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HOW THE CREDIT-LOSS CYCLE GOT SUPERSIZED
The financial crisis could drag on another two or three years, says Wall Street veteran.
Robert Albertson does not see a quick end to the financial crisis, and believes it could drag on another two or three years.
The seeds of this crisis – most notably, too much liquidity, in his view – were sown earlier in the decade. Albertson sounded several warnings: “We conclude that denial is growing,” he wrote in a November 2006 note. “The markets are hearing what they want.”
The 62-year-old chief strategist for Sandler O’Neill & Partners has had a long career on Wall Street, including an extended stint as director of bank research at Goldman Sachs (1987 to 1999). Albertson joined Sandler O’Neill, an investment bank focusing on the financial sector, in 2002. Barron’s caught up with him last week in his midtown office.
Barron’s: In 2006, you wrote that the consensus economic view was way too optimistic. What concerned you?
Albertson: There were three key trends that had been growing over the years. The first was that there was a complete reversal of global monetary flows. We had never had the emerging markets running the show on liquidity, and it became huge.
Do you mean in terms of emerging-market governments buying Treasuries and basically funding a lot of borrowing in the U.S?
That is right, essentially. So it dawned on me that the Fed[eral Reserve] no longer really had control. But more importantly, the money flows were distorting interest rates to the low side – ridiculously so. Then, starting in 2003, the Fed compounded the problems by driving rates even lower.
What were the other themes that alarmed you?
The assumptions on home prices in the United States and elsewhere were clearly decoupling from any kind of reality. And third – and I did not notice this until about 2004 – the consumer in America did not go through a recession in 2000; we had a half-recession, if you will. So [consumers] continued to spend.
I looked at those three themes together, and I thought there was too much liquidity in the system, and that it was going to come back to haunt us.
Talking about subprime mortgages seems almost quaint these days, considering all of the other things that have happened in this financial crisis.
Everyone was noticing how much subprime delinquencies were going up, and by 2006 it was evident that [they were] unraveling. But then I looked at prime-mortgage delinquencies, and found out they were deteriorating at exactly the same time and pace. So this said to me it was not a subprime problem.
When I looked beyond just mortgages, I began to see the same unraveling in all consumer credits in 2006. So the conclusion had to be that we were going through a credit-loss cycle to end all credit-loss cycles.
What is your biggest surprise about how this crisis has unfolded?
Instead of recognizing the damage in a controlled fashion and trying to deal with it, everything has gone to the other extreme. In other words, stress tests back in 2005 or 2006 were useless; they were silly and assumed things were going to continue to go to the moon.
Now you hear about nothing but toxic assets and their worthlessness and the impending disaster, and I have to believe the reality is probably somewhere in between.
What is your sense of how far along we are in trying to work this out?
You have to look at this from the economic side, and then from the financial-sector side. On the economic side, all consumer debt is at 130% of income. Go back to 2000, and it was at 100%; 10 years earlier it was at 80% or 90%. It has to come down. So the first step is that we have to deleverage, probably by 10 to 20 percentage points, to repair the consumer’s balance sheet.
Also, the savings rate used to be 10% to 12% of income, but it went to zero, and it is back up to 3%. It probably has to go back to somewhere near 10%. So, let us just say we got a 25% correction in consumer income, which is about $10.5 trillion.
That is a $2.5 trillion headwind of income that has to go toward debt reduction and savings, as opposed to spending. But no government-stimulus program is going to offset that effectively. To me, it is a two- or three-year process.
Where do you think we are in terms of stabilizing the economy?
We are certainly in a recession, and it is probably a depression, if you define it as a long recession. We may have some false starts, but it is going to take two or three years to come out of this. In terms of the financial system, we have to recognize the damage to the balance sheets – and there are various estimates. I have done a very granular-level look at bank loans, just in the banking system by category, and when I tally it up, it is close to $1 trillion of embedded losses.
The banking system earns money, so it can pay down some of that on its own. The banking system got $200 billion in the original TARP [Troubled Asset Relief Program], excluding the big investment banks, and that is helpful. But we probably then have another $200 billion to $300 billion of additional capital just to fill the remaining hole there. That is going to take a couple of years, if we want to get it from the private sector, as we should. Getting it from the government is wrong.
How effectively has the government responded to this crisis?
I am seeing very odd interpretations from the government, in particular about what we need. The government is not thinking about deleveraging. The government is talking about jump-starting consumer credit. I hear the word jump-start all the time. It is such a bad word. Jump-start consumer credit for what? So we can be more indebted?
So what has to be done?
We need to reduce the debt. If you jumpstart credit, you are just going to prolong the problem and deepen it. What we need now is the patience to de-lever. We do not need the stimulus package. We need a savings package, but that could not be further from the goals at the moment. The mistake is that the government believes credit drives the economy, instead of the economy driving credit. They have got that backward, and this is a very dangerous time to be misfiring.
What is your advice to the government?
The first thing you need to realize is that all that capital flow from emerging markets, which is now plateauing and likely to decline, will put enormous pressure on our government’s borrowing costs.
Presumably if emerging markets curtail their buying of Treasuries, the demand for those securities lessens, pushing up rates. Then what?
The U.S. government is thinking in terms of adding trillions to our debt that is going to cost 5%, 6%, 7% or 8% eventually – not 2% or 3%.
If [officials] really understood that, I do not think they would be so ready to put the taxpayer at risk. Secondly, the consumer has gone through an artificially prolonged period of spending based on too much debt, house prices and home-equity lending, and that has to come out of the financial system.
But assume that consumers repair their balance sheets. Does that not make it harder for gross domestic product to recover?
There is no choice; that is where we are. We should have had this decline in consumer spending in 2000, along with the corporate sector decline that should have been the recession that reset the economy. We have a cyclical economy; that is normal. We had an 18-year expansion, which had never happened before.
What is the biggest danger of the stimulus plan?
That it will be a false start. It will be priming a pump that still has an empty well underneath. It will stop again even harder, and we will be further in debt and have further problems in the financial system from that debt.
What else concerns you?
Just as we ignored the absurdity of home prices before, we are now taking that absurd calculation to the negative in terms of bank balance sheets.
There are many securities in banks that are perfectly current and likely to pay over time that are now being marked down to 30 or 40 cents on the dollar – because the accountants think they are not going to work out. We are not giving it a chance. So we are now absorbing problems that do not exist in the future. We are truncating them into the present, and we are making the hole that much deeper and the inability to fill that hole becomes that much more shocking and it scares the private investor away.
It looks like the stimulus package, whatever form it finally takes, will include some tax cuts along with a lot spending.
As I said, there is at least $2.5 trillion that has to come out of consumer spending in order to pay down debt and build savings. If you want to replace that $2.5 trillion with the government, they are only at around $800 billion. Number 2, going back to the economic stimulus of early 2008, we now recognize that the bulk of it was not spent; it was saved. So you can split this package any way you want. It is not going to give the desired effect. It is going to give a false small blip, although it could give us a spike.
You noted recently that bank lending is a small fraction of consumer borrowing. Could you elaborate?
I am fearful that the government does not understand how consumer credit is generated. If savings decline and deposit growth stalls, which it did, how did we have an expansion in the mortgage, auto, and student loans over the last five to seven years? We got it from Wall Street via the secondary market.
Wall Street went out and found investors willing to take a package of securities. When you go get a car and you do it on credit, you do not want to go to the bank. At the showroom someone helps you fill out the form for what is, in essence, a loan that is going to be funded by Wall Street, which then finds the investor. For all consumer debt, Wall Street has provided $3 out of $4 of the credit. That is what has collapsed, and that is what needs to be rebuilt.
What needs to be done to fix the secondary loan market?
Number 1, we have to have price discovery, so we all understand how toxic the toxic assets are. The second thing we need to do is literally rebuild what has been destroyed, somewhat unnecessarily, on Wall Street in terms of generating credit from investment pools and other liquidity pools – not from deposits. The final thing we need to do is to stock the banks with deposits, and we cannot do that until people save.
Is it time to start nibbling at the financials?
The opportunity is coming, and it could come as early as later this year – if it is clear the government understands the problem and does no more harm. This could be a massively great opportunity to invest, but it could also be a kiss of death, and you cannot tell which one it is from the information we now have.
What is your advice to investors?
Keep your powder dry; focus on sectors outside the financials, and remember how we got here – which was the enormous strength of the emerging markets getting the model right and building their own domestic infrastructures and their own domestic demand.
We make a big mistake when we think that we are still leading the world and that all those emerging markets rely on us and other industrialized countries for export demand. It is still critical. It is still important, but most of these countries, most notably Brazil and China, now have huge domestic markets, and no one has noticed that they are increasingly independent.
Your outlook is very cautious, but are there any sectors that look attractive to you?
My fear is that the recession is multiyear, and completely different from what we have seen before. It seems to me that the consumer is down for the count. The government can only go so far, and the corporate sector can revive eventually. If you want to focus on areas that are going to benefit from infrastructure improvement, that certainly makes sense. If you want to focus on agriculture, commodities and raw materials, and bet on the emerging-market demand driving those prices up, that makes sense as well.
