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

W.I.L. Finance Digest :: June 2009, Part 4

This Week’s Entries :


The economy got stimulated. That was Act I. In Act II it is going to be smothered.

When the economic recovery, such as it is, is deemed robust enough to be out of danger expect another round of smothering taxes and costly regulations from Congress.

Tech companies won big when the money was being dished out, with $37 billion of the February stimulus set aside for health information technology, smart electric grid and broadband investments. They will also be a prime beneficiary if Congress adopts President Barack Obama’s bid to make the research and experimentation tax credit permanent at a cost of $74 billion over a decade.

But at the Technology CEO Council, Executive Director Bruce Mehlman says his “number one, two and three” priority these days is to block a Treasury proposal to wring $210 billion more in taxes over the next decade from multinationals’ offshore profits. “We found the Obama Administration a great partner on infrastructure and research and we hope the distraction of populist tax policies can be shelved so we can help enable a long-term recovery,” says Mehlman, whose members include the honchos of IBM, Intel, Dell, HP and Motorola.

When Washington was putting trillions in bailouts and stimulus on Uncle Sam’s credit card, many business leaders applauded (or at least stuck out their hands for the cash). Now, with the economy seemingly back from the brink, the cheering has stopped and the defensive game is on. Someone, after all, must pay for all that emergency deficit spending; for the $46 trillion (net present value) of Medicare and Social Security benefits already promised but not funded under current law; for renewing some of the expiring Bush tax cuts and containing the growth of the dreaded alternative minimum tax. Moreover, someone must pay for the Democrats’ expensive shopping list: covering 46 million Americans without health insurance; mandating paid sick leave; moving to a low-carbon economy; and adopting tougher consumer, worker and investor protections.

The stock market, now trading at 134 times trailing earnings, can be justified only with the presumption that profits will snap back to pre-2008 levels as soon as the recession ends. That may be a naïve presumption. No sooner will there be a recovery in corporate profits than Congress will find ways to snatch them away.

“Once the economy looks a little better, we move on to higher taxes, more regulations – all the punitive things that had to be put on the shelf as we saved the economy,” says longtime Washington analyst Gregory Valliere, now at Soleil Securities. “It is going to be a modest recovery with all sorts of political risk,” he adds.

Candidate Obama promised no tax hikes on families earning less than $250,000, so Democrats are coming after upper-income folks and big business first. Assuming an economic recovery, rates for the better off will rise in 2011 as the Bush tax cuts expire. Clint Stretch, managing principal of tax policy at Deloitte Tax, speculates Congress might consider following the lead of states such as California, New York and Maryland and creating an even higher rate that kicks in at $500,000 or $1 million.

The moral justification for such tax grabs is “pay as you go” budgeting – meaning if Congress wants to give a tax break or a new benefit to one group it must raise taxes or cut benefits for another. The nature of politics is such that over time tax raises are more likely than benefit cuts.

Budget pressures could produce another nasty side effect besides tax hikes: When elected representatives reach the limit on their federal credit card, they will be even more tempted to order up new benefits to put on the private sector’s tab.

Even during the recession Congress has continued to mandate new benefits. Last October, while approving the $700 billion bailout for Wall Street, it tacked on a provision requiring group insurance plans to provide the same level of benefits for mental health and substance abuse treatments as for physical ones, beginning in 2010. In February it set aside $7 billion in stimulus money to prod states to make more workers, including laid-off part-timers and folks who quit jobs for a “compelling family reason,” eligible for unemployment insurance. Employers will eventually pay for that expansion through higher insurance premiums. Still, that is small stuff compared to what could come, as Congress wrestles with how to pay for covering the uninsured.

“It’s going to get ugly,” Stretch says.

Ugly enough that businesses will be attacking one another even as they push back the advance of big government. In June Congress made tobacco subject to Food & Drug Administration regulation. Philip Morris parent Altria Group broke with the industry to support the bill. No coincidence that new restrictions on cigarette advertising should help protect its 50% market share. Then there is the National Retail Federation, which is hoping to capitalize on the banks’ current doghouse status to push through legislation giving merchants leverage to cut the fees they pay Visa and MasterCard.

In the current climate even tax hikes can become a competitive cudgel. A coalition of 14 U.S insurers, including Berkshire Hathaway, Travelers and Chubb, is arguing that Congress could raise billions by levying a tax on the premiums that U.S. insurance subsidiaries send to their parents or affiliates in Bermuda or other tax havens. Existing tax law puts U.S. insurers at a competitive disadvantage. In prosperous times the situation might have called for a tax cut on onshore insurance. Now, with the federal government in deficit, the best the domestic insurers can come up with is a plan to punish the other guys. William R. Berkley, chairman of the domestic-based insurers’ group and the insurance company that bears his name, notes that while the Bush Administration opposed all tax hikes, his group hopes the Obama Treasury will support a tax on offshore insurance operations.

