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

W.I.L. Finance Digest :: March 2009, Part 2

This Week’s Entries :


Bob Farrell is a Wall Street legend who pioneered the use of technical analysis as a valid complement to fundamental analysis. We always looked forward to reading his weekly commentary back in the day. His composite conveyed wisdom has been condensed to these 10 market rules. We can think of worse ideas than making a habit of reading them each morning before making any investment decisions.

Bob Farrell was the head of Merrill Lynch Research for decades, and during that time he established himself as one of the premier market analysts on Wall Street. His insights on technical analysis and general market tendencies were later canonized as “10 Market Rules to Remember” and have been distributed widely ever since. Let us take a look at these timeless rules and how they can help you achieve better returns.

#1. Markets tend to return to the mean over time.
In layman’s terms, this means that periods of market insanity never last forever. Whether it is extreme optimism or pessimism, markets eventually revert to saner, long-term valuation levels. For individual investors, the lesson is clear: Make a plan and stick to it. Do not get thrown by the daily squawk and turmoil of the marketplace. (You can learn more about how stocks behave in Forces That Move Stock Prices.)

#2. Excesses in one direction will lead to an opposite excess in the other direction.
Like a swerving automobile driven by an inexperienced youth, overcorrection is to be expected when markets overshoot. Fear gives way to greed, which gives way to fear. Tuned-in investors will be wary of this and will possess the patience and know-how to take measured action to safeguard their capital. (Read more about fear and an omen that predicts sharp corrections in “Be Aware Of The Hindenburg” and “When Fear And Greed Take Over”.)

#3. There are no new eras, so excesses are never permanent.
The tendency among even the most successful investors is to believe that when things are moving in their favor, profits are limitless and towers can be built to the heavens. Alas, as in the ancient Tower of Babel story, it is not so. As the first two rules indicate, markets revert to the mean. Profits have to be taken while they are still profits, lest all be lost! (To read more about statistics, see Five Stats That Showcase Risk.)

#4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.
The big money knows to hold on while a steeply profitable move is in effect (as seen in the trader saying, “let profits run”) and to patiently stay in cash in the grip of a market panic (“don’t attempt to catch a falling knife”). Moreover, these types of sharply moving markets tend to correct equally sharply, preventing investors from contemplating their next move in tranquility. The lesson: be decisive in trading fast-moving markets. And always place stops on your trades to avoid emotional responses. (You can see more about using limit orders to protect you from yourself at A Logical Method Of Stop Placement.)

#5. The public buys the most at the top and the least at the bottom.
This is the sad truth of the average John Q. Investor. He is incurably impressionable – and innocent to boot. He reads the newspapers, watches market programs on television and believes what he is told. Unfortunately, by the time the financial press has gotten around to reporting on a given price move – up or down – the move is complete and a reversion is usually in progress: precisely the moment when Johnny Q. decides to buy (at the top) or sell (at the bottom). (Read more about stock news in Mad Money ... Mad Market?)

The need to be a contrarian is underlined by rule No. 5. Independent thinking will always outperform the herd mentality. (For more on contrarian investing, see Buy When There’s Blood In The Streets.)

#6. Fear and greed are stronger than long-term resolve.
Basic human emotion is perhaps the greatest enemy of successful investing. By contrast, a disciplined approach to trading – whether you are a long-term investor or a day trader – is absolutely key to profits. You must have a trading plan with every trade. You must know exactly at what level you are a seller of your stock – on the upside and down. Better still, place stops with each buy order, because once the market begins to move, the world becomes a very different place. (To keep reading on this subject, see Buying Fear, Neuroeconomics And The Science Of Investing Fear, and Master Your Trading Mindtraps.)

Knowing when to get out of a trade is far more difficult than knowing when to get in. Knowing when to take a profit or cut a loss is very easy to figure in the abstract, but when you are holding a security that is on a quick move, fear and greed will quickly act to separate you from reality – and your money.

#7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names.
Many investors are “Dow-obsessed,” following with trance-like concentration every zig and zag of that particular market average. And while there’s much to be gained from a focus on the popular averages, the strength of a market move is determined by the underlying strength of the market as a whole. Broader averages offer a better take on the strength of the market. Instead, consider watching the Wilshire 5000 or some of the Russell indexes to get a better appreciation of the health of any market move. (Get to know the most important indexes in our tutorial on Index Investing.)

#8. Bear markets have three stages – sharp down, reflexive rebound and a drawn-out fundamental downtrend.
Market technicians find common patterns in both bull and bear market action. The typical bear pattern, as described here, involves a sharp selloff, a “sucker’s rally", and a final, torturous grind down to levels where valuations are more reasonable; a general state of depression prevails regarding investments in general. (Learn about how your portfolio should evolve in bad times at Adapt To A Bear Market.)

#9. When all the experts and forecasts agree, something else is going to happen.
This is not magic. When everyone who wants to buy has bought, there are no more buyers. At this point, the market must turn lower and vice versa.

#10. Bull markets are more fun than bear markets.
This true for most investors – unless you are a short seller. (If you want to enjoy the bear markets by short selling, check out our Short Selling Tutorial.)

Many investors fail to see the forest for the trees and lose perspective (and money) unnecessarily. The above listed rules should help investors steer a more focused path through the market’s vicissitudes.


An interview with David Levy: With many tough years ahead, this economist suggests getting hyperdefensive in assets like Treasuries.

David Levy is a respected and well-known economic analyst. He spotted the current troubles on the horizon a few years ago and, as was the case for many of us, was surprised by how long the bacchanalian credit party continued. He thinks that now is the time to be “hyperdefensive.” No Austrian, he also thinks the government’s economic-stimulus package is a faltering step in the right direction, so the problems will not continue indefinitely – an optimist in our book. He likes U.S. Treasuries despite the gargantuan deficits as far as the eye can see because collapsing consumer borrowing will offset those increases. U.S. corporate balance sheets are also debt heavy, so not much borrowing demand there.

"Anybody who weathers the next year or two without losing any money is going to feel like a hero. This period is going to create some great investment opportunities. But right now, we have asset deflation spreading across the board, along with financial instability and too much uncertainty,” Mr. Levy concludes.

Economic forecasting is a tricky, if not dismal, science. David Levy, who comes from a family whose roots in the industry go back to the early 1900s, acknowledges it is impossible to hit the nail on the head every time. However, the chairman of the Jerome Levy Forecasting Center in Mount Kisco, New York, did spot trouble brewing some time ago, although he thought the economy would implode a lot faster than it did. He thinks the economic-stimulus package is a step in the right direction – however flawed – but he does not expect a quick recovery. In the meantime, he likes Treasuries. Last week, Barron’s caught up with Levy, 54 years old, to hear his latest forecasts.

Barron’s: Forecasting is a very difficult task. If there is a call you would like to have back, what would it be?

Levy: You do not do this for three decades without accumulating a number of forecasts that did not exactly hit the nail on the head. The most recent and important one was our prediction that the financial unwinding and economic decline would unfold fairly rapidly after the bursting of the housing bubble, which began in late 2005.

We expected the economy to fall into recession and financial crisis before the end of 2006. We failed to recognize the enormous inertia in structured-mortgage finance, and the risk-obscuring Wall Street money machine that caused mortgage-lending standards to paradoxically ease until 2007.

In the past, banks always started tightening [lending] standards shortly after the housing market turned down. The result [this time] was an enormous, and still rising, volume of home-equity extraction until late 2006, with a lagged impact on the economy that did not begin to wane until late 2007.

Your consumer-confidence index is at an all-time low. What is that based on?

Confidence is a symptom that aggravates the problems. There are very good reasons that people do not have confidence, but the fundamental problem underlying the economy is that balance sheets in the private sector became much too large to be supported relative to incomes.

Just how bad is this economy?

We have to go through many years of getting balance sheets back into line with incomes.

We have to go through not a year, or two, but many years of getting balance sheets back into line with incomes.

Stretching the rubber band required not only that we have a lot of asset inflation so we could borrow against the assets, but also that we increasingly liberalize our attitudes about investing and lending.

Now that things are blowing up, it has moved us back to much more conservative and cautious attitudes toward lending and asset valuation. This means the contraction in asset values and debt will ultimately be pushed even further than they would normally have to go. So it is going to take years and years.

Are you referring to U.S. consumer debt?

Corporate balance sheets stink too.

I am talking about the household sector; the nonfinancial business sector, which had a record debt-to-GDP [gross-domestic-product] ratio; and the financial sector, which, of course, is at ridiculous levels.

How long will it take for a recovery?

This process is going to take more than one recession. This is what causes depressions – when you have this kind of severe, long-term imbalance. It will take something more on the order of a decade.

It does not mean a period of continual decline, however. We will have business cycles, and we will have some growth during those cycles. But, as measured by the amount of time, it is similar to the Great Depression.

I do not think it will be as long as the two lost decades in Japan, but it will be a difficult period. However, it will be, to use a term we coined some years ago, a contained depression, meaning the government efforts to prop up the financial system prevent things from completely breaking down. And the fiscal stimulus will help us along.