Any parting thoughts?
Don’t make the same mistake twice. Don’t make an assumption that makes no sense. Everyone assumed home prices would not go down, but do not assume they cannot bottom and go up. No one would ever have guessed interest rates would have been this low. Do not assume that is a normal state; assume they are going back up again.
Everyone recognizes that recessions only last 18 months – but that is wrong, some last longer.
We are in a test now for what could be something longer. Don’t be in a rush to commit funds. Do it very gradually and wait for conviction, as opposed to the fear of missing the bottom.
Thanks very much, Robert.
HOW HARVARD’S INVESTING SUPERSTARS CRASHED
Stocks were tumbling last fall as the new school year began, but at Harvard University, it was as if the boom had never ended.
Workers were digging across the river from Harvard’s Cambridge, Massachusetts, home, the start of a grand expansion that was to eventually almost double the size of the university. Budgets were plump, and students from middle class families were getting big tuition breaks under an ambitious new financial aid program.
The lavish spending was made possible by the earnings from Harvard’s $36.9 billion endowment, the world’s largest. That pot was supposed to be good for $1.4 billion in annual earnings. Behind the scenes, though, a different story was unfolding.
In a glassed-walled conference room overlooking downtown Boston, traders at Harvard Management Co., the subsidiary that invests the school’s money, were fielding questions from their new boss, Jane Mendillo, about exotic financial instruments that were suddenly backfiring.
Harvard had derivatives that gave it exposure to $7.2 billion in commodities and foreign stocks. With prices of both crashing, the university was getting margin calls – demands from counterparties (among them, JPMorgan Chase and Goldman Sachs) for more collateral. Another bunch of derivatives burdened Harvard with a multibillion-dollar bet on interest rates that went against it.
It would have been nice to have cash on hand to meet margin calls, but Harvard had next to none. That was because these supremely self-confident money managers were more than fully invested. As of June 30, they had, thanks to the fancy derivatives, a 105% long position in risky assets. The effect is akin to putting every last dollar of your portfolio to work and then borrowing another 5% to buy more stocks.
Desperate for cash, Harvard Management went to outside money managers begging for a return of money it had expected to keep parked away for a long time. It tried to sell off illiquid stakes in private equity partnerships but could not get a decent price. It unloaded 2/3s of a $2.9 billion stock portfolio into a falling market.
Now, in the last phase of the cash-raising panic, the university is borrowing money, much like a homeowner who takes out a second mortgage in order to pay off credit card bills. Since December, Harvard has raised $2.5 billion by selling IOUs in the bond market. Roughly a third of these Harvard bonds are tax exempt and carry interest rates of 3.2% to 5.8%. The rest are taxable, with rates of 5% to 6.5%.
It does not feel good to be borrowing at 6% while holding assets with negative returns. Harvard has oversize positions in emerging-market stocks and private equity partnerships, both disaster areas in the past eight months.
The one category that has done well since last June is conventional Treasury bonds, and Harvard appears to have owned little of these. As of its last public disclosure on this score, it had a modest 16% allocation to fixed income, consisting of 7% in inflation-indexed bonds, 4% in corporates and the rest in high-yield and foreign debt.
For a long while, Harvard’s daring investment style was the envy of the endowment world. It made light bets in plain old stocks and bonds and went hell-for-leather into exotic and illiquid holdings: commodities, timberland, hedge funds, emerging-market equities and private equity partnerships. The risky strategy paid off with market-beating results as long as the market was going up. But risk brings pain in a market crash. Although the full extent of the damage won’t be known until Harvard releases the endowment numbers for June 30, 2009, the university is already working on the assumption that the portfolio will be down 30%, or $11 billion.
The strain of market turmoil is visible in staff turnover at the management company, which axed 25% of its staff recently and is on its 5th chief in four years. Mendillo, 50, came to Harvard last July after running Wellesley’s small endowment. She declines to comment. But how much blame she should get is unclear. The big bets on derivatives and exotic holdings were in place before she got there. The bad bet on interest rates – a swap in which Harvard was paying a high fixed-interest rate and collecting a low short-term rate – goes back to a mandate from former Harvard President Lawrence Summers.
Jack R. Meyer, 64, a revered money manager who headed Harvard’s endowment until 2005, offers a few guarded comments. “The liquidity thing most concerns me – that should not have happened,” he says. Though he was not there at the time, Meyer says Harvard Management bought the commodity and foreign stock derivatives as a way to get exposure to those asset classes while freeing up cash to put to work elsewhere. The strategy, he says, “drained liquidity” from the endowment in recent months. “Many endowments stretched too far, and I think Harvard did as well,” he says.
The endowment will remain stretched. Harvard has been counting on it to fund more than a third of its $3.5 billion operating budget. Assuming the fiscal year ends with around a $24 billion endowment value, the university will be drawing down half again as high a percentage of its assets as it did in 2004, the last time the endowment was around that size.
That cannot go on forever. The strain on liquidity will continue, as the private equity partnerships compel Harvard to meet billions in capital calls in future years. Why not just unload those partnerships along with the liabilities that stick to them? Because no one wants to buy them. Private equity stakes like Harvard’s are selling at 40% to 60% discounts in various markets. “Endowments will be shocked at the valuations of their [private equity] portfolios,” says Stewart Massey, an endowment consultant at Massey Quick. “It is going to be an absolute bloodbath.”
Harvard’s woes are in some ways no different from those at other universities or in the market generally (the S&P 500 is down 37% since last July 1). “A loss in these kinds of markets is inevitable,” says Michael Eisenson, a former HMC staffer who now runs private equity firm Charlesbank. The average endowment is down 23% in the five months through November, according to a university trade group.
But Harvard was supposed to be different. In the 15 years through last June, it returned an annual 15.7% versus 9.2% for the S&P. Meyer landed at Harvard in 1990 after scoring big investment returns at the Rockefeller Foundation. In an unorthodox move for an endowment chief, Meyer built a Wall Street-like trading operation and managed most of HMC’s money in-house. It looked like a giant hedge fund, and it had paychecks to match. A high-level HMC manager would make as much as $35 million in good years. Those sums triggered what became an annual Harvard tradition: first, the disclosure (compelled by tax laws applying to nonprofits) of the HMC bonuses, followed by an outcry led by the late William Strauss and a group of Harvard alumni from his class of 1969.
HMC not only became a place to make big bonuses, it was also where you could make a name for yourself and become a “crimson puppy,” meaning launching your own private equity firm or hedge fund with Harvard’s backing. One of the puppies, Jeffrey Larson, left in 2004 to start Sowood Capital. That pile of smart money cratered in 2007, losing $350 million for Harvard.
By September 2005, Meyer himself decided it was time to go. Some people say it was because of the persistent criticism about bonuses, which were reduced near the end of his tenure. Others say he had run-ins with former U.S. Treasury Secretaries Lawrence Summers and Robert Rubin, who assumed Harvard leadership positions at the start of the decade. Meyer denies both reasons and says 16 years at Harvard was simply enough.
Meyer formed his own hedge fund, Convexity Capital, which seems to have held up well in the current market. He took with him the Harvard heads of domestic and international fixed income and both their staffs, as well as the chief risk officer, chief technology officer and chief operating officer. The survivors were demoralized. “You walked onto the trading floor, and it was just 10% full,” says someone who was there at the time. “There was a sense that if you were good, you left.”
Five months later, Mohamed El-Erian, now 50, took over. The son of an Egyptian diplomat, he had risen to deputy director of the International Monetary Fund before joining giant bond manager Pimco. He seemed perfect for smoothing relations between HMC and the university. Filling the hole that Meyer left was another matter.
One solution: Do not even try, just hand over all of the endowment to outside money managers. But El-Erian insisted on keeping things intact. He talked of the “structural advantages” of investing a big endowment backed by an AAA-rated university, such as allowing you to borrow at low rates when making leveraged bets. The former Pimco emerging-market superstar also believed that the developing countries offered big profits to smart investors like HMC because they had become less risky thanks to ample dollar reserves and a growing middle class.
So El-Erian upped HMC’s exposure to emerging-market stocks, which rose from 6% of assets when Meyer left, to 11% two years later. He also used total return swaps to bet on developed world stocks and commodities on the cheap, freeing up money for other investments. Tapping former Stanford endowment staffer Mark Taborsky (an “important hire,” El-Erian would later write in a book), El-Erian also took money from hedge funds he did not like and redirected it to ones he thought were winners, putting hundreds of millions into funds in Latin America, Asia and the Middle East.
The moves looked brilliant. For the year ended June 2007, Harvard returned 23% versus 17.7% for 151 other big institutional investors (and 20.6% for the S&P 500). Fearing all markets could soon fall, El-Erian injected what he referred to as “Armageddon insurance” into HMC’s portfolio for the first time by buying interest rate floors, or a wager that rates would fall, and betting, via credit default swaps, that companies could soon struggle to pay their debts.