With the Congressional Budget Office estimating that under the Obama budget the federal deficit will hit a stunning 13% of GDP for 2009, taxes and mandates will not cover all the bills. The tempting alternative is for the government to inflate its debt away. U.S. Chamber of Commerce Chief Economist Martin Regalia fears the Obama Administration will try to tax its way out of the deficit and, when that does not work, will let the economy inflate.

Then there is the nagging question of how and when the Administration will extricate itself from the banking, insurance and auto businesses and whether its proposed overhaul of financial regulations can prevent another crisis without discouraging the private lending needed for economic growth.

“Instead of talking about market failures, we are going to be talking about government failures,” warns Mohamed El-Erian, chief executive of Pimco, the world’s largest bond fund manager. That is one of the reasons Pimco is now predicting lower growth, more uncertainty and a risk of stagflation over the next three to five years.

As an Oxford-trained economist and International Monetary Fund veteran who managed Harvard’s endowment for a time, El-Erian is not one to rant about backdoor socialism or big-government Democrats. “The irony is the Bush Administration, a Republican Administration, would be doing 80% to 90% of the same things. In a crisis you tend to shift to a command-and-control mode,"”he observes.

Yet El-Erian does see a significant swing under way – from an era of leverage, self-regulation and growing income inequality to one of deleveraging, more heavy-handed government regulation and policies that tilt toward labor. “When growth slows, there is a tendency to get through regulation a bigger piece of the pie. You already see it in the Chrysler restructuring, which gave a much larger share to labor than would have been the case,” he notes. He adds: “When the pendulum swings, it overshoots in both directions.”


Obama has already proposed hundreds of billions of dollars (over 10 years) in hikes on upper-income individuals and on businesses. Taxes are central to the health insurance debate, too. But if you really want to know how much Congress is meddling in the economy – and on whose behalf – you will need to put down that John Grisham novel and take up the tax code as your bedtime reading.

University of Southern California law professor Edward D. Kleinbard, who recently finished a stint as chief of staff at Congress’s Joint Committee on Taxation, complains that both parties have been using special tax breaks and credits (“tax expenditures,” they are called) to make government look smaller than it really is and to favor one industry over another.

The credit game has got so arcane that Congress has trouble keeping tabs on what it has created. In June the Senate’s top tax writers, Max Baucus (D-Montana) and Charles Grassley (R-Iowa), said they are drafting new legislation to stop the paper industry from making dubious claims for alternative fuels tax credits, using the “black liquor” produced as a by-product in papermaking to qualify.

Obama, for his part, has already mastered this tax illusion game. He has packaged tens of billions in income subsidies for poor and working-class folks as refundable tax credits rather than as welfare grants.

Still, James Poterba, an MIT economics professor who is now president of the National Bureau of Economic Research, points to some hope for reform. Obama recently asked a task force of outside economic advisors, headed by Harvard economist Martin Feldstein (the emeritus nber head), to suggest changes to the code. Maybe. But President George W. Bush appointed a similarly distinguished group (including Poterba himself) and ignored their handiwork.


Here is what you get when Congress tries to micromanage the transition to a lower-carbon economy: Representatives Henry Waxman (D-California) and Edward Markey (D-Massachusetts) have produced a 932-page bill that, among other things, sets up a “cap-and-trade” system designed to reduce greenhouse gas emissions by issuing a fixed number of salable permits to pollute and then initially gives away 85% of those permits to favored industries and interests. Coal, with influential Democratic state supporters, gets off easy; oil refineries do not. Since the idea is to reduce the use of fossil fuel by increasing its price, why not just tax carbon emissions? That would require the politicians to admit they are raising taxes on the middle class (and on all energy consumers, including business) and would not allow them to pick specific winners and losers by handing out permits.

Some other parts of the Waxman-Markey opus might become law on their own. Among them: a national renewable energy standard, requiring utilities to obtain a portion of their power from wind, solar, biomass or other renewable fuels, and a requirement for new residential and commercial buildings to be more energy efficient, forcing a rewrite of local building codes.

Almost all renewable sources of electricity are more expensive than conventional sources today, points out economist Lester Lave, codirector of Carnegie Mellon’s Electricity Industry Center. To some degree, the burden of these higher costs will be borne by residential ratepayers. But inevitably costs will fall as well on businesses that either generate or use electricity. “Anything which increases the price of electricity is likely to be not so good for business,” says Lave.