So the good news is that we are not headed for the Great Depression, but the bad news is that we are in for a tough economy for many years to come.

Here is a very basic fact about this period. Balance-sheet contraction makes it impossible for the private sector to generate the profits it needs to function, whereas balance-sheet expansion generates booming profits. Therefore, it is not a matter of getting rid of the bad assets from the bank, and then the economy is ready to go. This process involves not just cleaning up the banking sector, but also shrinking assets and liabilities.

How long before we start seeing GDP turning positive again?

The earliest recovery would be in 2010. But I am not sure we are going to get a recovery then, based on the economic-stimulus plan that has been passed so far, although it is moving in the right direction. But the enormity of what it is trying to overcome may be too great. It is very likely we will see additional moves by the government later this year, so there will be something added, mainly because of higher unemployment.

One of the problems for any government trying to deal with this situation is the expectation that, like past recessions, it is a problem that should get cleaned up and we should go back to some level of prosperity.

But it is much more difficult this time. If we had no government action – and if we had let Citigroup, AIG (AIG) and Bear Stearns and a whole bunch of other firms all go under – the whole system would have collapsed by now. We are having enough trouble as it is, but we have managed to avoid another Great Depression. No one gets any credit for that, because things are so miserable compared to expectations. And the government is going to have a very difficult time keeping the public behind it as things unfold.

Because people get impatient?

Yes, and the single biggest political problem is going to be unemployment.

Which you see going a lot higher, possibly to 12% before this is over, compared with 8.1% in February.

That is correct. We have been losing more than a half-million jobs a month. If you look over the course of any past recession, the rate of job loss does not moderate over the course of that recession. It intensifies.

What does higher unemployment mean for the economy? More foreclosures?

Definitely. And it aggravates all the financials – and, again, this is one of the things that is critical: this vicious cycle encompassing the deteriorating financial conditions and the deteriorating economy.

And that is the main reason why people have consistently underestimated this crisis, going back several years. At first, there was a lot of talk about it being contained in subprime mortgages, and that maybe housing was bottoming. But it has not bottomed.

What will finally get us out of this tailspin?

The basic instinct of government is: If the economy is hurting, we had better do something, whether it is cutting taxes or spending more money.

There are pros and cons to all of these options, but all of them have some effect in boosting the economy.

The government will do more eventually. Inventories do get worked off, housing will not be able to fall indefinitely, residential construction will not be able to fall much further, and you have other things that start to kick in. The biggest challenge will be [determining] how bad the rest of the world [is] going to be.

What do you see for emerging markets?

They face what could be a tragic outlook, because they have no means, in many cases, to contain their own depressions, because of foreign debt and their exposure to foreign-exchange markets.

Which countries are you talking about?

Well, certainly the BRICs [Brazil, Russia, India and China], but also the smaller countries. Eastern Europe is the most obvious basket case right now.

What is it structurally about emerging-market economies that is causing them to fall apart?

Two things. One is that they were heavily dependent on exports to the U.S. and other big-balance-sheet economies, primarily Europe, but also countries like Australia and Canada. The other factor was that one of the symptoms of having bigger and bigger balance sheets, along with all these pressures on investors and lenders, is that it made it harder for them to make sound loans and investments. And it got harder to get the returns they wanted in the so-called liquidity glut, which led to incredibly cheap capital everywhere, with almost no risk premium.

So in countries like Brazil, a consumer-credit market developed that never existed before. In Eastern Europe, people could finance housing like mad. But when credit got cut off, it was a big shock to these economies.

There is no free lunch. ... Does it worry you that the additional debt the U.S. government is issuing will cause rates to rise, making an economic recovery even harder to attain?

I am actually bullish on Treasury bonds. While there is a huge increase in Treasury debt, there are going to be dramatic reductions in the amount of private debt available. That is already happening. We have maybe a $1 trillion to $1.5 trillion increase in our annual federal borrowing. But a couple of years ago, we had a $4 trillion rate of private-debt growth, which is collapsing.

Treasuries have had a big run. Late last week, the 10-year Treasury was yielding 2.83%.

In a zero-inflation to mildly deflationary environment, amid fear about equities and a lot of other assets, the idea of getting a solid real return of practically 3% on the 10-year bond, without risk, is pretty attractive. Another thing to consider for investors is what other sovereign debt are they going to hold?

Europe has got even worse problems than we do, with more debt – if you average all of the countries – and the U.K. has bigger financial problems.

What is your outlook for corporate profits?

Obviously, we had a horrendous 4th quarter of 2008. We might see a little bit of a bounce from that into the first quarter, but we expect the trend for profits to be flat to down, and [to remain] at very poor levels.

Is there any chance of a recovery in corporate profits by 2010?

It depends on how bad the world is, and what else our government does. One of the questions is: Can consumers cut back their spending faster than their incomes are falling? In the past few months, they have been able to do that, causing some pretty wrenching declines in spending.

And to some extent, if personal savings go up, it is essentially at the expense of business profits. So while we need higher savings in the long run, the shift is very painful.

You said recently that you expect core consumer prices to slip on a year-over-year basis. Is that good or bad for the economy?

In this case, it is a negative.

No one is worried about the cost of living going up. To the extent that there is deflation, it means margins are going to be squeezed. It means, to some extent, that businesses are able to cut their pay rates, but that also means somebody else’s income is being squeezed.

What about the housing market? Is there a bottom in sight?

No, it is still declining, and this issue of dealing with foreclosures is a real one. If we do not deal with that, we are going to see more foreclosures as more people lose their jobs. There is so much downward momentum in home prices, and such an overhang in the market, that we are likely to see prices overshoot on the downside.

Longer term – say, a decade from now – you are bullish on the prospects for U.S. manufacturing. Why is that?

We are going through a very rough period, but we are going to move into a period where labor costs are much less important than manufacturing location. Logistics and proximity to markets will be much more important. That is because automation will become more advanced, taking many of the labor costs out of manufacturing.

But won’t that automation lead to fewer manufacturing jobs?

Not exactly. There will be more capital spending, which equals profits. It is similar to agriculture, which 100 years ago employed a much larger percentage of the population. Manufacturing has been shrinking for a long time, but you will have more workers working here, and more of the plants will be here, even if they have fewer workers per unit produced.

What are you telling your clients when it comes to investing?

This is a period to be hyperdefensive.

People use the term defensive, often at various points of the cycle, but this is a period to be hyperdefensive. Treasuries are attractive, and we have a class of new government-guaranteed debt instruments that need to be looked at so we know what is really guaranteed and how much is guaranteed, but there are some higher yields in some of those instruments.

What is an example?

The government has put guarantees on some of the bank debt, for example. I am not recommending a particular instrument. But the most important thing is to put your cash where it is safe – short-term Treasuries, even if you do not want to buy long-term Treasuries.

Anybody who weathers the next year or two without losing any money is going to feel like a hero. This period is going to create some great investment opportunities. But right now, we have asset deflation spreading across the board, along with financial instability and too much uncertainty.

Thanks very much, David.


By most measures, they are downright cheap.

Barron’s has stuck its neck out this week and published a set of articles making the case that equities are very cheap, with upside notably greater than the downside. This one is the lead story.

The peak-to-(so far) trough decline of 56% in the S&P 500 has been the worst since the 60% decline during the 1937-1942 bear market. The backdrop to that market included a few trivial events like the fall of Continental Europe to the Nazis, the Pearl Habor attack, Stalin’s purges, and an ongoing worldwide depression. The 86% decline of 1929-32 was worst post-1920s bull market slide.

The drop in stocks has happened so fast and gone so far that important market statistics have indeed come back into reasonable territory. Some indicators are in the vicinity of where they were when the market was a value in the aggregate, during the mid-late 1970s and early 1980s. The S&P 500 to U.S. GDP ratio has fallen all the way from close to 200% in 2000 to 60% today – still well above the market bottoms in 1974 and 1982 but, as Barron’s validly points out, a much greater proportion of the S&P company profits come from overseas vs. 25-35 years ago, so the adjusted ratio today is considerably lower.

Incredibly, the S&P 500’s price/book value has fallen all the way from a peak of 5 in 2000 to 1.3 today – which is still well above 1974/82 lows of about 1. In 1982 we recall various studies showing U.S. stocks were selling at maybe 40% of replacement book value, so it would be interesting to see what the equivalent statistic is today.

P/E ratios now, when compared to previous market bottoms (table here), are lower than at some previous significant bottoms but higher than in 1932, 1949 (just before the great 1950s/‘60s bull market took off), 1974, 1982, and 1987 after the crash. Not proven, as the Scotch would say. We would like to see stock prices vs. longer-run average earnings. 2009 earnings estimates may be optimistic. The U.S. also faces a historically unique need to restructure its capital stock. So who knows what the earnings power will look like on the other side of that?