For the following year, through June 2008, Harvard gained 8.6%, versus a 13% fall in the S&P. El-Erian’s insurance accounted for much of HMC’s outperformance. Hedge funds, however, were sucking up cash – HMC had increased investments in those areas to 19% from 12% a year earlier. The returns were flat. It is unclear how much of the results – good or otherwise – were El-Erian’s doing. He left at the end of 2007, six months before the results came in, citing a desire to move back near his wife’s family in California and return to Pimco as heir apparent to founder Bill Gross.
Since July, emerging-market shares have been a disaster, falling 50%, as measured by the MSCI Emerging Markets Index, worse than U.S. stocks. Another problem: El-Erian’s insurance has been partly taken off since he left, leaving HMC vulnerable when markets plunged this fall. The total return swaps, which easily could have been terminated, were left alone. The EFG-Hermes Middle East North Africa Opportunities Fund, a hedge fund launched in September 2007 with some $200 million of HMC cash, was down 35% in 2008. El-Erian’s big hire, Taborsky, left HMC in September. He has since joined El-Erian at Pimco. El-Erian and Taborsky decline to comment.
By the time Jane Mendillo walked into HMC’s offices in July 2008, she figured some changes needed to be made. A former consultant who worked for years at HMC under Meyer, Mendillo got the HMC gig partly as a result of Meyer’s recommendation. She had spent the last six years running the $1.6 billion Wellesley College endowment, which was completely outsourced to external managers. Her detractors say that she was ill prepared for Harvard’s liquidity crisis and slow to take cognizance of the swap exposure. But they concede that the crisis came fast on the heels of her arrival.
Mendillo did move quickly to deal with the private equity portfolio. One of her first moves at HMC, which she initiated before the markets started to fall in earnest, was to sell between $1 billion to $1.5 billion of Harvard’s private equity assets in one of the biggest such sales ever attempted. The high bids on such assets have recently been 60 cents on the dollar, says Cogent Capital, an investment bank that advised Harvard on the sale. Cogent says the big discounts are due to “unrealistic pricing levels at which funds continued to hold their investments” and “fantasy valuations.”
Defenders of Harvard’s portfolio argue the secondary market is discounting private equity stakes too much. The market is made up of a dozen secondary funds with at most $15 billion available, says Bryon Sheets, a partner at San Francisco secondary firm Paul Capital. That makes it a buyer’s market, given the slew of desperate banks, pension funds and endowments looking to unload assets to meet obligations. So what are Harvard’s private equity stakes worth? Most private equity investors like Harvard have been waiting for their money managers to finish marking down their assets following a brutal 2008. It is a slow process that lags the public markets by as much as 180 days, says William Frieske, a performance consultant at Northern Trust, which administers endowment accounts.
But one clue to what may be coming can be found in Harvard’s own portfolio. It owns units of Conversus Capital, a publicly traded vehicle that holds slices of 210 private equity funds. Conversus has cut its net asset value by 21% since last summer to make a “best estimate.” Yet stock investors think things are a lot worse. Conversus shares have fallen 67% since June 30 and are trading at a 62% discount to the net asset value. The Conversus stock drop translates into a potential $168 million loss for Harvard, which, as of January 31, was still listed as a “strategic investor.”
Conversus is run by Robert Long, a former Bank of America exec who went to Boston and got $250 million from El-Erian to help him set up the firm and buy $1.9 billion of Bank of America’s private equity assets. Harvard also owns a piece of Garnett & Helfrich Capital, a $350 million fund opened in 2004. Garnett has purchased six companies but, five years later, is yet to realize any returns. The value of one of those investments, software maker Ingres, has been reduced by its minority owner to nothing “as a result of reported losses.” Then there is Tallwood Venture II, a $180 million fund raised in 2002 to invest in semiconductors. It has hardly exited any of its portfolio companies, according to Thomson Reuters and SEC filings.
The fact that a fifth of HMC’s portfolio is in private-equity-like investments makes it vulnerable to the kind of problems HMC faced this fall. HMC has made $11 billion of capital commitments to investment partnerships through 2018, says Moody’s. HMC used to make good on those commitments with income generated by the existing private equity portfolio. “Endowments are afraid capital calls will come quickly and far ahead of any liquidity from private equity funds,” says Colin McGrady, managing director at Cogent Partners.
Watching all of this, the group of 10 Harvard alumni from the class of 1969 feel vindicated. “The events of the last year show that the whole procedure of rewarding people so handsomely based on increases on paper value of the endowment was deeply flawed,” says a spokesman for the group, which recently sent a letter to the Harvard president suggesting HMC staffers return $21 million of their latest bonuses. “Even now, we don’t really know how well it has done in the last 10 years.”
BUFFETT’S DEADMAN’S HAND
It is not exactly aces and eights, but Warren Buffett is holding some nice cards.
The headline of this column is a touch melodramatic. After all, Warren Buffett is two-handed.
His left hand is shaky, holding on to his five largest positions valued at over $41 billion. Several dropped more than 50% these past 12 months. So-called defensive holdings like Procter & Gamble (PG) and Coca-Cola (KO) were market performers, declining over 30%. Wells Fargo (WFC), American Express (AXP) and ConocoPhillips (COP) turned into mini-disasters, down more than 50% from year-ago highs.
I like Buffett’s right hand much better. It holds multibillion-dollar positions in convertible preferred stocks and debentures in capital-starved financials like Goldman Sachs and Swiss Re. Although Buffett is on record that the stock market is in a fundamental buying range, over the past several months tens of billions got earmarked for defensive, fixed-income investments with equity kickers. In short, Berkshire Hathaway’s (BRK) portfolio seems headed closer to a balanced construct rather than pure equities.
Investors can learn a lot from this gambit. Obviously, we odd lotters cannot negotiate privately issued convertible preferreds with 12% yields. But we can buy A-rated preferreds like those from JPMorgan Chase (JPM) and Viacom (VIA) yielding 9%.
Not that these issues stand free of risk: All bank preferred stocks carry the risk of nationalization by the federal government if the bank’s tangible net-worth ratio to risk assets melts away. Viacom’s cable programming franchise could erode, and advertising revenues may drop 20% or more this year.
Serious investors crave yield, starved with 10-year Treasuries at 3% and Treasury paper maturing within five years, adjusted for inflation, in negative yield territory. Even single-A corporates yielding more than 6% months ago now rest below 5% after a major rally. The yield disparity between 10-year, low-investment-grade corporates and Treasuries has closed from 350 basis points to approximately 200 – still sizable, but no longer a bargain.
Like all successful investors, Buffett faces the dilemma of inventorying low-basis cost equities. He has lived by the rule of never selling any viable security even if it is temporarily overpriced. Growth bails you out if you are patient, but forever?
I got caught up in this spider web, and it turned sinister a year ago when my inventory in Google (GOOG), Apple (AAPL) and Celgene (CELG) headed south. Google and Apple, even after the past month’s rally, stand sliced in half from high water marks.
For Buffett, this predicament proved even more dangerous. Berkshire’s five largest holdings include two major financial properties, Wells Fargo and American Express. Both stocks tot up to $17 billion, and their fundamentals are conjectural, even after declining over 50%. Google and Apple actually showed upside surprises in year-end quarterly results.
The disparity between growth and value indexes widened dramatically since year-end, now approximately 1,000 basis points. Investment performance for value players was destroyed by the financial sector’s toxicity.
Wells Fargo’s acquisition of Wachovia may not be as disastrous as Bank of America’s deal for Merrill Lynch but its commercial real estate loans made at top of the cyclical valuations in 2006 to 2007 remain shaky along with Wells’ home mortgage portfolio. Credit card losses for American Express are piercing through conventional loss-reserve allocations, unlikely to top out before mid-2010 as unemployment levitates.
Berkshire Hathaway holds another $25 billion market value in P&G, Coca-Cola and ConocoPhillips. Earnings continue to disappoint for these three properties. Oil stocks currently discount $60 oil with futures now ticking at $40 a barrel. The best diversification play P&G has unveiled is a car-wash franchise – not exactly mind-blowing. In a long recession, Coke drinkers cut back and keep jugs of ice water in the refrigerator. Bottled water demand is shrinking, no longer a growth driver. The most complimentary thing you can say is that these properties no longer are overpriced.
In the present volatile market setting, the tried and true investment concept of defensive investing is on the table for reevaluation. Even prescription drug demand is under attack. Users break tablets in half, cutting back on their daily intake. Kraft and other consumer food purveyors of high-end products experience contraction in their product lines.
Only Campbell Soup (CPB), McDonald’s (MCD) and Wal-Mart (WMT) escape declining sales as consumers trade down. Mr. Sam’s kosher frankfurters are a hit item currently. Delicious! The big box in my locale, Kingston, was mobbed last Saturday morning while the main floor at Saks (SKS) stood deserted. At Lowe’s (LOW) I could not spot a sales person on the floor.
Like Buffett, I put capital into beaten-down financials, but I am taking much more risk in the face of rising premiums for insurance underwriters and banks to hedge out risk on real estate and commercial mortgage-backed securities and variable annuities.
