those folks who lost money with Madoff in his $50 billion Ponzi scheme would have saved themselves a lot of money just with this single insight.) And avoid excessive leverage. It is one thing to lose money. It is another thing to lose it taking on stupid and pointless risks.”
Meanwhile, here are some particularly stupid/tragic examples of pointless risks which ran aground, courtesy of Mayer.
Satyajit Das’s book, Traders, Guns & Money has a great anecdote about a meeting with an Indonesian noodle company. The noodle men were “Indonesians of Chinese extraction,” Das writes. “They were part of the infamous ‘bamboo network’ of ethnic Chinese business interests that crisscrossed South East Asia.” The noodle shop was an old business, plying an ancient and humble trade, the kind you find throughout Asia. Sounds like a nice simple business, right? Yes, but ...
The noodle company got itself into some trouble. To simplify the story greatly, it basically lost a lot of money using derivatives to bet on dollar-rupiah movements. The loss suffered was, in fact, more than the capital of the company itself. At one point, Das writes: “What this had to do with producing noodles was a mystery.”
Unfortunately, this kind of story riddles the markets today like worms in an otherwise worthy cut of swordfish. There are so many of these incidences and they are ruining companies and investors across the world. It takes a nasty crisis like the one we are in to expose all these things. And the rot is extensive.
I want to share with you three little-reported events and one historical example that all show how pervasive this mindless risk-taking became during the last few years. They would be almost comical if they were not true.
First, consider the sad example of several Mexican and South American companies that made, large, company-jeopardizing currency bets. For example, Mexico’s 3rd largest retailer, Controladora Commercial Mexicana, recently filed for bankruptcy after losing so much money speculating in the forex markets. What does currency speculating have to do with selling tortillas, milk and eggs? Nothing. That is the point.
Similarly, Sadia, a poultry producer; Cemex, a cement outfit; and Gruma in tortillas – all lost huge amounts of money on currency bets. Aracruz Cellulose, the much admired pulp giant of Brazil, owes more than $2 billion to its banks for making bets on currencies that went sour. What was once a great franchise has been brought to its knees. It will take years to pay that back and debt payments now make up 40% of its pre-tax earnings.
The second example of mindless risk-taking is the story of so-called “portable alpha.” Apparently, the brain trusts that run pension funds thought this strategy sounded like a good idea. What is it? I still do not understand it fully. But it basically amounts to a leveraged bet on the stock market. If you lose, you lose big as many pension funds are finding out. So now the Pennsylvania state employees’ pension fund, for instance, will have to take a multi-$billion bath on this exotic investment strategy.
As the Wall Street Journal reports: “The stock-market downturn could force the Pennsylvania state employees’ pension fund to make cash payments of $2.5 billion or more to trading partners on Wall Street.” The fund has only $27 billion in total. At least, it had $27 billion.
Several other funds have reported billion dollar losses on portable alpha strategies. I can only imagine how many more institutional investors are in the same boat. The people running these things and advising these people should all find other work.
The third example is so-called “accumulators,” which is another kind of tactic for placing highly leveraged bet on stocks, currencies or commodities. I do not want to get into the details. It is so complicated; it would take me a page to explain it. Just know that, like “portable alpha” if you are wrong, you lose big.
And yet all kinds of wealthy individuals and businesses have gotten wrapped up in these things. Accumulator losses are showing up in some unlikely places. For instance, VeraSun Energy Corp., which makes ethanol, filed for bankruptcy in part because of big losses on accumulators tied to the price of corn. Citi Pacific, a Chinese conglomerate, lost $2 billion on accumulator contracts linked to currencies.
Billions and billions of dollars lost on nonsense. There was no reason for anybody to buy these things – especially when they clearly did not understand the risks involved. The losses are so bad in Hong Kong that Any Xie, an independent economist, said recently that “Accumulators are ruining Hong Kong.”
I will offer one other example of this kind of recklessness that is both a historical and contemporary study: Goldman Sachs.
I just recently finished perusing Charles Ellis’s new history The Partnership: The Making of Goldman Sachs. I was particularly interested in the early history of Goldman Sachs. I thought I would come away thinking how Goldman Sachs used to be a simpler business. I thought Goldman’s history would show how it took prudent risks with adequate equity backing those risks. My conclusion would then be that the current crop of leaders at Goldman were just reckless and ruined a franchise that had been around since the 1880s.
In fact, that is not what I learned at all. From Goldman’s earliest days as a commercial paper specialist it operated with minimal capital. All through its history, it has been a business that took big risks and often took huge losses. That Goldman even exists at all today is something of a financial miracle.
In reading this history, I was struck by how the company found itself in the soup again and again and again. In the 1920s, one of the biggest speculative busts was in investment trusts in which a small amount of capital supported a spider’s web of investments in other companies. Guess who had the biggest blow-up of them all?
Goldman was big in this through a subsidiary called Goldman Sachs Trading Corporation, which basically lost everything for its investors. Ellis writes:
“While all the investment trusts suffered, Goldman Sachs Trading Corporation – because it was so large and so highly leveraged ... [it] became one of the largest, swiftest, and most complete investment disasters of the twentieth century.”
The loss to Goldman Sachs itself was enormous. It basically wiped out 30 years of profits and eliminated the “fruits of all the labors of a generation.”
Fast forward to 1970 and the biggest bankruptcy in the country at that time. You find Goldman was waist-deep in it. Penn Central at the time of its bankruptcy in 1970 was the 8th largest corporation in the country. Again, Ellis writes: “the loss it [Penn Central] threatened to impose on Goldman Sachs was not only larger than any prior loss, it was larger than Goldman Sachs.”