Finally the S&P to gold price per ounce ration has fallen from over 5 in 2000 (1500+ vs. $300/oz.) to 75% today. Bill Bonner’s “trade of the decade” in 2000 to “buy gold, sell the Dow” has obviously worked out. Now it might be time to worry about overstaying one’s welcome. Stocks, as David Dreman and now Barron’s have pointed out, do offer some inflation protection due to their real assets and earnings which rise with inflation. Only in times of extraordinary monetary disorder, e.g., the late 1970s and today, does gold provide a true “safe haven.”

After the stunning decline of the past five months that has left the Dow Jones Industrial Average and Standard & Poor’s 500 Index more than 50% below their 2007 highs, a lot of investors are worried stocks could fall much further.

In a worst-case scenario, based on current earnings estimates and the most pessimistic reading of market history, the Dow could fall a further 25%, to 5000, and the S&P could drop to about 500. The Dow industrials closed at 6,627 Friday, and the S&P 500 ended at 683, both down 24% so far this year and both at 12-year lows.

The lousy economy is the main factor, but stocks have not been helped by Obama administration proposals that would hurt a range of companies, including drug makers, managed-care firms and student-loan providers. Investors also have not liked the president’s plan to raise taxes on the wealthy. It does not help that the Street is calling this an “Obama bear market” and that some investors are looking to “Obama-proof” their portfolios, avoiding sectors targeted by the president.

However you feel about President Obama, he got at least one thing right last week: He said stocks are cheap for long-term investors. Our research shows that to be true, whether you look at stocks relative to book value, U.S. economic output, gold, or a normal level of corporate earnings.

These factors, plus the huge amounts of cash now sitting on the sidelines, suggest that, barring a global economic and financial meltdown, the Dow should bottom well above 5,000 and the S&P Index well above 500.

It is tough to predict this year’s corporate profits because of the deepening global downturn and potential likelihood of little or no earnings in the U.S. financial sector. Citigroup financial economist Steve Wieting sees $51 in operating profits for the companies in the S&P 500 this year before big write-downs, down from $66 in 2008. Based on his estimate, which is in line with the current Wall Street consensus, the S&P 500 is valued at more than 13 times projected 2009 profits.

That Price/Earnings multiple is in line with the lowest levels hit during most bear markets over the past 80 years. Key exceptions were 1974, 1982 and 1987, when the S&P 500 was valued at about 10 times forward earnings, according to Goldman Sachs. If stocks do get to a P/E of 10, the S&P 500 could drop as low as 500, a decline of more than 25% from current levels, and the Dow Jones Industrial Average could drop toward 5000.

This scenario seems extreme, however, because prior market lows occurred during periods of higher inflation and interest rates, decreasing the relative appeal of stocks. Treasury yields, for instance, were in the double digits in 1982, against 2% or 3% now.

Tobias Levkovich, chief U.S. equity strategist at Citigroup, is encouraged, partly because he sees signs of panic.

“I have met recently with retail brokers who have told me that people are coming to them and saying: ‘Just get me out,’” says Levkovich, who views this capitulation as a bullish sign. An optimistic Levkovich says “it is too late to sell,” but admits he was saying the same thing when stocks were appreciably higher than they are now.

Levkovich has set a bullish S&P 500 price target of 1,000, which is more than 40% above current levels. That may be too optimistic, but if the Dow industrials and S&P 500 merely get back to where they started 2009, the indexes would rise more than 30%.

The brutal bear market of the past year has affected all industry groups and nearly every stock. All 30 members of the Dow Jones industrials are in the red for the past 12 months and just one stock, IBM, is in the black for 2009. Within the S&P 500, just eight stocks are higher in the past year, led by Family Dollar Stores (FDO), which has gained 56%. The worst performer in the S&P 500: AIG, which is off 99%, to just 35 cents.

One of the problems with projecting earnings is the mess surrounding financial companies. Citigroup’s Wieting assumes no profits this year for financial companies in the S&P 500 index, as charge-offs for bad loans offset operating earnings. That is a far cry from 2007, when the financials chipped in 20% of the index’s profits.

It is too pessimistic to assume that the financial sector will continue to earn nothing over the long haul. Goldman Sachs strategist David Kostin sees $63 in S&P profits this year, before provisions and write-offs, and $71 next year. Based on his estimates, stocks look much more attractive. The last time the S&P was at these levels, in 1996, operating earnings were running at about $40, well below current levels.

Stocks are also inexpensive relative to U.S. economic output, book value and gold. As the nearby chart shows, the stock market is currently valued at less than 60% of the U.S. gross domestic product of $14 trillion. That is the lowest stocks have been relative to annual economic output since the early 1990s. In 2000, at the market’s peak, stocks were valued at almost 200% of the nation’s annual output. True, today’s 60% level remains considerably above bear-market lows hit in 1990 and 1982, but investors need to recognize that American companies get a much bigger share of their profits from abroad now than they did then. Adjust for this factor, and the ratio would be lower and more bullish.

The S&P 500 is valued at just 1.3 times its book value, or shareholder equity, down from a peak of 5 in 2000. The most recent official figure for book value from S&P is $529 for year-end 2007. Ned Davis Research assumes a small increase last year. Book value still is relevant, despite a lot of goodwill and intangible assets mixed in with hard assets like cash, factories and inventories. On the flip side, many companies, like Coca-Cola and Altria, are worth much more than their small book values due to valuable brands that are not fully reflected on their books.

Gold has been a star during the downdraft of the past six months, rising $140, to $942 an ounce. Gold’s rise reflects its haven status, as investors worldwide worry that massive stimulus programs ultimately will prove inflationary and significantly erode the value of paper money.

Stocks, however, look like a better value than gold based on their historical relationship. The S&P 500 index is worth about 75% of an ounce of gold, versus a peak of more than five times the value of gold in 2000 when the S&P peaked at more than 1,500 and gold languished around $300 an ounce. Over the past 40 years, the S&P has averaged 1.6 times the value of an ounce of gold. Stocks do offer some inflation protection because of corporate assets and earnings power.

Defensive industry groups like drugs and consumer products haven’t been spared lately. The major drug stocks – Pfizer, Lilly, Merck, Bristol-Myers Squibb and Schering Plough – are down an average of 23% this year and now trade for an average 2009 P/E of just eight. (See Bristol-Myers story.)

Consumer stocks like Heinz, Kraft, Procter & Gamble, Coca-Cola and General Mills are trading for 10 to 12 times earnings and with yields of 3% to 5%.

Once confidence returns, expect such stocks to benefit. And don’t forget, there is plenty of potential fuel for a market rally. A key measure of liquidity, money-market mutual funds, now hold almost $4 trillion, roughly half of the $8 trillion value accorded U.S. stocks. That nearly $4 trillion is about double the level of two years ago. Do not be surprised to see some of that money being put into the stock market soon.

Case Closed: Stocks Work

If past is prologue, returns over the next five and 10 years will be better than average – so do not give up yet.

Stocks have done terribly over the last 10 years. This is good news ... for future performance. Not surprising at all, when you think about it. Barron’s has detailed proof, with some help from Wharton finance professor Jeremy Siegel, author of the best-seller Stocks for the Long Run.

This year marks the 30th anniversary of a famous Business Week cover story “The Death of Equities.” Along with those scary words, the magazine’s August 13, 1979, cover read, “How inflation is destroying the stock market.” But starting around that time, investors could have beaten inflation quite handily by snapping up stocks and holding them for 5 or 10 years.

Buying the stock market at the close of 1979 would have yielded, after inflation, [emphasis added] an average annual return of 7.3% over the next 5 years. An even higher 5-year return of 9.47% could have been captured by going long at the end of 1978. The 10-year performance would have been healthier still, yielding 9.52% or 10.75%, depending on whether the investor bought at the close of 1978 or ‘79.

With the stock market in the throes of yet another near-death experience, another rebirth could be in the offing. Five- and 10-year returns on stocks through year-end 2008 have run negative, and would have looked even worse at the lows of last week. But based on the historical record, performances like these bode well for the next 5 to 10 years.

For 20- and 30- year periods, inflation-adjusted returns on stocks have never been negative.

The historical record shows that for 20- and 30- year periods, inflation-adjusted returns on stocks have never been negative. Over the 137 years from 1871 through 2008, returns after inflation for 20- and 30-year intervals have been consistently positive. Median returns over the 20-year intervals have been 6.85%, and for 30-year intervals, 6.23%.

With this consistently strong performance over long periods, it stands to reason that below-par returns over 5- and 10-year intervals would tend to be followed by much better results over the subsequent 5- and 10-year intervals. And in fact, the historical record shows that, following below-average returns over five and 10 years, subsequent periods of similar length do tend to perform better than average.

An investor whose retirement is drawing near might take heed: Investing in stocks today could help produce the cash you will need 5 or 10 years down the road.

Those who plan to retire in less than 10 years would benefit if the historical trends hold true. Positive returns over the next 20 or 30 years would only make retirement more of a breeze.