I own Goldman Sachs equity and debentures, JPMorgan’s preferred stock, MetLife (MET) and, lately, Allstate (ALL). Allstate is so risky I dare not buy it for clients. The possibility of a dividend cut, equity dilution, more credit downgrades and even insolvency stare you in the face.
I got away with buying the HMO Aetna (AET) when the fear of major losses in its bond portfolio and commercial real estate led to major short-selling. Aetna touched down at $14 and now trades at $32, still selling at eight times this year’s earnings power. Sometimes it pays to be counterintuitive and do what seems at the time to be sheer stupidity.
Last week, Cisco (CSCO), an iconic property, reported disappointing numbers – earnings down 30% – and the stock rallied! Numbers were not any worse than the Street expected. Parsing the quarterly report, I noted management cut back on overhead. R&D, selling and administrative expense lines were flat compared to a year ago. Cisco may be selling at 15 times earnings, but in a normalized setting it is at 11 times, an attractive valuation.
Anyone who believes the economy turns at mid-year needs intensive counseling. Buffett turning to fixed-income securities with equity kickers suggests the equity market again faces upstaging this year by other asset classes – even gold, oil and the dollar perhaps, but above all by corporate debentures and preferreds.
Beware of high-yielding common stocks. Analysis shows defensive stocks yielding 7% or more underperform because their dividend-paying capacity is suspect. General Electric (GE) is a good example because it is paying 100% of its earnings at a time when it should be conserving capital. Are outside directors still sleeping on this issue?
The irony in all this is that well-heeled investors did not need Madoff in their lives. Low double-digit rates of return existed outside of Ponzi operators. I just wish there was more non-financial paper available in the universe.
Unlike Buffett, I will not put more than 5% of my assets in any financial house that may crumple for the count of nine if not 10. The list is too long and still expanding. If nothing else, Citigroup, Bank of America and AIG have made obsolete the euphemism “faded blue chip.” These are colorless, shattered chips.
These days, not even the expression “Nobody Buries Disneyland” seems airtight.
THE 20 BEST DIVIDEND PLAYS FOR 2009
As fat dividends become scarce, here are 20 stocks with reasonably secure payouts of 4% or more.
Buying stocks for their dividend yield may bring forth images of your grandmother’s utility stocks portfolio. This has always been misguided, as the reality is that dividends have always been a large component of stocks’ total return. Various analysts have pointed out that dividend paying stocks in fact outperform their non-paying peers over time. The idea of capital gains as a realiable source of investment return is a fairly recent development. Now that dividends are taxed at only a 15% rate there is no reason to favor returns in the form of capital gains.
An additional point is that dividends come in the form of cash on the barrelhead, as opposed to ephemeral, easily-given-back capital gains. Cutting dividend payments is not a rare event for U.S. companies, and there is plenty of that going on right now, but we dare say it is somewhat rarer than stock price declines. Cutting to the chase, while yield investing has never gone out of style we see it becoming more prominent.
It is getting tougher to have confidence in the security of dividends, as former payment stalwarts such as Bank of America , Pfizer, Carnival, Dow Chemical, Citigroup and Motorola slash or eliminate payouts.
This year likely will see the largest annual decline since 1942 in dividends paid by the companies in the Standard & Poor’s 500 index. S&P projects dividends will fall by 13% in 2009, and the numbers could get worse. “We are taking an optimistic view,” says Howard Silverblatt, the senior index analyst at S&P. “If corporations do not see better business conditions later this year, dividend cuts could become more widespread." S&P, for instance, still assumes General Electric will pay its lofty annual dividend of $1.24 a share, even though many investors and analysts expect GE will have to cut its payout in the second half. The company is expected to barely earn its dividend in 2009 and arguably should be conserving capital to bolster its financial-services unit. With the stock down 28% this year to $11 and the yield above 10%, Wall Street is banking on a dividend cut. GE, the biggest dividend payer in the U.S. at $13 billion annually, accounts for 6% of all S&P 500 dividends.
Given the ugly economic and financial backdrop, there are few guaranteed dividends, especially among financial companies. Dividends at JPMorgan Chase, Wells Fargo and U.S. Bancorp could be trimmed this year. Pfizer recently surprised – and angered – many shareholders by cutting its dividend 50% in conjunction with its $68 billion deal to buy drug maker Wyeth. Some say dividends do not affect stock prices, but the Pfizer action suggests otherwise: Its shares are down $3, to $14, since the Wyeth announcement last month.
These companies all are offering 4%-plus yields, and the prospects for continued dividend payments are good. Company/Ticker Stock Price($) Yield Annual Dividend* Payout Ratio** 2009E P/E Reynolds Am / RAI 39.04 8.7% 3.40 71.9% 8.3 Embarq / EQ 35.37 7.8 2.75 56.2 7.2 Altria / MO 16.55 7.7 1.28 74.4 9.6 AT&T / T 24.29 6.7 1.64 82.0 12.1 Verizon / VZ 29.86 6.2 1.84 73.3 11.9 Int’l Game / IGT 9.80 5.9 0.58 56.9 9.6 Meredith / MDP 15.19 5.9 0.90 44.3 7.5 Lorillard / LO 64.60 5.7 3.68 68.3 12.0 PPG Ind / PPG 36.92 5.7 2.12 64.6 11.3 Bristol-Myers / BMY 22.52 5.5 1.24 63.9 11.6 Eli Lilly / LLY 36.34 5.4 1.96 47.1 8.7 Merck / MRK 29.34 5.2 1.52 46.5 9.0 Whirlpool / WHR 33.07 5.2 1.72 54.4 10.5 Heinz / HNZ 35.01 4.8 1.66 57.4 12.1 Nordstrom / JWN 13.77 4.7 0.64 50.8 11.0 Kraft / KFT 25.47 4.6 1.16 60.7 13.3 Kimberly-Clark / KMB 50.44 4.6 2.32 55.6 12.1 Eaton / ETN 43.93 4.5 2.00 48.8 10.7 Pfizer / PFE 14.65 4.4 0.64 30.2 6.9 VF Corp / VFC 54.06 4.4 2.36 43.1 9.9 *$ per share.
**Annual dividend divided by estimated 2009 earnings.
Sources: Thomson Reuters; Bloomberg
With money-market funds and many bank accountings paying just 1%, investors are hungry for yield. We are happy to help them. In the table nearby, we have assembled a list of S&P 500 companies that have reasonably secure dividend yields of 4% or more. That is above the index’s current yield of nearly 3%.
These 20 companies include Merck, Eli Lilly and Bristol-Myers in pharmaceuticals; Heinz and Kraft in food; Altria, Reynolds American and Lorillard in cigarettes, and Verizon Communications and AT&T in telecommunications.
In putting together this list, we have considered industry conditions, financial strength and dividend-payout ratios, which are derived by dividing annual dividends by estimated 2009 earnings. A low payout ratio is preferable because it means a company has a cushion to pay dividends. Most of the payout ratios are below 70%, with the average at 58%. We have excluded electric utilities, many of which have secure 4%-plus yields.
Two exceptionally high payout ratios belong to Altria, maker of Marlboro cigarettes, and Reynolds American, producer of Camel and Winston brands. Both companies aim to distribute 75% of their profits in dividends. Many investors find the cigarette business distasteful, and the industry domestically is in decline, hurt by falling consumption and higher taxes. Yet cigarettes’ addictive nature gives tobacco companies pricing power, even in a recession.
Which dividends are in danger? The nearby table, “Too Good to Be Paid?", includes 10 prominent stocks with high dividend yields that may be in jeopardy. The companies include General Electric, CBS and Alcoa. They have high payout ratios or nonmeaningful ratios because they are projected to lose money. These 10 stocks, many of which are down sharply in the past year, could rebound in 2009, but investors should not buy them for their seemingly attractive dividends.
Dividend cuts continue to come fast and furiously. We initially put Harley-Davidson and Dow Chemical on our endangered-dividend list, but removed them after the companies slashed their payouts last week.
The market for S&P 500 dividend swaps, which allow institutional investors to bet on dividends, implies a sharp reduction in payouts this year to a weighted average of $20.50, down from the current rate of about $25 and last year’s $28.39. Next year’s dividends are expected to be even lower.
While our list of attractive dividend payers includes mostly defensive consumer names, Mattel and Meredith are riskier choices. Toy maker Mattel surprised Wall Street with bad 4th-quarter profits, and Meredith, publisher of Better Homes and Gardens and other magazines, has been stung by the drop in print advertising. Meredith does not seem too fazed because it recently raised its dividend – albeit by a penny a share.
The drug sector is well represented with industry leaders Merck, Bristol-Myers, Lilly and Pfizer. Dividends at all four look secure, although future payout increases could be muted by modest annual profit growth. The new Pfizer dividend of 64 cents annually, for a 4.5% yield, looks safe at just 30% of projected 2009 earnings. The negative investor reaction to the Pfizer payout cut may make other drug makers wary of reducing dividends.