The Obama Administration has other environmental ambitions. Capitalizing on its dearly bought influence over the auto industry, it has reached a deal with carmakers to impose a strict national standard for tailpipe emissions and to accelerate the current timetable for raising vehicle fuel economy standards. More: In April the Environmental Protection Agency concluded that high concentrations of CO2 and five other greenhouse gases endanger public heath, opening the way for their regulation under the Clean Air Act. (The EPA has not yet decided whether to impose those costly regulations.)

Lawyer Richard M. Gold, head of the public policy and regulatory practice at Holland & Knight, predicts companies may be unhappily surprised by how many existing Bush-era environmental regulations the new Administration rewrites. “It used to be when you put a reg in place, it pretty much stuck. Now we are in this place, and it started with the Bush Administration coming in after Clinton, where regs are things that can be altered, and I think we are going to see that pendulum swing here,” says Gold. He notes that more than a dozen regulations issued by the Bush Administration are still under court challenge by environmentalists, providing a convenient opening for the Obama EPA to reverse course.


Put aside for now worries about the stalled “card-check” bill – a union priority that would make it far easier for workers to organize and ink union contracts. A more immediate concern is what the politicians might do to directly affect terms and conditions of employment.

The very first act Obama signed overturned a Supreme Court decision and gave employees longer to sue for pay discrimination. Recession or not, a previously mandated increase in the federal minimum wage – from $6.55 to $7.25 an hour – kicks in on July 24. And if you are a government contractor (who isn’t these days?), Obama has already issued three executive orders affecting how you treat workers. Paul Galligan, a labor attorney at Seyfarth Shaw in New York, says there is concern that Obama might sign yet another order that would restrict contractors’ ability to classify people as independent contractors (who do not have benefits) instead of regular employees.

The most significant mandate on the horizon is a possible “play-or-pay” health insurance mandate. Another priority for Democrats: ending the U.S.’s status as the only economically developed country without paid sick leave. A bill just reintroduced would require companies with more than 15 workers to pay for up to seven days of sick leave a year. Obama supported this when he was in the Senate. –I don’t think they are that worried about the impact on the economy or business,” says Susan Eckerly, senior vice president for federal public policy at the National Federation of Independent Business, which adamantly opposes the mandate. “Some of these people have an agenda, and they have been out of power for a long time.”


Greenspan is wrong again.

Since the breakdown in confidence in Wall Street finance, notes Doug Noland, it has for all intents and purposes only been federal obligations – Treasuries and obligations with a federal guarantee – that have retained the perception of “moneyness” – that is, something that trades liquidly and at face value – in the marketplace. And, since the onset of the credit crisis, this “money” has been issued in unprecedented quantities. This has stabilized the system temporarily, while setting the stage for a future crisis of confidence in “federal” credit. When the “Government Finance Bubble” pops there can be no more bubble blowing, for confidence in government backing has been the ultimate backstop of every reflationary policy. This confidence is now critically dependent on the willingness of the Bank of China and other foreign central banks to step up and buy.

Oddly – or not – the parallels between this bubble and the recently and tumultuously concluded mortgage/Wall Street finance bubble are seemingly being all but ignored. Perhaps the Washington nabobs feel they have no choice, but recent history shows that the choice being exercised is an illusion.

“The U.S. is faced with the choice of either paring back its budget deficits and monetary base as soon as the current risks of deflation dissipate, or setting the stage for a potential upsurge in inflation. Even absent the inflation threat, there is another potential danger inherent in current U.S. fiscal policy: A major increase in the funding of the U.S. economy through public sector debt. Such a course for fiscal policy is a recipe for the political allocation of capital and an undermining of the process of ‘creative destruction’ – the private sector market competition that is essential to rising standards of living. This paradigm’s reputation has been badly tarnished by recent events. Improvements in financial regulation and supervision, especially in areas of capital adequacy, are necessary. However, for the best chance for worldwide economic growth we must continue to rely on private market forces to allocate capital and other resources. The alternative of political allocation of resources has been tried; and it failed.” Alan Greenspan, writing in the Financial Times, June 26, 2009

June 3 – Dow Jones (Judith Burns): “U.S. Federal Reserve officials are well aware of the danger of an inflationary flare-up ahead, but don’t need to take action on that for now, former Federal Reserve Board Chairman Alan Greenspan said. ... Greenspan defended the flood of spending by the U.S. and other nations, saying it is needed to combat a dramatic contraction in the global economy. ... Greenspan acknowledged that reversing course will put the brakes on the economy, and he questioned whether political leaders have the stomach for such efforts. ‘I don’t think it’s an economic problem; I think it’s a political problem,’ said Greenspan.”