Critics of stocks as vehicles for retirement often rig their case by assuming that investors entered and exited with the worst possible timing, buying at peaks and liquidating at bottoms.

But diversification over time – buying and selling periodically, rather than all at once – can be quite effective. Most investors would be foolish to liquidate all their stock holdings on the day their retirement begins, unless they feel endowed with timing skills that few can claim. If they plan to live 20 years past their retirement, they might plan to hold on to at least part of their holdings for 15 to 20 years.

And of course, retirement accounts are set up in such a way that buying can occur in installments over many years. The acquisition of stocks can therefore be diversified over time, along with the process of liquidation.

From this perspective, useful insights can be gleaned from the exhaustive record originally pieced together by Wharton School finance professor Jeremy Siegel for his best-selling book, Stocks for the Long Run, now in its 4th edition.

Siegel has amassed data on rolling 5-year periods dating back to 1871 (1871-1876, 1872-1877 and so on). He has similar data on rolling 10-, 20- and 30-year periods.

Why begin with 1871? Prof. Siegel can also provide data going back to 1802, but prior to 1871, the quality of the data is not particularly reliable, and data over the past 137 years are more than sufficient to reveal the long-term performance of stocks as an asset class.

The data can track all failed stocks into bankruptcy, so there is no “survivors’ bias,” a common flaw in historical analysis. And Siegel adds that, even in the 1800s, the U.S. stock market featured a fair range of different industries, roughly similar to more recent eras.

Siegel has analyzed the data in terms of “total returns” after inflation. All publicly traded stocks are bought on a capitalization-weighted basis, with all dividends reinvested. Average annual returns benefit from the magic of compounding. Thus, for example, $1 invested at 6.26% over 30 years becomes an inflation-adjusted $6.13 with compounding.

For any given holding period from year-end close to year-end close, no taxes are assumed – not unrealistic, given the advent of tax-deferred accounts. Perhaps a tad unrealistically, management fees are not factored in, either. But in the era of index funds and exchange-traded funds, such fees are lower than ever. Some ETFs charge as little as 0.07%.

Jeremy Schwartz, research director of WisdomTree Asset Management – a firm with which Siegel is affiliated – updated Siegel’s figures at Barron’s request. We asked him to line up the worst-performing quartile of 10-year stretches since 1971 and then see how the following 10 years performed in each case. That meant examining about 30 intervals of poor performance.

The result: In each case – without exception – the subsequent 10-year periods performed better and ran positive. The median performance for each was 8.17%, 1.33 percentage points higher than the median for all 10-year intervals.

Schwartz performed the same exercise for the worst quartile of 5-year returns. Here the finding was that, in 25 out of the 31 cases, the subsequent 5-year periods performed better and ran positive. The median performance for all these cases was 9.47%, 2.50 percentage points higher than the median for all 5-year intervals.

Prof. Siegel also compares long-term equity performance with returns in U.S. Treasury bonds – an apt comparison for risk-averse investors seeking reliable income in retirement. Assuming buy-and-hold strategies in Treasuries over 20- and 30-year intervals, how often did the inflation-adjusted income and possible capital gains from bonds prove superior to the returns of stocks?

Answer: Through 2008, stocks have always done better than Treasury bonds over 30-year periods. And over 20 years, stocks bested Treasuries in all but a little over 5% of the cases.

Despite the bear market of 2008, long-term returns through year end were fairly good, running 5.17% annually for the previous 20 years and 6.6% for the previous 30. But what if the investor had the bad luck to liquidate at of the close of February 2009? Add these two disastrous months to the 20- and 30-year holding periods, and returns would have been 4.09% and 5.86%, respectively.

Why do stocks tend to do better over the long run than either bonds or inflation? Mainly because their returns are driven by rising profits – which in turn are driven by real growth in the U.S. economy. That is why stocks can be indispensable for retirement planning.


Barron’s follows up its pronouncements (above) that stocks are cheap with 10 picks for “the long haul.” Not the bluest of the blue chips, these all might be characterized as mature growth stocks on the cusp of blue-chipness: Microsoft, EMC, and Google rather than IBM; Coca-Cola Femsa rather than Coca-Cola or Pepsi; Wellpoint and CVS rather than J&J or Abbot Labs; ACE rather than AIG ... etc. Other than Wynn Resorts the companies feature clean balance sheets, established franchises with reasonable growth prospects, and “visible” (i.e., higher probability of being realized) earnings ... as they used to say.

Studies have found that if one decomposed investment returns into constituent components that the choice to be in stocks or not was the most important, the choice of sector weightings the next most, and the choice of stocks within the sectors the least important. So if you have already chosen to be in stocks you want to be careful about your sectors or, perhaps instead, the styles – value, growth, yield, etc. (See “There Is No Value, Only Growth” in the Short Takes section below.) These mature growth stocks or their like strike us as good core holdings, given the choice to be in stocks.

In this tumultuous market, visualizing the next week, let alone the next 10 years, can seem impossible. Still, good stocks bought on the cheap today could pay off handsomely by the time you are ready to retire.

In fact, there has rarely been a better time for long-term investing, thanks to the beaten-down prices. The Dow is off more than 50% from its peak in October 2007, and the last two times it fell that much – during the routs of the early 1970s and 2001-03 – big bull markets followed, says Jeremy Siegel, a finance professor at Wharton. “It does not mean there will not be more pain in the short run, but history is very favorable once you have reached that 50% decline,” he says. (For more on the long-term trends, see “Case Closed: Stocks Work.”)

As Barron’s would be the first to admit, picking stocks to stash away for five years or longer can be humbling. When we last did this exercise – five years ago this month – we chose six stocks. If you had invested $10,000 in each, your $60,000 holdings would have fallen to $52,400 by today. While that is better than the broad market’s 34% decline, losses of any kind can take the shine out of your golden years.

“Seeing past 12 to 18 months gets very difficult,” says Jerry Senser, chief executive of Chicago asset manager Institutional Capital. But Senser knows it is essential at least to try, and so do we. This time we’ve picked 10 stocks that could shine over the next five or 10 years. For the names and numbers, please read on.

Coca-Cola Femsa

At about 26, shares of the world’s second-largest Coca-Cola bottler are down nearly 60% from their 52-week high, with investors fretting over the pace of growth at the Mexico-based company.

But David Winters, the savvy portfolio manager of Wintergreen Fund, likes the prospects for Coca-Cola Femsa. “It is really a play on Latin America, which has been out of favor,” says Winters. “But it is a very well-run company, and they are continuing to grow.”

The company remains on solid financial footing, with $650 million of cash as of late February. While earnings were off 70% in the 4th quarter, bulls think double-digit growth could return by the end of 2010, thanks to the company’s leadership position in the Latin American market.

The American depositary receipts (ticker: KOF) fetch about 7 times the $3.74 a share analysts expect the company to earn this year – very reasonable, assuming earnings pick up. “Right now people think it is never going grow again,” says Winters.


The shares, at a recent $15.27, have been a big disappointment. Despite attracting many value hunters, the stock has headed ever downward as spending on information technology declines.

That problem masks the company’s long-term strength. Wally Weitz, who helms asset manager Weitz & Co., calls Microsoft (MSFT) “a gigantic cash machine.”

Bill Nygren, co-manager of the Oakmark Fund, notes the company’s low price-to-earnings ratio – less than 9, based on his estimates for this year’s earnings – is closer to 7 if you exclude the $4 a share in net cash.

“Investors, especially individual investors, put too much focus on growth expectations and too little focus on price,” he says.

The stock is also sporting a dividend yield of 3%, slightly more than last week’s quote for 10-year Treasury bonds.

ACE Limited

The property-casualty industry may not be glamorous, but it is clearly essential, insuring everything from airplanes to office buildings. ACE Limited (ACE), one of the largest global players in the field, “is very strong financially, and they have weathered the current environment quite well with a strong balance sheet,” says Institutional Capital’s Senser. What is more, ACE stands to benefit from AIG’s woes by gaining market share and raiding its rival for talent.

By Senser’s calculation, the stock trades at about 90% of its book value, compared with its historical average of 1.3 times book.

Earnings are apt to be flat this year, but Senser sees high-single-digit growth next year.

Wynn Resorts

Shares of Wynn Resorts (WYNN) are down more than 80% in the past 12 months as the global recession has taken a toll on casino gambling. In the 4th quarter alone, Wynn’s revenue fell 14% from a year earlier.

“I continue to believe that people are going to want entertainment, assuming the darkness lifts. And that is our assumption – that the world will go on,” says Winters. He calls the company’s properties, including luxe resorts in Las Vegas and Macau, the best of their kind. The company is run by gaming veteran Steve Wynn, who owns a big chunk of the stock.

Besides the falloff in business, there is concern about the company’s debt load, which totaled $4.3 billion, or 73% of total capital, at the end of December. But its cash totaled $1.1 billion, providing some real breathing room.


A top player in network storage and security, EMC (EMC) has seen its shares lose more than 50% since late 2007. The big worry is softer corporate IT spending.