Dividend yields are high in the telecom sector, but payout ratios are lofty, a potential concern. Verizon and AT&T made our list with their 6%-plus yields, but their payout ratios exceed 70% based on projected 2009 earnings. Both dividends look pretty safe. Embarq, a Sprint Nextel spinoff, has a yield of nearly 8% and a comfortable dividend-coverage ratio of 56%. The risk with Embarq – and Verizon and AT&T – is exposure to the declining wireline phone business.
VF Corp., another name on the list, has a strong balance sheet and markets popular apparel brands such as North Face and Wrangler. Its 4.4% dividend yield looks safe.
Food makers Heinz and Kraft make our list with their 4.8% and 4.6% dividends, respectively. Heinz is expected to boost its dividend in May – by a small amount. It has an above-average stable of brands and could be a takeover target, as we argued last month (see “Anticipating the Return of the Ketchup Kid,” January 26.)
Kraft has disappointed since its 2001 initial public offering, with the company unable to keep annual profit at more than $2 a share. This year does not promise to be any better. Kraft’s stock, now 25, could be supported by its bond-like yield. Investors can buy the stock today for less than what Warren Buffett’s Berkshire Hathaway paid for its stake of 132 million shares. Berkshire’s average cost is $33 a share.
Citigroup and Bank of America have slashed their dividends to a penny per quarter in conjunction with government-assistance programs. Regional banks like Suntrust, Zions Bancorp and KeyCorp also have sharply reduced their payouts.
Wells Fargo and U.S. Bancorp are among the strongest banks and have not touched their dividends – yet. Those payouts could be vulnerable because neither may earn its dividend this year. JPMorgan’s annual dividend of $1.52 a share is high relative to projected 2009 profit.
The implosion in media profits is stinging CBS and Gannett, which once had secure dividends. CBS’s dividend looks unsustainable given its high payout ratio and debt levels. “It is hard to see a scenario where CBS does not have to dramatically scale back its dividend to create more financial flexibility,” Bernstein media analyst Michael Nathanson recently wrote.
Gannett, the largest U.S. newspaper company, could be fighting for its survival in the next few years, given industry trends. With its debt yielding 20%, Gannett ought to conserve every spare dollar to repay its $4 billion of debt. Kodak and Alcoa are operating in the red, imperiling their dividends.
GE plans to review its dividend in the second half of this year, and some think the company should act sooner. “It is unclear to us why the dividend has not been cut yet,” wrote Credit Suisse analyst Nicole Parent last week. “The company is constraining its available cash flow by paying such a large dividend and making it more difficult for it to emerge stronger from this downturn.”
If equity returns are muted in coming years, investors holding high-yielding stocks should do well. Historically, dividends have accounted for about 35% of equity returns. Some dividend-paying stocks may seem boring, but there is nothing wrong with that in this market.
AGAINST THE GRAIN: FOUR STOCKS RAISING THEIR DIVIDENDS
At a time when many companies are cutting dividends in order to conserve capital, looking for high yields is not enough, as is pointed out in the article immediately above. You have to analyze whether the dividend is secure. The four stocks discussed here actually raised their dividends recently. Three of the four were nominal 1 cent per quarter increases – the smallest increase possible. As is pointed out here, any increase is noteworthy. More significantly, our guess is that an increase is a reliable indicator, albeit not a guarantee, that a dividend is not foreseen anytime soon. Avon, Honeywell, and 3M are yielding over 4%, which is more that T-bonds.
Investors seeking dividends either for income or reinvestment purposes had a pretty good thing going with most large, blue-chip companies back in 2007. Unfortunately, the sunny days of regular dividend payments and increases gave way to the dark reality that is the global economic meltdown and 2008 showed investors that any company at any time can substantially cut, or altogether eliminate, its dividend.
Financials were leaders on the dividend slashing front. Formerly among the most steady dividend payers, large banks, such as Bank of America and Citigroup now pay a meager 1 cent a share in dividends because they have taken assistance from the Troubled Asset Relief Program (TARP).
Financials have not been the only dividend slashers. This epidemic spread across a broad swath of industries. The outlook for dividends is in fact so dour that General Electric, America’s largest dividend payer in dollar terms, looks poised to reduce what has historically been one of the most reliable dividends.
Believe it or not, there are companies increasing their dividends. Let us take a look at four:
Company Dividend Increase ($) Quarterly Dividend ($) Yield (%) Archer Daniels Midland (ADM) 0.01 0.14 2.0 Avon Products (AVP) 0.01 0.21 4.2 Honeywell (HON) 0.025 0.30 4.3 3M (MMM) 0.01 0.51 4.3
Archer Daniels Midland is a dominant name in the agriculture and food commodities industries and that market position has led the company to be one of Wall Street’s most consistent dividend payers. Granted, a 1 cent increase is not going to fund your retirement, but these days, any increase is noteworthy.
Keep in mind that there are still a plethora of companies mulling dividend cuts and ADM is a market leader that just raised its dividend, which it has done for 34 consecutive years. The company now has a dividend yield of 2% and trades at a scant 1.3 times book value, though its enterprise value is almost 1/3 larger than its market cap. ADM is more a value than growth play, but there is something to be said for consistency and reliability in this market. ...
Despite the fact that its earnings outlook is bleak, Avon Products has found a way to deliver some value to its shareholders and that came with a recent dividend increase. The company is the world’s largest direct seller of beauty products with $10 billion in annual sales and its recent dividend hike was its 19th. Paying 84 cents annually, Avon shares currently yield 4.2% and trade around 13.5 times book value. Beyond the dividend, there could be some nice capital appreciation in store for Avon shareholders when the global economy turns around as the company now generates half its sales from international markets.
Honeywell and 3M are both Dow components and two of the most familiar names to market observers. Neither company does anything that could be considered “sexy,” but both quietly go about their business(es) and deliver solid dividend results for shareholders.
Honeywell has been steadily increasing its dividend since 2005 and the conglomerate now yields 4%. Besides the steady payout, investors should expect the shares to increase when the economy improves. The company is expected to be a main beneficiary of President Obama’s stimulus package, which calls for improvements to the U.S. power grid, a key line of business for Honeywell. Honeywell shares look cheap here, trading at approximately 3.2 times book value and at a forward P/E ratio of 9.2.
3M is another industrial conglomerate that has the dividend game down to a science. It currently pays 51 cents a quarter and its most recent boost was the 51st consecutive year in which it raised its dividend. The company now pays $2.04 a share annually, which is good for a 4.3% yield as of market close February 18, 2009. 3M also extended its $7 billion share repurchase program. (See what this could mean for investors, read “A Breakdown Of Stock Buybacks".)
All is not well with 3M shares, though. Earlier this month, they reached a 52-week low and are down almost 20% this year. The company said it expects Q1 sales to plunge 15-18%. Then again, those statistics apply to many a lesser company and 3M has the appearance of a value play, trading at 3.5 times book value and around 10 times forward one-year earnings.
There is one simple fact that investors need to know about dividends: dividend paying stocks outperform their non-paying peers over the long-term. With that mind, Honeywell and 3M appear to be the best of the breed.
GOODWILL HUNTING: BALANCE SHEETS’ LATEST TORMENT
15 companies that are vulnerable to goodwill impairments.
Here is the latest installment in the ongoing heartbreak called corporate-earnings releases.
In coming months, do not be surprised to see more charges against earnings – and resulting losses – owing to goodwill impairment. Last week, NYSE Euronext recorded a $1.34 billion 4th-quarter loss, as it took a charge related to the New York bourse’s 2007 purchase of its European counterpart. The charge involved a write-down of $1.59 billion of goodwill. Without the charge, NYSE Euronext would have posted a profit.
The spectacular fall in stock prices in the past year triggers these goodwill-impairment tests. Goodwill is the difference between the price paid for a company in an acquisition – often lofty in the bull market – and the value of its assets. That difference is assessed annually and recorded in the company’s results, thanks to accounting rule SFAS 142. As the value of the assets declines, companies must write them down and take goodwill-impairment charges. That is bad news for corporate earnings.
“Over the next two months, we will see a substantial number of goodwill impairments, which will be taken as expenses and hit earnings,” says James Kaplan, chairman of Los Angeles-based Audit Integrity, which provides accounting-and-governance risk analysis on public companies to auditors, insurers and institutional investors.
Some companies in the news lately for goodwill impairments are Fifth Third Bancorp, which reported a $965 million charge, part of a $2.2 billion fourth-quarter loss; Regions Financial, with a $6 billion charge; Weyerhaeuser, with charges of $827 million and a 4th-quarter loss of $1.21 billion; Lubrizol, which had a $325 million charge and 4th-quarter loss of $243 million; and Hartford Financial, with a $597 million after-tax write-off of goodwill.
Fifth Third shares plunged 29% after the call following the announcement, pushed down by its chief executive’s pessimism about the current quarter; Regions Financial fell 24%; and Hartford at one point was off by more than 25% before finishing down about 16%.