And so it is today, that the company once again finds itself in the middle of yet another big crisis that threatens its very existence. I do not know about you, but I have to wonder about all the brains at Goldman Sachs and all the people who say what a great firm it is. Seems to me, for such a bunch of supposed geniuses, they routinely shoot themselves in the foot, time and time again. You do not find Berkshire Hathaway fighting for its life every decade.
All of these anecdotes scream at me to avoid the complex and the leveraged, which often means a potential for a mega-loss if you are wrong. The problem is these kinds of bets infect many companies, as I have shown, even when they have nothing to do with the core business. Even otherwise seemingly simple enterprises, like making tortillas or producing chicken, have been hurt.
The advice I have is not novel, but bears repeating since so many seem to forget it. Stay away from anything you do not understand. (All those folks who lost money with Madoff in his $50 billion Ponzi scheme would have saved themselves a lot of money just with this single insight.) And avoid excessive leverage. It is one thing to lose money. It is another thing to lose it taking on stupid and pointless risks.
A Better Grid: Will It Juice Stocks?
It is too soon to track the windfall from the modernizing of our electric grid
Many savvy stock analysts put “infrastructure plays” on their short list. Included in the infrastruture that needs upgrading is the U.S. electrical grid. Barron’s presents a list of those companies which might benefit from this trend, while suggesting the case for the group is not ironclad.
In 1849, tens of thousands of easterners joined a gold rush to California, lured to the new territory by the discovery the previous year of 23-karat flakes in the river by Sutter’s Mill. Now, 160 years later, on the opposite coast there is a “Grid Rush.”
Lobbyists for electrical utilities, their suppliers, and their consultants are descending on Washington in droves to pan for a share of the $11 billion that President Barack Obama initially wants to spend to help modernize our aging electrical-transmission system – a web of 250,000 miles of power lines connecting millions of homes and businesses to 9,200 electric plants.
About $4.5 billion of that lucre would help utilities convert the low-voltage part of the system into a so-called smart-grid, introducing digital-age efficiencies into the system, reducing waste and negating the need for expensive and polluting new power plants. Similar upgrades are under way in world capitals from Brussels to Beijing as governments struggle to reduce greenhouse emissions and their dependence on Middle East oil.
The other $6.5 million is for repairing and maintaining existing wiring. A study by the Brattle Group estimates utilities will have to spend more that $1.5 trillion between 2010 and 2030 merely to maintain the level of today’s service.
Obama’s proposal might just be the start of years of big expenditures, because he was a big supporter of the smart-grid concept on the campaign trail and because, frankly, $4.5 billion is a drop in the bucket.
Some smart-grid proponents recommend spending $10 billion every year for at least five years, which they say would save utilities and business billions and create about a quarter of a million new jobs. That kind of money could lead to such things as electric meters that talk back to the utilities, allowing them to bill you without hiring a meter reader, and time-of-day pricing that allows you to reduce your bill by, say, running the dishwasher after midnight.
The real question here is whether the money in the stimulus is a one-time boost, or a down payment on a longer-term commitment. Investors thinking of snapping up grid-related stocks, such as the ones shown in the table above, should give some serious thought to the question. ...
[I]t remains unclear just how much of a jolt Obama’s first stimulus will send through the grid. That is why we would wait until next budget season before connecting our investment dollars heavily to it. Investors could be in for a big shock unless the federal dollars start begin to flow more freely.
Australia’s High Dividend Yield Has a Catch
Stock issues are used to fund payouts companies cannot otherwise afford.
The seemingly attractive dividend yields coming from Australian companies highlight the risks of cuts – or dilutions – rather than signal value, we are warned. There are lunches you pay for and lunches that are free. Often the later turn out to be more expensive.
Dividends will be a huge part of returns in Asia this year, and the highest major-market yield is Australia’s 6.8%, according to Bloomberg.
Don’t break out the champagne. Australian payouts are often matched by a capital increase in the form of a “fully underwritten dividend-reinvestment plan,” or DRP. Companies around the world regularly allow investors to take annual dividends in shares. But issuing new shares to pay for a current dividend is unique. Australian companies often give the new shares to a bank, which then sells them at big discounts. (For some nice explanations, see here.)
As stocks languish, underwritten DRPs increase. That raises the hackles of some big investors. “Cash gets tight, and they issue shares to pay the dividend. It has really picked up in intensity over the course of the last six months,” says Vincent McBride, manager of Lord Abbett International Dividend Income fund (ticker: LIDAX). “You cannot see this or touch it. The investment banks, who underwrite these share issues, take no notice of this in their research. You think you are buying a stock with a 6% yield, but in reality, there was a stock offering to pay that dividend. If they cannot afford to pay it, they shouldn’t.” Echoes Don Gimbel of Carret & Co.: “I personally would rather see a company cut their dividend a little bit to preserve cash.”
The sell-side, says McBride, does not flag the share issues because it is doing the underwriting. Culprits this year include such Standard & Poor’s ASX 200 members as Australia & New Zealand Banking, Billabong International, and Westpac Banking. Citigroup reckons DRP capital raisings in Australia amounted to A$15 billion (US$10 billion) in the past 12 months, equal to nearly 2% of the market.
Still, the discounts are narrowing. Graham Harman, a Citi strategist in Sydney, calls fully underwritten DRPs “harmless.” You can buy Australian banks yielding 8.5%, says Harman. If dividends are cut by 30%, “that is still well ahead of Treasury notes.” And Australian stocks yielded 6% or more only five times previously in the past 50 years.
However attractive, such fat yields seem bound to get slimmer. Says Tanya Branwhite, a Macquarie strategist in Sydney: “Rather than signaling value, this continues to highlight the risk of further dividend cuts.”
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