However, Jeff Coons, co-director of research at Manning & Napier Advisors, says the company is well positioned to take advantage of Corporate America’s rising need to store and protect data.

“We need more and more storage for our data, and we need more security to protect the information coming in and out” of those networks, he says. Coons’s firm expects revenue from the entire network-storage industry to grow at an 8% to 10% annual clip.

Although EMC is likely to come under more pressure from the recession, its profit outlook seems reasonable right now. Analysts expect earnings of 91 cents a share, up from 77 cents in 2008. Even if it falls short of that mark, Coons puts the stock’s fair value at about 18, compared with its current price of about 10.

One lingering worry: a recent lawsuit against EMC accusing it of paying kickbacks and overcharging government agencies. But the company denies any wrongdoing, and the suit is not expected to affect long-term growth prospects.


It has been well documented that much of the health-care field is not at the cutting edge of information technology, particularly when it comes to record-keeping. Fewer than 14% of doctors nationwide use a basic electronic system for record-keeping, says the New England Journal of Medicine. As a result, doctors are prone to more errors.

That is where Cerner (CERN) comes in. It builds and runs data systems, many used to store medical records.

“We look at health-care information technology as a growing trend and really a necessary tool to improve the efficiency and productivity of hospitals,” says Manning & Napier’s Coons.

The market does not seem to believe that, with the stock at about 36. But Coons figures the shares are worth $50 or more.


Managed-care stocks have taken a drubbing lately, as investors worry about cuts to Medicare benefits under President Obama’s proposed health-care overhaul.

Shares of WellPoint (WLP), the largest Blue Cross Blue Shield managed-care company, have been under pressure for some time. The dismal economy is another factor as more layoffs erode membership in its health-insurance plans.

However, Wally Weitz points out that roughly half of WellPoint’s health-insurance business is in administering plans for businesses, rather than taking underwriting risk. Result: Earnings are far more predictable.

He thinks the company will keep growing regardless of what the government may do. “It is unlikely that the current administration wants the federal government to be the only game in town,” says Dave Perkins, an analyst at Weitz’s firm.

The shares fetch about six times the $5.50 a share Weitz expects the company to earn this year, and he thinks the shares can produce annual returns in the mid-to-high teens for the next few years.


Google, at about $305, has lost more than half of its value since late 2007, as investors have grown wary of its dependence on advertising during a recession. But the fears are overdone. To the extent companies are advertising, they are increasingly doing it on the Net. That trend should continue for some time to come.

Says Coons of Manning & Napier: “The long-term driver for Google (GOOG) is the push toward online advertising. “We are going to see more and more ad spending moving in that direction.”

Already, 9.6% of all advertising dollars are spent on the Web, up from 7.6% in 2007, according to eMarketer, a research firm.

Further helping Google: It has absolutely no debt. That is a huge plus in any economy.


Here is another Internet titan that has been unduly pounded. Investors have been fretting not only about the effects of the economy, but about increasing reports of counterfeit items peddled on the Website.

Those concerns do not worry Bill Nygren of Oakmark, a long-term investor who sees some similarities between Microsoft and eBay (EBAY). Both have big holdings of cash, relatively light needs for cash investment to support growth, and strong brand names, he points out.

He adds that eBay is attacking the counterfeit problem in earnest. “They are doing everything they possibly can do to minimize that,” he says. The company’s cash position works out to $3 a share, and the share price is just $10, or about seven times this year’s estimated earnings. Also, as Nygren notes, the business has “powerful competitive and scale advantages.”

CVS Caremark

The company runs two businesses: retail pharmacies and pharmacy-benefit management, which helps health-plan sponsors manage their prescription-drug costs.

On the drugstore side, the company (CVS) widened its footprint last year when it acquired Longs Drug Stores, a big West Coast presence, for $2.9 billion. Senser of Institutional Capital expects the drugstore business to get a boost as more drugs take on generic status, leading to higher retailer margins.

The pharmacy-benefit-management business, for its part, is helped as companies step up efforts to control health-care costs.

Senser thinks the company is capable of generating $3.5 billion of free cash flow, for a cash-flow yield of 8.5% – “very, very attractive,” he says.


A lot of the economic activity over the next couple of years is going to be generated by governments throwing money at everything in sight. Most of this will end up being a total waste – and a disastrous one cumulatively – diverting scarce resources from activities that would actually add to someone/anyone’s economic well-being. In other words, it will be like most government spending.

China’s version of this will be to spend on infrastructure projects. This program has the virtues of: (a) targeting projects that look like they actually have some legitimate merit, and (b) converting some of China’s U.S. dollar pile into hard assets while the former still has some exchange value. This article enumerates some of the likely beneficiaries of the Chinese program, some of which look fairly cheap.

While the U.S. and Europe scramble to bail out their banks, China has a different approach to stimulus.

Unlike New York or London banks, China’s largely isolated lenders are not in dire straits. But faced with slowing exports and rising unemployment, Beijing last November moved to inject both confidence and cash into its flagging economy – at least 4 trillion yuan ($585 billion; one yuan is worth around U.S. 15 cents) during 2009 – with a promise to dip further into the country’s $2 trillion in foreign reserves if necessary in the future.

Markets were disappointed when Premier Wen Jiabao failed to announce another injection Thursday (March 5); however, officials later hinted that the fiscal and monetary stimulus already in place might make further moves unnecessary.

The key words here are “infrastructure investment.” From China’s stimulus package, 600 billion yuan will be pumped into new rail services this year, 70% of it earmarked for high-speed passenger lines. That is almost double the 330 billion yuan 2008 budget for rail, and solid jumping off place for 2010’s 700 billion yuan. Around 250 Chinese cities are planning to build new subway lines by 2015. The city of Changshang in central China alone is investing 22.4 billion yuan in two new subway lines.

And this is just the start. As Andy Rothman, China macro strategist at brokerage CLSA in Shanghai, notes: “This is a political exercise as much as anything, and there are no constraints, so [the Chinese state] can spend as much money as possible to get the economy going again.” If nothing else, the package has helped boost the Shanghai Composite, an index of all mainland-listed stocks, by 14% on the year to March 3.

A failed state 30 years ago, China is frantically rebuilding a country in which 600,000 towns and villages have few paved roads, or none. A nation that seems disposed toward vast public building projects – grand canals, giant dams, great walls – is still in want of 10 million miles of roads and rail lines, and 100 million new apartments.

Manop Sangiambut, deputy head of China research for CLSA in Hong Kong, sees three sectors gaining most: railways, municipal subways, and power transmission. “The government is basically speeding up projects, pushing through approvals so that construction startup plans for 2010 and beyond are moved forward,” says Sangiambut.

That is music to the ears of China’s state-owned infrastructure majors, many of which have listed vehicles in Shanghai and Hong Kong.

So where should skittish stockpickers look in a lean year to benefit from Beijing’s coming largesse? CLSA highlights three undervalued companies set to ride the infrastructure wave. China Railway Group (tickers: 390.HongKong; 601390.China) has seen its Hong Kong stock fall 22% in the year to March 3, with its Shanghai securities down 2.2%. Yet the brokerage has a Buy rating on the stock, making CRG its “top pick among rail plays” due to its “reasonable valuation and dominance in subway projects.”

Just shy of 1/5 of all China rail orders placed in the first two months of 2009 – worth some 65 billion yuan – were won by CRG, which had a market cap of $16.6 billion on March 3. CLSA’s Sangiambut sees CRG’s price-to-earnings ratio rising to 20 times by year end, from 16.79 at present. Infrastructure pump-priming in calendar 2009 alone will boost earnings by 10% to 11%, with total profits set to rise by 30% to 40% both this year and in 2010, the brokerage says.

CLSA analysts also have an Outperform rating on China Southern Locomotive (1766.HongKong; 601766.China), already the country’s leading maker of rolling stock and subway cars, after its founding in 2007. On February 26, CLSA advised that China Southern would enjoy “multiyear earnings growth,” predicting earnings to jump around 11% in 2009 just from new infrastructure deals, with overall profits again rising between 30% and 40% in each of the next two years.

Macquarie Group’s financial advisory, meanwhile, has an Outperform rating on Zhuzhou CSR Times Electric (3898.HongKong), a division of China Southern Locomotive and the leading mainland maker of train components. Anderson Chow, an analyst at the Australian brokerage and infrastructure investment specialist, describes Zhuzhou as “more reasonable” than other China railway-related stocks, with its earnings per share tipped to rise at a compound rate of 25.5% between calendar 2008 and 2010 inclusive.

Analysts highlight a few other stocks as wild cards in the sector, notably two Shanghai-listed makers of high-voltage industrial switches, Henan Pinggao Electric (600312.China) and Baoding Tianwei Baobian Electric (600550.China), as well as a major maker of transformers and cables used in the transport and power sectors, TBEA Company (600089.China).