Some argue goodwill impairment is a pointless metric, since stock prices anticipate the write-down, and the charge is noncash. But they reduce assets, and such write-downs may prompt trouble with lenders. Last week, Moody’s put Weyerhaueser under review, partly citing goodwill-impairment charges “that may reduce covenant headroom” under two credit facilities. Failure to take write-offs also extended Japan’s long decline.
We asked Kaplan’s firm, Audit Integrity, to run a screen of companies it believes are likely to report goodwill impairments. ... Audit Integrity compiled the list by looking for companies where goodwill is at least 15% of total assets and where that ratio is greater than the industry median. Another prerequisite was a ranking of “aggressive” or “very aggressive” on Audit Integrity’s proprietary Accounting and Governance Risk rating. That is a quantitative model that weights specific accounting-and-governance metrics from corporate reporting. Aggressive describes risky accounting-and-governance practices.
Among the measures included in the proprietary model are rising ratios of the following: accounts receivable over sales; accumulated depreciation over plant, property and equipment; underfunded pension benefits versus liabilities; and cumulative accounting changes. It also flags companies with several amended filings in the past year. Traditionally, Audit Integrity explains, ratios should not change much, and the ratio of receivables to sales, for example, ought to be pretty consistent from quarter to quarter. When they change, it is a red flag – a sign of potential problems. Those companies with lower AGR ratings, Audit Integrity says, have a greater potential for events like restatements or regulatory actions that are obviously negative for stock prices.
Some of the companies include Procter & Gamble, which bought Gillette for $57 billion in January 2005; serial acquirer ConocoPhillips, created in a 2002 merger, and which in 2006 bought Burlington Resources; biotech giant Amgen, which has been buying companies since taking over Immunex in 2002; Monsanto, which bought Delta & Pineland Seeds and Seminis; Kraft, which bought Group Danone’s cookie and cereal division in 2007 and is itself the product of a merger with Nabisco; and CVS Caremark, which has acquired companies since its 2006 megamerger.
We are going to see a jump in corporate goodwill impairments in the next two months. They will hit earnings and, in many cases, stock prices as well.
Mostly, companies declined to comment, without knowing the specifics of the analysis. P&G said it “held itself to the highest standards.” Some, like Northrop Grumman and ConocoPhillips, noted they had already announced impairments. And David Rickard, chief financial officer of CVS Caremark, said “This is an excellent illustration of the problems with mechanistic analysis. It points out potential risks that simply do not exist,” as CVS has done a “phenomenal” job with its acquisitions.
Kaplan and colleague Jack Zwingli are quantitative analysts and credit experts who oversee the six-year-old Audit Integrity. Among the companies Kaplan is short in his personal account, it ought to be mentioned, are eBay (EBAY) and Transocean (RIG), both on the list.
International value fund managers bet on Experian and other companies that can expand their businesses during hard economic times.
David Samra and Dan O’Keefe’s bottom-up approach to choosing stocks held up better than most last year, as the credit and commodities markets crashed. The next challenge for the co-managers of Artisan International Value Fund (ARTKX) is to see whether their micro strategy outperforms in the steepest global recession since World War II.
Though down 30% in 2008, their fund returned 17 percentage points more than the average foreign small- to mid-value fund. (They do own some large-caps as well.) That, and their impressive long-term performance and consistency, earned them Morningstar’s International-Stock Fund Manager of the Year award for 2008.
Of course, Samra, 44, and O’Keefe, 39, recognize that is cold comfort for shareholders who lost nearly 1/3 of their money. On the other hand, the shallower the hole, the easier the climb out.
And for that, the Artisan managers are sticking to their key indicators of opportunity: stocks that trade at a steep discount to underlying valuations; companies with an aversion to debt and leverage; and management teams that play offense even in a down environment.
In hindsight, they started the roughly $1 billion fund at an opportune moment, in September 2002, even if it did not seem so at the time. The dot-com bust and shallow recession had brought share prices lower in many parts of the world. Artisan International Value soared more than 50% its first full year, in 2003’s bull market.
But back in 2001-2003 the linchpin of the global economy – U.S. consumers – barely flinched, and they were about to get a steroid shot from the housing bubble.
Yet after the collapse of Lehman Bros. in September, the latest downturn started hitting the type of no-frills, consumption-driven businesses that investors usually flee to in tough times. Consumer discretionary and staples stocks are a sizable chunk of Samra and O’Keefe’s fund, too, including investments in Signet Jewelers , which operates Kay Jewelers. Signet is off 22% since early November, and the San Francisco-based fund itself has lost 7.77% this year through February 11.
With major economies hemorrhaging jobs and discretionary spending evaporating here and abroad, the bedrock of corporate earnings is at risk this time around. In late 2002, stocks were cheap. Now, many have good reason to be.
“We have no crystal ball,” says O’Keefe, a graduate of Northwestern University. One thing is for sure: There is no basis for a meaningful recovery in earnings this year.
Over the last five years, Samra and O’Keefe, who previously worked together at money manager Harris Associates, are up 2.9% on average, well above their peer group (-1.43%) as well as the S&P 500 (-4.49%), thanks in part to their decision to steer clear of large commercial and investment banks and energy stocks in 2007 and 2008.
Artisan today likes what Samra, a Columbia Business School grad, calls “entrenched toll booth” companies – fee-based operations that rely on human capital. An example: Experian (EXPN.UK), the top holding in the International Value Fund. The Dublin-based company is the world’s largest provider of credit-checking services and trades at about 10 times earnings.
Samra and O’Keefe think management can navigate a tough environment and is even on the lookout for acquisitions. Artisan loves companies that can, as Samra puts it, “go out and grow their business during bad economic times.”
Of course, unlike P/E ratios and return on capital, management skill cannot be screened for. To help inform those judgments Samra spends several weeks each year abroad, kicking the tires by grilling executives of target companies and rivals alike.
Another favorite: Savills (SVS.UK), a London-based commercial real-estate broker. It is a brutal sector these days, but it is another cash cow with low debt, and Artisan bought its shares after they tumbled.
Samra and O’Keefe are still on the lookout for bargains – big ones. These days companies need to trade around 45% or 50% below estimated intrinsic value to dislodge one of their existing 40 to 45 holdings. Normally that discount would only be about 30%.
Artisan International Value Top 10 Holdings Stock Ticker % of Portfolio* Experian PLC EXPN.UK 5.5 Novartis NVS 4.4 Credit Saison 8253.JAPAN 4.1 Covidien COV 4.1 Television Francaise 1 TFI.FRANCE 3.9 Arch Capital Group ACGL 3.6 Unilever PLC UN 3.4 Diageo PLC DEO 3.2 Panalpina Welttransport AG PWTN.SWITZ 3.1 Julius Baer BAER.SWITZ 3.0 Total 38.0 *As of Dec. 31, 2008
In the fourth quarter, Samra and O’Keefe added Julius Baer (BAER.Switzerland), which isn’t saddled with a big investment bank unit. The bank, they note, can both attract new clients and hire experienced private bankers. They bought shares at 10 times their estimate of net income.
When Julius Baer shares recently started plummeting over rumors of a scandal, Samra and O’Keefe, who originally bought shares in the mid-30s (Swiss francs), added to their holdings in the high 20s. (Julius Baer downplayed the seriousness of the incident, and the shares rebounded.)
Another relative newcomer is France’s Publicis Groupe (PUB.France). Advertising usually generates good cash flow, they note, and Publicis’s shares have “more than priced in the underlying risk of a downturn.” In December, Samra and O’Keefe bought Japanese brokerage Daiwa Securities (8601.Japan). They like its retail orientation and think its exposure to investment banking losses will be contained.
In December 2007, Samra and O’Keefe started Artisan Global Value Fund (ARTGX), which, unlike International Value, allows them to invest in U.S.-domiciled companies using the same philosophy. The top holding: Johnson & Johnson, another company making acquisitions during the downturn.
Recalling the last recession in 2002, when they were starting out at Artisan, Samra says, “it did not feel like a good time as we were getting involved.”
And now? These are among the best times to be buying stocks, they say, even if people do not realize it yet.
T-bonds, the new speculative commodity, are being bid up on raw momentum rather than fundamentals. Short them.
What disturbs me about the crash of 2008 is not merely the collapse in investor portfolios but also the fact that the logical assumptions that led to their construction were also left in tatters. When financial markets collapse globally, from stocks to commodities and even municipal bonds, one begins to question the very foundations of investment theory, like the wisdom of diversifying. It reminds me of a line from the philosopher Ludwig Wittgenstein: “We feel as if we had to repair a torn spider web with our fingers.” Looking at my 401(k) statement and those of many of my clients, I know exactly what he means.
At least I was fortunate enough to have some bearish plays among the exchange-traded funds I recommended, including two holdovers from 2007: ProShares Short Dow (DOG), up 16% last year, and iShares Comex Gold Trust (IAU), up 5%. My few other winners include PowerShares Dynamic Pharmaceuticals (PJP), up 4%, and PowerShares DB US Dollar Bullish (UUP), up 3%. My worst pick in 2008 was a March recommendation of Van Eck Market Vectors Coal ETF (KOL) that declined 64%.