China has shown itself and the world that it is prepared to dip into its savings pot to boost its flagging economy. Several stocks in rail, subways and power infrastructure are expected to gain the most. A piece of sage advice might be: Get them before they are hot.


The author of this article posted a piece on Seeking Alpha on January 29 titled “Is a 20% Yield Sustainable? Look at Atlas Pipeline Partners". We were considering reposting it in turn but first checked for followup research or news. There was some, and the answer to the original piece’s title question is: Perhaps, but the market does not believe it and is not taking any chances. The MLP unit price has fallen from $7.50, where the yield was 20%, to about 3, where the yield would be around 50% if the distribution is sustained – which it has been so far but, again, the market is effectively betting against it continuing.

The dissection of the price decline by the original author and Capital & Crisis’s Chris Mayer is instructive. The bottom line is the business is extraordinarily cheap, and it definitely has its risks due to a debt-heavy balance sheet and exposure to oil/natural gas prices. As with most energy distribution Master Limited Partnerships the cash flow is good; the margin of error has definitely lost some padding over time. The partnership is attempting to sell some deemed non-core assets. If there is any news about getting a decent price for those and lowering the partnership’s debt the unit price should jump. It is a speculative roll of the dice, with some decent odds by Mayer’s calculation, as well as by respected hedge fund operator Leon Cooperman’s.

Before I invest my money in an investment, I work hard to do my own “due diligence” so I have no one else to blame but myself. Part of that process involves getting opinions and analysis from people I believe are smarter than myself and have a fairly good track record.

Before I bought two helpings of Atlas Pipeline Partners LP (APL), I read everything I could get my hands on including the company’s own web site. I wanted to understand the “key statistics", especially the balance sheet numbers. Master Limited Partnerships (MLPs) can be very tricky to understand and analyze. That makes the “due diligence” process both important and more difficult.

Frankly, I have been terribly disappointed with the results of my investment in APL, and I’m humbled by the fact that even when we try to know what we are doing and what we are buying, we sometimes get “burned". Look at the awful 1-year chart ... [which at the time showed the MLP units falling from over 40 to 3 or so].

During these times it is even near-impossible to know where the bottom is with MLPs and energy companies like Enterprise Products Partners LP (EPD), ConocoPhillips (COP) and BP (BP).

Today’s wretched economy and perilous stock market means both “danger and opportunity” for investors, but right now we are feeling the “danger” side and it is painful.

Many times there are forces beyond our control and unforeseen events that can make even the best “value” stocks plunge in the aftermath of a decent quarterly earnings report. So it has been with APL, and the lessons I am learning are myriad.

First of all maybe we have reached a time where trailing stop-losses are more essential than ever. Secondly, there are no opinions and analysis that are fool-proof, so do not invest in any company or human-directed enterprise where you cannot afford to experience the results of “mistakes and miscalculations". Caution and circumspect are always essential.

When it comes to what to do now, I cannot say it any better than one analyst has said it today. Chris Mayer who writes the newsletter Capital & Crisis explained to his readers his own frustration and lessons learned from APL.

Thank you Chris for allowing me this chance to share it and I hope it increases the number of readers who are interested in your work. For those of us who own APL, what you have written is more instructive than anything else I could find on the worldwide web today. Here is how Chris summed it up on March 5th:

Atlas Pipeline Partners
We got an earnings report from APL this week. APL owns and operates approximately 1,600 miles of natural gas pipelines in Appalachia. APL also owns 7,870 miles of gathering systems, a 565-mile interstate gas pipeline, seven processing plants and one treating facility.

You have to have a strong stomach to own APL. The stock has been cut nearly in half this week – falling from $6 to about $3.30 as I write. There are a lot of things going on here. I will get into all of that more below.

But first, I want to say that I made two mistakes with APL initially. The first was that I compromised on my CODE system by admitting a company with such leverage – APL has about a $1.5 billion in long-term debt, though none of it is due until 2013. It did not meet the “E” for excellent financial condition. I knew that. I rationalized it by looking at APL’s ample cash flows. And I was bullish on energy prices. Instead, energy prices tanked, and with them APL’s cash flows – which gets to the second mistake.

The second mistake was not fully appreciating the commodity risk and complexity inherent in APL’s business. It is not as simple as pipelines would seem to be.

However, I have sorted through these things since we have owned it. And even though I do not think we will see $40 per share for a long time, the current shares seem well below intrinsic value, assuming APL pulls through. I believe it will. While we wait, APL pays a sustainable distribution of 38 cents a quarter, or $1.52 per year – assuming commodity prices fall no further. In a better commodity environment, APL has the potential to pay two or three times that.

A big part of APL’s cash flows is linked to the price of oil. That is because a big part of its business is taking natural gas and turning it into natural gas liquids (NGLs) – things like butane and propane. NGL prices tend to follow oil prices, averaging maybe 60% or so of the price of oil. Of late, that spread has widened even further, to little more than 50% of crude oil. This reflects lower demand from petrochemical companies and refineries – the primary users of NGLs. Bottom line: This is hurting APL’s margins.

Lower natural gas prices also do not help. Some of APL’s contracts give it 16% of the price of the natural gas that flows through its pipelines. Also, lower natural gas prices mean less drilling and fewer new wells connecting to APL’s pipelines.

And since APL has quite a bit of debt, the worry is that APL is going to have some financial trouble. The consensus is that APL will not meet its debt covenants. If that happens, the creditors come over the walls and extract their pound of flesh from the unit-holders.

However, results from the latest quarter, guidance from management about APL going forward and a slate of impending asset sales mean that APL should meet all of its covenants and keep its creditors at bay.

Let us take a quick look at each of these.

In the last quarter, APL generated distributable cash flow (DCF) of $75 million – that is after interest expense of $23 million. It is also after some one-time gains. Back out the one-time gains and APL generated DCF of $37 million, or 80 cents per unit. This covered the distribution of 38 cents about twice. Volumes were up, and should be up again in 2009.

APL also wrote off all of its goodwill – a noncash charge that led to the reported loss. Now book value is almost entirely made up of APL’s infrastructure assets with useful lives of 20-40 years. Book value per share is $16. That book value is a historic cost. The cost to build APL’s pipelines and processing plants today would be far greater than book.

Let’s turn to management’s guidance. Management anticipates $300 million in gross margin in 2009 – even after the asset sales. If that turns out to be true, APL will be fine. The market does not believe it. Management also maintains its current distribution of $1.52 annually is sustainable and “very likely to increase in the coming years.” It also said it expects to comply with all covenants with the asset sales.

Let’s move onto the potential asset sales, which include a 50% interest in APL’s Nine Mile processing plant, all of its Ozark assets and a portion of its Appalachian assets. These deals are not final. But management says we could expect to see them in a “few weeks.” APL also said that the deals would significantly delever APL.

Management did not give a dollar amount for these sales, so we cannot make too much of this right now. I do not even want to speculate on how much these sales might raise. I suspect APL will not get great prices in this environment, but we will see.

So what does it all mean and what do we do?

I am leaving APL at buy, but realize it is speculative. You have to have a strong stomach to own this thing. And if commodity prices go lower and stay there for a few months, APL is going to have problems. What ails APL is a heavy debt load and low commodity prices.

But it is too cheap to sell at this point – the distribution of $1.52 and the book value of $16 make the current price of $3.50 look absurd unless APL turns out to be a zero. Based on management’s guidance and the potential asset sales, I do not think it will be a zero. Also, natural gas and NGL pricing has been destroyed. Any bounce here would greatly help APL’s business.

And for what it is worth, Leon Cooperman, the longtime successful investor, added to his position in the 4th quarter. He is the largest stockholder and owns nearly 10% of the units.
The last lesson I am learning from all this is “keep our investments very, very simple.” Part of the big problem evidently with MLPs is that they have a more complicated internal structure and company set-up. It is not about how many units of natural gas or barrels of oil can they sell or move.

MLPs apparently involve a more complex web of relationships, covenants and other factors that are not part of the “nuts and bolts” of corporations like Pepsi or Ensco International.

Analysts like Chris Mayer have a tough job and I am convinced they do the best they can with the knowledge they are given. But even the sharpest minds (think Warren Buffett buying lots of Procter & Gamble or ConocoPhillips) overlook certain factors that can be very costly to investors and to themselves.

On a day like today when the Dow closes below 6,600 and the Nasdaq below 1,300, we need all the encouragement and lessons-learned that we can find. So many “bargains” and “unprecedented opportunities” have turned into “quick-sand” that it is making us downright “gun-shy.”

Hopefully we will not loose our resolve, we will separate our emotions from reality, and we will end up much smarter investors in the long-run.

Also see Energy Infrastructure MLPs: Among the Very Best High Dividend Stocks and Potential Upside in Energy-Related MLPs.


You can easily screen for all kinds of fundamental valuation and performance factors while looking for cheap stocks whose underlying businesses are decent. So can everyone else. The ability to conduct such screens is freely available on the internet. This means that the likelihood of consistently outperforming your stock-picking peers via your quantitative screening accumen alone is unlikely, especially if your universe is the liquidly-traded, extensively-followed stocks. Consistent outperformance requires an edge which is not easily replicated, in other words ... a sustainable competitive advantage.

When Warren Buffett talks about wanting “a wide moat” around the kind of businesses he seeks to buy he is referring to such an advantage. Firms with such an advantage have the capacity to consistently create value for their shareholders. They also have a cushion against mismanagement. As Buffett has said, he also likes to own businesses that any idiot can run, as eventually some idiot will.

Competitive advantage is hard to screen for quantitatively, although persistently high returns on capital are undoubtedly correlated with it. In the end there is no substitute for understanding the business and identifying for yourself if and where the advantage exists. As Buffett and others have shown, the rewards for identifying competitive advantage can be substantial.

Imagine a stock that offers the combination of high growth, a low P/E ratio, low debt levels and a high return on equity (ROE). It looks like a recipe for an unbeatable investment, and investors would be hard pressed to find a stock with better fundamentals.

But as compelling as these fundamental features might be, they still do not hold a candle to the best indicator of a company’s future success: sustainable competitive advantage. While performance measures like PE and ROE are certainly important tools for assessing a company, they are not necessarily a complete reflection of future growth and profitability. A company’s long-term success is largely driven by its ability to maintain a competitive advantage – and keep it, even in the toughest, most volatile economic times. (For background reading, see Economic Moats Keep Competitors At Bay.)

The Survivors

In its 2008 Value Creators Report, Boston Consulting Group analyzed the total shareholder returns (TSR) of more than 5,000 companies to identify the world’s top performers and their underlying drivers of success. A recurring theme in the BCG’s research is that firms with competitive advantage are capable of creating value for shareholders. The 2008 report focused on the importance of value creation in a corporation’s strategy. The top companies in the report showed strong growth in sales and shareholder returns in the 2003-2007 period.

A good example of a business that outperformed the market in the period examined was Apple Computers [AAPL], which was ranked 9th in the report’s Global Top 10 with sales growth of 34% between 2003 and 2007 and total shareholder returns of 94.2%. As of February 2009, it was also holding up against a market recession better than many of its peers. (To learn more about what it takes for a company to be successful, see 3 Secrets Of Successful Companies and The Characteristics Of A Successful Company.)

What Does Competitive Advantage Look Like?

The trouble for investors is that, most of the time, sustainable competitive advantage is not easy to spot. For starters, it is awfully hard to measure. Unlike performance measures like return on capital employed (ROCE) and valuation metrics like P/E, competitive advantage cannot be boiled down to a formula or a ratio. Furthermore, distinguishing between competitive advantage and operational efficiency is often difficult.

Harvard Business School Professor Michael Porter, in his excellent essay, “What Is Strategy?” (1996), argues that these two concepts must not be confused: operational effectiveness means a company is better than rivals at similar activities while competitive advantage means a company is performing better than rivals by doing different activities or performing similar activities in different ways. Investors should know that few companies are able to compete successfully for long if they are doing the same things as their competitors.

At the same time, gaining a sustainable competitive advantage is not as simple as just being different. When companies do eventually manage to achieve competitive advantage, more often than not the advantage is short lived. Like bees to honey, competitors are drawn to the high profits of competitive advantage. Competitors work hard to develop new technologies and business techniques that can quickly upset the competitive status quo. Remember, today’s competitive advantage can become tomorrow’s albatross.

At the end of the day, it is sustainability that is so critical. Powerful competitive advantage creates a big barrier around a business, allowing it to fend off competitors and enjoy extraordinary growth and profitability. The best long-term investments are those companies whose walls are not only high but also getting higher and thicker over time. Think of Coca Cola’s global brand name recognition, Microsoft’s dominance of the PC operating system, or Wal-Mart’s advanced information technology and inventory management systems. Investors need to understand the circumstances in which a company and its business model compete and whether the model puts the company at a competitive advantage or disadvantage.

Spotting Competitive Advantage

A company’s future is never certain, so how can an investor pinpoint companies with growth and profits that will be substantially higher in the years to come? In Berkshire Hathaway’s 1996 Chairman’s Letter to Shareholders, Warren Buffett, one of the world’s greatest investors, says that the trick is to look for firms that already have competitive strengths and that operate in areas that are not susceptible to big changes:
"You will see that we favor businesses and industries unlikely to experience major change. The reason for that is simple: We are searching for operations that we believe are virtually certain to possess enormous competitive strength 10 or 20 years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek.”
More than anything, Buffett looks for companies that have a sustainable competitive advantage. Here is what he says in the December 1999 issue of Fortune Magazine:
"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”
(To read more about Buffett’s strategies and theory, see Think Like Warren Buffett and Warren Buffett’s Best Buys.)


When it comes to determining a company’s competitive advantage, there are a few important questions that investors can ask about a company: Is its strategy different from other companies in the market? Does the company’s strategy position deliver superior profits? Is the strategy defensible? If investors can respond yes to these questions, the company may have good future prospects.


Doug Noland, editor of PrudentBear.com’s Credit Bubble Bulletin, continues to find the false lessons deduced from this decade’s credit bubble – to put words in his mouth – morbidly facinating and aggravating. As he puts it, “confusion, flawed analysis, ideologies and the overwhelming forces of historical revisionism create imposing obstacles to understanding” credit bubbles. He stops short of an outright indictment of the political system per se, but that is ultimately to where all fingers point.

March 5 – Bloomberg (Dawn Kopecki): “The ‘phenomenon of securitization’ must be curtailed by lawmakers to prohibit banks and mortgage lenders from shifting all the risk on loans they originate and sell to investors, U.S. House Financial Services Committee Chairman Barney Frank said. ‘I will be pushing for legislation that will make it illegal for anybody to securitize 100% of anything,’ Frank ... told reporters ... Securitization is a ‘large part’ of the problem in the housing market, he said.”

March 5 – Bloomberg (Scott Lanman and Craig Torres): “Federal Reserve Vice Chairman Donald Kohn came under fire from Democratic and Republican senators for rescuing American International Group Inc. without providing cost estimates or enough openness, risking public confidence in government. Federal aid to AIG ‘appears to be a bottomless pit,’ said Mark Warner ... Regulators ‘are asking for an open-ended check and’ are ‘not going to get’ it, said Senator Robert Menendez ... ‘The people want to know what you have done with this money,’ said Senator Richard Shelby ... The $163 billion AIG rescue ... may worsen prospects for congressional approval of more spending on bank rescues beyond the $700 billion Troubled Asset Relief Program, lawmakers said ...”

Our Washington policymakers have too belatedly recognized the perils associated with unregulated credit and speculative finance. They now come down hard on our Federal Reserve and Treasury Department officials, quickly losing sight of the mountains of blame to be spread around. Let us not forget that Congress repealed the Depression-era Glass-Steagall Act back in 1999. And it is fair to remind leaders from both parties and both Houses that they are directly culpable for the spectacular rise and unfolding fall of the Government-Sponsored Enterprises (GSEs). I get no sense that a coherent understanding of the credit bubble is manifesting in Washington.

I could on a weekly basis come with dire predictions, but there is more than enough of this type of reading available these days. I will stay focused on (contemporaneously) analyzing this historic credit bubble from every angle, with the objective of contributing to lessons learned. And I believe quite strongly that gleaning the key lessons from major bubbles is incredibly more challenging than one would ever imagine – that confusion, flawed analysis, ideologies and the overwhelming forces of historical revisionism create imposing obstacles to understanding. One can point to the 80 years or so of writings examining the Roaring Twenties and the Great Depression (what Chairman Bernanke refers to as the “Holy Grail of Economics”) to support this view.

There is no doubt the securitization and CDS (credit default swap) markets were key facets of the credit boom and are today at the heart of the devastating bust. Financial “innovation” always plays a critical role in major bubbles – and this process of experimentation and innovation is consistently evolutionary in nature. While it is in many ways reasonable to cast blame upon these markets and their operators, lessons learned requires an understanding as to how these markets came to play such decisive roles. What critical features of the financial landscape contributed to the marketplace’s enthusiasm for these types of instruments? More specifically, how was it that total mortgage credit growth surpassed $1.5 trillion annualized during the first-half of 2006? How did asset-backed securities (ABS) issuance balloon to $900 billion annualized in late-2006? How was it that Wall Street asset growth surpassed $1.0 trillion annualized during the first-half of 2007? How could CDO issuance have possibly reached $1.0 trillion in 2007 – and that the CDS market mushroomed to more than $60 trillion at the very top of the credit cycle?

The ratings agencies provide such easy and browbeaten scapegoats. They adorned “AAA” ratings on trillions of MBS, ABS, and CDOs (collateralized debt obligations) during the heyday of the boom – back when home prices were forever rising, incomes were surging, credit losses were disappearing, and New Era babble was as unnerving as it was alluring. The rating agencies, Wall Street, Congress and virtually everyone else believed the boom was sustainable. But the radically-altered post-bubble backdrop now finds the rating agencies appearing as nincompoops complicit with shady Wall Street operators. Such a post-boom spotlight is predictable. From an analytical perspective, however, focus on the idiocies and malfeasance of the boom is certain to neglect key bubble nuances.