All told, I made 29 ETF recommendations, and if you followed my advice you would have lost 26.4%, assuming a 1% transaction cost on new positions. While I never like losing money, this strategy would at least have beaten the market. Had you put the same money into the S&P 500 at the same times, you would have lost 30.8%.
Which ETFs of my 29 recommendations should you still hold? The Fidelity Four-in-One Index (FFNOX), Diamonds Trust Series 1 (DIA), United States Oil (USO), ProShares Short MSCI Emerging Markets Fund (EUM), iShares Comex Gold Trust and the PowerShares Dynamic Pharmaceuticals Fund.
After one of the worst Januarys in history it may feel as though the mattress is the safest place for your money. I do not think so. The National Bureau of Economic Research announced in December that the recession had begun a year earlier. That makes it 15 months old already, which is long in the tooth for a recession. The two longest recent recessions (1973-75 and 1981-82) lasted 16 months.
Stock valuations are cheap by historical measures, and I think President Obama’s version of socialism’s New Deal might improve things by the end of 2009, even if it is merely a deceleration of deteriorating economic trends.
Believe it or not the next bubble to burst will be long-term U.S. Treasurys. In my opinion T-bonds are the new speculative commodity. They are being bid up on raw momentum rather than fundamentals. Investors are assuming that current dismal times will only keep getting much, much worse. In 2008 the 20-year U.S. Treasury, easily purchased with ETFs like the iShares 20+ Year Treasury Fund, gained 33.8%, with most of that gain coming in the last two months. I am calling it a T-Bubble.
So for 2009 I am recommending a position in ProShares UltraShort 20+ Year Treasury (48, TBT). The TBT, which has a 0.95% expense ratio, seeks results that correspond to twice the inverse daily performance of the Barclays Capital 20+ Year U.S. Treasury Index. For example, if the index returns -10%, you will make +20% owning TBT. In 2009 I think this ETF could deliver a gain equal to the amount of the S&P 500’s loss last year – 39%. TBT has a market value of $3 billion and a daily trading volume of 5.3 million shares, so it’s liquid.
To hedge my speculative bet on a 2009 turnaround, I am recommending SPDR Barclays Capital 1-3 Month Treasury Bill (46, BIL) fund. But I would not stop there.
Government-backed mortgage bonds offer enticing yields. If the Fed continues to buy up mortgage-backed bonds and mortgage rates remain low or if the housing market appears to be turning, there are significant gains to be made. The best way to play this is via iShares BarclaysMBSBond (104, MBB). Corporate bonds also offer relatively high yields, given soaring default rates. I would buy iShares iBoxx InvesTop Investment Grade Corporate Bond (98, LQD) ETF. When the Treasury bubble bursts, money will flow to high-grade corporates, and the profits will be big.
With an Atlas Shrugged scenario in front of us, investors should build on income stream rather than trying to earn back 2008’s losses with 10-bagger stocks and other speculations.
Remember Adam Smith’s “invisible hand"? It is now a helping hand from our government, and do not be surprised if it becomes a heavy hand before the feds are done helping us. The end result, even after this crisis passes, will be an economic system dominated by a Congress reluctant to give up control. Like most government-sponsored enterprises, this one will fail. Read Ayn Rand’s book Atlas Shrugged if you want to know where this leads.
The above is my way of telling you that this economic downturn is likely to last much longer than only a year and that the capitalist system we once knew has ended. Investors need to reexamine their long-term investment strategy if it presumes that someday soon the stock market will stage a mighty rally and years of 20% gains will return. That is wishful thinking. More likely are years of market volatility where the swift and the lucky will prevail and the rest of us will watch and wonder.
If you are worried about your retirement, do not try to earn it back with 10-bagger stocks and other blind speculations. Instead you should be thinking about building an income stream to replace lost earnings once you retire. Think yield and safety, and that means moving up the balance sheet from shareholder’s equity to the lender’s section. In short, buy bonds.
But not all bonds. The safest bonds, Treasurys, were great buys until last October. But with yields on 10-year T bonds below 3%, there is not much room for improvement in price. On the contrary, the risk of a price decline is high. The Treasury will be funding big deficits. It might have to offer a steep interest rate to keep the money coming in.
What about junk bonds? Their huge yields, 18% to 30%, offset some of the risk from rises in interest rates. But there is too much danger of another sort. The worst bond-default era in history is upon us. As much as 30% of junk issues will default before it is over. If you are tempted to invest here, ask yourself, How lucky do I feel?
Municipal bonds look attractive, but they are vulnerable to inflation and ratings downgrades. Keep in mind that corporations have an equity cushion to absorb shocks during an economic downturn. States and municipalities live hand to mouth.
I recommend buying investment-grade corporate bonds with relatively short maturities, especially industrial and financial issues. The industrial issues have been the least affected by the financial crisis but offer a premium yield because of the blind fear gripping the market. One bond issue I like is the Allegheny Technologies 8.375% senior unsecured debenture of December 2011. It is rated Baa3/BBB- and at a price of 95.50 yields 10.2% to maturity. Another is the Alcoa 6% senior unsecured debenture due January 2012 and rated Baa1/BBB+; at a price of 91.50 it yields 9.4% to maturity.
Investment-grade financial bonds offer yields from 7% to 14%. A few months ago only junk paid such high yields. I like financials for both yield and capital gains. Safest among them are the entities in which the government has injected capital. These are bad bets for equity and preferred stockholders, since regulators have been known to cut dividends on a whim. Stiffing bondholders would have much more serious implications because it could refreeze our thawing credit markets.
I recommend the Morgan Stanley Senior Unsecured Note A2/AA- due May 16, 2018. This variable rate note pays 3% monthly plus the year-over-year Consumer Price Index change adjusted monthly. At a price of 67 it yields 9.9%. Best of all, at this price going forward the yield adjusts at 1.49 times the CPI. That sure beats Treasury Inflation-Protected Securities that currently yield a real rate of 1.7% (which gives you a nominal 1.8% at the moment).
Now for my 2008 confessional. The 19 recommendations I made did terribly. If you had bought them all you would be down 21.4%, including coupons and dividends (and including the effect of an assumed 1% transaction cost on new positions). Had you put the same money in relevant indexes on the same dates (the S&P 500 when I was recommending equity and the Merrill Lynch Corporate/Government index otherwise) you would be up 0.9%. The best two recommendations: Flaherty & Crumrine Preferred Income Fund (PFD) (total return of 45%) and Credit Suisse (CS) 6.25% pplus (total return of 32%). Worst two: Fannie Mae and Freddie Mac preferreds, both nearly wiped out.
The small-unit ($25 par) fixed-income issues I tend to like are volatile and did badly in the bear market for corporate bonds. But they should do particularly well in a rebound. Continue to hold on to all of the bonds and preferreds I recommended in 2008, except Fannie, Freddie, Citigroup and AIG.
CORPORATE BOND JUNKIES
The guys running the Berwyn Income fund have moved from Treasurys into medium-grade corporates. The tactic worked in the last recession.
After three years of hunkering down in cash and Treasurys, Berwyn Income fund comanager George Cipolloni’s moment to shine arrived this fall. Hedge fund managers were dumping bonds to raise cash amid a wave of investor redemptions. Cipolloni decided to test the waters with a few low-ball bids. He was shocked when offers started coming back even lower than what he had proposed.
“It was scary,” says Cipolloni, 34. “There seemed to be no floor.”
The panic has receded somewhat since Lehman Brothers’ collapse last year, widening spreads on junk bonds to 13.7 percentage points and on investment-grade debt to 4.5 points above 10-year Treasurys. Spreads are off a percentage point or so since then. Still, the yield premium you get from investing in something shakier than a U.S. government IOU is two and a half times what it was at the low point three years ago, and 1.7 times the high point 3.5 years before that.
Since mid-October Cipolloni and comanager Edward Killen, 57, have been pouring tens of millions of dollars into corporate bonds of all stripes – investment grade, junk and convertibles. As they buy risk, they are selling the safety they formerly owned via government-guaranteed securities. A year ago Berwyn Income was 16% in Fannie Mae, Freddie Mac and Treasurys paper. Today it holds none.
“We have been looking for a blowup,” explains Killen, who has comanaged the fund for 15 years. “This is our opportunity.”
Opportunity, perhaps, but not one the Berwyn managers are willing to paint with too wide a brush. Will junk yields return to their autumn peaks? “No way to know,” says Killen. Where are default rates going? “Up,” he adds. Even the more loquacious Cipolloni shuns big-picture chatter. “You can nail the default rate and still make a mistake” with a specific security, he says.
The granular approach has worked pretty well for Berwyn Income over the long haul. The $250 million fund returned 5.9% annually in the decade through 2008, versus 2.5% for Lipper’s blended stock and bond index. That performance is net of the modest 0.7% in annual fees.
Killen and Cipolloni swim against the prevailing currents. At the depths of the last bear market in 2002, when many funds were unloading corporate debt, Berwyn Income started buying junk bonds, real estate investment trusts and convertibles. It returned 9.4% that year, versus a 4.1% loss for the Lipper index.