From a “moneyness of credit” perspective, the Wall Street credit mechanism evolved to the point of creating virtually endless debt instruments perceived by the marketplace as safe and liquid stores of nominal value (contemporary “money”). One cannot overstate the principal role top-rated money-like debt instruments played in fueling the bubble, although let us not get carried away and convince ourselves that the rating agencies had much at all to do with market psychology and speculative dynamics. For more culpable villains I suggest Washington look in the mirror. The “moneyness” enjoyed by Wall Street finance was either explicitly or implicitly underwritten within the beltway.

It was said back in the 1960s that Alan Greenspan blamed the Great Depression on the Federal Reserve repeatedly placing “coins in the fuse box” – repeated market interventions with the intention of perpetuating the 1920s boom. Going back at least to the 1987 stock market crash, our policymakers cultivated the markets’ view that Washington was right there to nurture and forever protect the “free” market. And the greater the prosperity and the higher asset prices went – the more certain the market became that policymakers would never let it all come crashing down.

The Greenspan Federal Reserve, in particular, nurtured the market perception that Washington was there to backstop marketplace liquidity. Greenspan pegged the cost of finance and essentially promised liquid and continuous markets. Mr. Greenspan became a leading proponent for securitizations, derivatives and “contemporary finance” more generally. “Liquid and continuous” markets were the lifeblood of these momentous credit system innovations – and Washington seemingly delivered the goods.

Importantly, the GSEs – with their implied government guarantees – became commanding market operators and quasi-central banks, aggressively intervening to stem varying degrees of financial stress in 1994, 1998, 1999, 2000, 2001, 2002, and 2003. Congress was enamored with the virtues of deregulation, while turning a blind eye to the most glaring market distortions and excesses. Both sides of the isle were elated with the newfound capacity for the Federal Reserve and GSEs to jam coins in our system’s “fusebox.”

Congress steadfastly refused to address the issue of the GSEs’ implicit government backing, thus endorsing the most dangerous distortion to a “free” market pricing mechanism in the history of finance. All along, market confidence that Washington was backstopping system liquidity became more ingrained and problematic. Trillions of “money-like” agency debt and MBS securities were accumulated, with operators (and GSE “enablers”) cocksure that this market was much too big to stumble. The GSEs eventually did falter and were hamstrung by their accounting issues. By that time, however, the inflationary bias within mortgage finance and housing had become so powerful that the boom in Wall Street “private-label” mortgages/MBS easily supplanted GSE-related credit creation.

This credit boom – along with the GSE’s (and Fed’s) capacity for intervening to stem market liquidity crises – played a fundamental role as the market’s evolving perception of “moneyness” branched out to Wall Street’s private-label mortgages and ABS more generally. Or, said another way: “No GSEs, then no uninterrupted credit expansion, no rampant housing inflation and current account deficits, no massive global pool of speculative finance, no endless demand for perceived safe and liquidity mortgage securities of all stripes, and no evolving mortgage/housing/ABS/CDS Bubble.” There is plenty of blame to share with New York, London and elsewhere, but a strong case can be made that this was, at its core, a Washington-induced credit bubble.

The securitization and CDS markets are the financial crisis’s current focal point. The markets’ misperception of liquid and continuous markets – that was instrumental in fueling the explosion of debt issuance and credit insurance – has come home to roost in a very bad way. The securitization market’s basic premise was that the creditworthiness of trillions of credit instruments would be supported by the capacity of borrowers to forever refinance and/or increase debt loads (Minskian “Ponzi Finance”). The basic premise of the CDS market was 2-fold: One, that contemporary securitization markets (backstopped by Washington) would provide borrowers endless quantities of inexpensive finance. And, second, that liquid securities markets would provide an effective means of (“dynamically”) hedging credit exposures sold into the (“Wild West”) CDS marketplace.

Today, those on the wrong side of the CDS market (having written credit insurance) are getting killed and this dynamic is seemingly taking the entire system down with it. Corporate bond (bear) market liquidity is scarce, while the viability of scores of participants on all sides of the market is very much up in the air. This means that the hundreds of billions of default protection sold against troubled debt issuers (i.e., GMAC, Ford Motor Credit, GE Capital, AIG, etc.) today confront a serious dilemma when it comes to hedging rapidly escalating losses (and unwieldy “books” of derivatives and counter-party exposures). Originally, the writers of this credit protection would have assumed only a remote possibility that any one of a number of major institutions would default. They also would have expected that, in the event of rising default risk, short positions would be established in the bond market to hedge credit risk. They wrongly assumed benefits from diversifying credit risks, the availability of market liquidity, and various forms of “too big to fail.”

Today, those on the wrong side of these trades and dislocated markets confront an environment that their models would have suggested was impossible: A domino collapse of major debt issuers in the face of near illiquidity throughout the corporate bond marketplace. During the boom, market participants would have assumed the opposite of an impotent Washington rummaging market wreckage for villains.

I will surmise that the CDS market is now in complete dislocation. I will also assume the sellers of CDS (and various Credit insurance) have resorted to shorting equities (individual stocks, ETFs and futures) in a desperate attempt to hedge escalating losses. This has likely placed additional pressure on sickly equities markets – and it goes without saying that it is especially damaging to market confidence when the stocks of our nation’s (and the world’s) major borrowers and financial institutions are all locked together in a death spiral. This dynamic has surely led to another round of forced de-leveraging. And, importantly, this type of market dynamic incites an acute case of “animal spirits.” While perhaps not as gigantic as before, the global pool of speculative finance (that accumulated over the boom) remains a force to be reckoned with. The dynamic of panic liquidations, de-leveraging and market operators seeking to profit from systemic dislocation creates a problematic deluge of selling.


There Is No Value, Only Growth

Ca. 1984 we saw a presentation by a strategist from a mid-level Wall Street house. He presented a table showing that the stocks which had performed the best the previous year were those whose company earnings had increased the most. This was a distinctly odd statistical fact, he pointed out, because so much Wall Street labor was devoted to estimating company earnings. One would have thought that for all that input of analyst hours earnings would be forecast accurately subject to a random error with a mean value of zero. In this case stock prices would discount expected earnings, with each stock fluctuating around its expected return path as actual earnings results or news that would impact earnings were reported.

Perhaps that analysis was too simplistic, and some rocket scientist could come up with a model where that observation was consistent with the random walk theory. Like any human confronted with evidence challenging our value to the world, the thought “Isn’t that interesting?” briefly flickered through our mind and then was dismissed. If we correctly understand Laslo Birinyi’s finding here, he is finding a similar correlation of late.

The classic value strategies – low P/E, low price/book value, high yield – have performed abysmally for the last two years and change. What stock picking strategy has done well? Growth. Is this just rotation into growth stocks after value has outperformed for a period? Perhaps, but is there a reason why now? It looks as simple as the fact that growth stocks have delivered earnings while value stocks, including non-financials, have not.

We are not suggesting that there is no value in stocks, more that there are no “value stocks.” The chart below highlights the performance [since 12/31/2006] of several style indices provided by S&P and Birinyi Associates. The “Birinyi Dividend Index” is constructed of S&P 500 stocks that yielded between 4 and 10% on 12/31/2008 (112 issues and not all financial). As shown, these dividend stocks and the S&P 500 Pure Value index have performed worst of the seven styles shown (-62.7% and -67.5% respectively; the S&P 500 Financial Sector is down 78.4% by comparison).

In short, the values have gotten better, the yields have gotten higher and the market does not care. P/E ratios, price to book, and other valuations do not matter in this market. At the end of the day any valuation based on trailing earnings has no bearing going forward, and estimates for these supposed “value” companies are so uncertain that they have become useless. Google with a P/E of 20 is up 34% on the year, and GE with a P/E of 4.7 is down 44%.

Stock Correlation Remains High

Laslo Birinyi finds that the average correlation of S&P stocks with the index as a whole has gone way up and stayed up since this past September. Bottom line: There is no place to hide. The somewhat encouraging news is that such rises usually happen after a bear market is underway, and then peak after the bear market has ended and the subsequent bull market starts to rev up.

Picking winners is becoming increasingly difficult, and picking sectors is now almost useless. The chart below shows the average correlation of each S&P 500 stock with the S&P 500 index on a rolling 200 day basis. As shown, beginning in the middle of September members became much more correlated with the market and have remained at high levels since then.

Moving up to the sector level there are no areas that stand out. A traditional long/short, market neutral strategy is useless in this kind of environment. Even holding stocks overnight is risky on the long or the short side.

One encouraging note is that this is the first occurrence of such high sector correlation in a bear market. Bear markets are shaded in the chart above, and as shown correlation generally rises during a bear market, and peaks afterwards.