The two managers say they started fearing a housing bubble in 2006 and shifting out of then popular corporate bonds and into government and quasi-government paper, which was yielding only a hair less. The move hurt returns at first but paid off in spades in 2008. “Now the pendulum has swung, and the [bond rating] agencies are being too conservative,” says Cipolloni.
He and Killen look at some standard yardsticks of creditworthiness, like the ratio of debt to capital and of interest expense to sales. But they claim to not even read Standard & Poor’s and Moody’s credit reports. Instead they comb corporate reports and listen to conference calls to gauge how management has previously dealt with creditors in tough times and whether it seems likely to buy back bonds before equity. “Some companies don’t even mention debt on conference calls,” says Cipolloni. “They just want to placate shareholders.”
Fearing a deep recession, the Berwyn Income managers are shunning debt from consumer discretionary, commodity and other cyclical businesses. They are also steering clear of distressed bonds trading at triple-C or below. With stocks, currently 25% of assets, they home in on firms with high dividends and ample means to continue payouts.
They have 7% bonds in Chattem (CHTT), maker of Gold Bond medicated powder, with a 9.4% yield to maturity in 2014. They believe Chattem deserves a BB rating, rather than the B assigned it by S&P.
Berwyn also owns debt of credit rater Equifax (EFX). Revenues have fallen along with housing sales, but “people still need credit scores,” Cipolloni says. Equifax’s 6.3% bonds, due in 2017, yield 10.1%. The Quest Diagnostics (DGX) 5.45s of 2015 are priced at a discount to yield 7.6% to maturity. Quest, notes Cipolloni, hiked profits in the last downturn.
Investors have unloaded bonds issued by household products maker Church & Dwight, pushing the yield on its 6% coupon bonds, maturing in 2012, to 8% (since fallen to 6.6%). The maker of Arm & Hammer baking soda has debt equal to 53% of capital. While there is a lot of goodwill in the capital total, the company has used cash to cut debt in the past and should be able to increase sales this year, as it did in the last two recessions, argues Cipolloni. His fund owns $7.5 million of the bonds.
Last year Berwyn picked up 5.25% convertible bonds due in 2024 from investors fearing that issuer American Equity Investment Life (AEL) was itself holding a lot of toxic financial securities. Berwyn bet otherwise. The price has climbed since, but the convert is still yielding 19.4% to first put in 2011.
Company Coupon End date Yield to Maturity American Equity Investment Life* 5.25% 12/2024 19.40%** Chattem 7.00 3/2014 9.40 Church & Dwight 6.00 12/2012 6.59 Equifax 6.30 7/2017 10.10 Quest Diagnostics 5.45 11/2015 7.56 Valeant Pharmaceuticals Int’l* 3.00 8/2010 7.59 *Convertible bonds. **Yield to put. Source: Berwyn Capital
Though they have rallied recently, these corporate bonds offer yields that more than compensate investors for their risks, according to Berwyn Income’s managers.
Intel’s Stimulus Plan
As the rest of the world just plain downsizes, Intel will spend $7 billion to downsize its chips.
Intel Chief Paul Otellini said ... that the chip maker will spend $7 billion over the next two years to upgrade its U.S. manufacturing facilities. ... Over the past eight years, Intel (INTC) has built six new fabs, and upgraded another. Since 2002 it has invested $50 billion in capital and R&D in the U.S. ...
Intel plans to use this particular investment to shift to a new manufacturing process for cranking out faster, smaller processors that use less energy. The company is not building fabs from scratch, but instead refurbishing and upgrading four existing facilities. Executives hope the move will keep Intel’s manufacturing capabilities a step ahead of rivals in the market for the so-called x86 processors that power the vast majority of the world’s notebook computers, desktop PCs and servers. ...
The gains will not come cheap. ... But the move could continue to help Intel erode the market share of rival Advanced Micro Devices (AMD). In the last quarter of 2008, Intel owned 82% of the market for so-called x86 processors – the kind found in the overwhelming majority of servers, desktop computers and notebooks--up from 76.3% for the corresponding period a year earlier, according to Mercury Research.
AMD will not make the shift to 32 nanometer technology until the end of 2010, with volume production beginning in 2011. And while other chip makers, namely IBM, Samsung Electronics, Chartered Semiconductor Manufacturing and ARM, are sharing 32 nanometer process technology that could swing into production as early as the second half of this year, none of them are ready to challenge Intel for control of the PC processor market. ...
The first Intel processors to use the new technology have been temporarily dubbed “Westmere,” and will be used in desktop and notebook systems. The processor will be based on Intel’s current “Nehalem” design, but will incorporate features just 32 nanometers wide – 71% of the size of Intel’s current generation of 45 nanometer processors. The Westmere chips will also incorporate additional graphics capabilities. ... [A]t least for now, there is no end in sight to such spending. Intel is planning on shifting to a new process technology every two years. Long term, that means exploring some pretty exotic technologies, including alternatives to silicon, such as gallium arsenide.
Consumers keep buying the new generations of chips – and that spells a powerful advantage for the company that can build the latest ones. “Each time we make this kind of transition people go “Big deal, ‘I don’t need more power,’” says semiconductor industry analyst Nathan Brookwood. “But two years later if you try to take away their newer, faster machines you will have to pry it out of their cold, dead hands.”
Verizon’s diverse mix of businesses will help it survive – and thrive – through these tough times
In times that are anything but normal, it pays to invest in a company that delivers reliable, business-as-usual results, keeps its focus on avenues of growth and holds the promise of market-beating returns. Verizon Communications (VZ), the New York-based telecommunications giant, fits the bill nicely.
Amid the market turbulence and economic upheaval of the past year, Verizon put about $17 billion into capital expenditures, launched a successful bid for wireless provider Alltel, boosted its dividend 7%, bought back $1.4 billion of its shares and showed solid revenue and earnings gains. Verizon’s profit jumped 15% in Q4, as demand for its wireless services surged. A record number of customers seeking high-definition television and ultra-fast Internet services signed up for its FiOS advanced, all-digital fiberoptic network, as Verizon took market share from cable companies.
Considering the epic slowdown affecting the world’s economies, it is not surprising that Verizon’s results had a downside: Wireline margins were softer than expected, hurt by pricing pressures and volume declines at the division created by the 2006 merger with MCI, Verizon Business, which provides global communications networks to corporations and governments.
Layoffs, severe weakness in the financial and retail sectors and a negative foreign-exchange impact were big factors affecting the business-enterprise segment. Verizon also gained fewer new wireless subscribers than expected. And the company estimated costs linked to pension and post-retirement benefits will shave nine cents to 11 cents from full-year 2009 earnings.
Yet, all in all, Verizon has shown it can handle tough times, helped by a well-diversified revenue mix. That is comforting, as conditions remain difficult.
For 2008, Verizon posted a profit of $6.4 billion, or $2.26 a share, on $97.4 billion in revenue, compared with $5.5 billion, or $1.90, on $93.5 billion for 2007. ... Trading around 12 times estimated 2009 earnings of about $2.53 a share and 11.5 times the $2.68 projected for 2010, Verizon offers an attractive refuge in a weak macroeconomic landscape. ... Verizon’s stable free-cash-flow and 6% dividend yield burnish the stock’s attractiveness ...
The recently completed $28 billion acquisition of Alltel makes Verizon Wireless – a joint venture with the U.K.’s Vodafone – the nation’s largest wireless carrier, with 83.7 million customers. The deal also puts Verizon in prime position to benefit from the dynamic opportunities associated with wireless. ... Already, because of the proliferation of smartphones such as the Blackberry Storm, data revenue – from broadband use, e-mail and text-messaging – is growing astronomically. It soared 44% in 2008 and stands at more than $10 billion a year. Total data based on average revenue per user rose nearly 28% in the 4th quarter alone from 2007’s level.
Verizon, which owns a controlling 55% stake in Verizon Wireless, expects $9 billion in savings from the Alltel acquisition and is on track to post 10% revenue growth from its wireless operations in 2009. ... Wireless generates about 55% of Verizon’s revenue, and Verizon Wireless has some of the business’s best metrics – a low customer churn rate, high profitability and strong customer satisfaction.
Moreover, FiOS is proving to be popular and competitive against the high-speed Internet and high-definition TV services offered by Comcast and other cable providers. In Q4, Verizon reported 303,000 net new FiOS TV customers and 282,000 FiOS Internet users, helped by the service’s introduction in the New York City market. Capital spending related to the buildout of FiOS peaked in mid-2007, and that allows Verizon to redeploy more free cash flow to pay down debt, much of it assumed in the Alltel purchase. ...
Richard Arvedlund, manager of $300 million Cypress Capital Management ... finds Verizon’s low-risk profile and “intriguing” dividend yield appealing. “The yield is twice that of the long-term bond,” Arvedlund says, noting that dividends are taxed at 15%, not at the higher ordinary income rate. “The math is compelling.”
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