Mr. Greenspan is, again, wrong. It is very much an “economic problem.” It is the nature of protracted credit bubbles to impart deleterious effects upon the underlying economic structure. As the master of “activist” monetary management, Mr. Greenspan’s reign at the helm of Fed saw a move into uncharted territory with respect to marketplace interventions and manipulations. Over this period, confidence flourished – in the markets as well as throughout the real economy – that astute monetary management coupled with Washington stimulus assured a steady economic course with robust growth, interrupted only occasionally by shallow recessions and little cub bear markets.

The Greenspan/Bernanke Fed championed the disastrous doctrine that our central bank should ignore expanding bubbles, choosing instead a course of aggressive intervention (“mopping up”) once they had burst. This analysis failed to consider myriad financial, economic and political realities, including that massive fiscal stimulus would be required – and generally welcomed – in the post-bubble crisis environment. Today’s political and inflationary landscapes are very much an outgrowth of Greenspan’s terribly flawed monetary management.

Credit explosion was at the heart of economy-wide structural transformation to consumption, services, de-industrialization and massive imports.

It is difficult for me to get the Q1 2009 “flow of funds” out of my mind. And the Fed’s own credit data refutes Greenspan. During the first half of the ‘90s, Non-financial credit growth averaged $565 billion annually. Over that period, Financial Sector borrowings averaged $285 billion a year. By year 2000, Non-financial credit growth for the year surpassed $2.0 trillion, before peaking in 2007 at $2.545 trillion. Annual growth in Financial Sector borrowings surpassed $1.0 trillion in 2004, before almost reaching $2.0 trillion in 2007. This was the massive expansion of system credit that inflated asset prices, incomes, corporate profits, and government receipts. This credit explosion was at the heart of economy-wide structural transformation to consumption, services, de-industrialization and massive imports – not to mention incredible financial leveraging and speculation. And once grossly inflated, it is a very difficult and painful process to return a system to a more even keel.

Greenspan can claim it is a political problem and warn against increased statism. Yet the real dilemma today and going forward is the maladjusted “bubble economy” structure that fends off systemic breakdown only through $2.0 trillion-plus annual credit growth. Of course, our politicians have not sat idly as the credit system buckled and the economy lurched downward. And, indeed, it was Greenspan more than any other individual that was responsible for the public’s blind faith in Washington policymakers’ capacity to resolve any and all financial and economic problems. As always, politicians have a propensity to try to inflate their way out of jams. And that is why it is critical to maintain a disciplined financial system, a stable and balance economy, and a tough and independent central bank.

But let us get back to the “flow of funds.” Federal government borrowings surged from 2007’s $237 billion to 2008’s record $1.239 trillion. Federal borrowings expanded at a $1.440 trillion annualized rate during the first quarter. As I did with last week’s analysis of the “flow of funds,” I believe grouping Treasuries with GSE debt and agency MBS issuance today provides a better gauge of the growth in marketable federal debt obligations. This is the current focal point for bubble analysis.

Combined outstanding Treasury, GSE and MBS obligations surged $1.949 trillion, or 15.3%, in 2008 to $14.709 trillion. This was a sharp increase from 2007’s $1.165 trillion, 2006’s $532 billion, and 2005’s $411 billion increase. The almost $2.0 trillion expansion of “federal” marketable debt compares to 2008’s increase of Total Non-Financial credit of $1.873 trillion. After the breakdown in Wall Street finance (i.e., “private-label” MBS, ABS, CDOs, etc.), it was virtually only “federal” obligations that retained the perception of “moneyness” in the marketplace. And, since the onset of the credit crisis, this “money” has been issued in unprecedented quantities, in the process stabilizing the system yet setting the stage for a future crisis of confidence in “federal” credit.

Ominous parallels between “federal” credit and the previous bubble in mortgage/Wall Street finance.

I found the most recent Z.1 report so disconcerting because of the parallels now apparent between “federal” credit and the previous bubble in mortgage/Wall Street finance. Recall that Total Mortgage Debt growth accelerated from the 1990s annual average of $269 billion to $1.00 trillion by 2003, $1.268 in 2004, $1.438 trillion in 2005, and $1.390 trillion in 2006. As more mortgage-related securities were issued in the marketplace, the annual growth in ABS surged from about $200 billion in 2003 to surpass $800 billion in 2006. With the explosion in “private-label” MBS issuance, the asset-backed securities (ABS) market actually doubled in size in just four years to surpass $4.5 trillion by the end of 2007.

Back in 2006, acute systemic fragility was being masked by the massive mortgage credit expansion intermediated through various sophisticated Wall Street structures. The crucial facet of the analysis was that this bubble was increasingly vulnerable to a crisis of confidence. [Emphasis added.] Not only was there massive issuance, but this boom was being sustained by rapid expansion of credit of increasingly poor quality. In true Ponzi Finance dynamics, this bubble was attracting enormous financial flows while having become susceptible to any reversal of speculator sentiments.

There was a confluence of critical dynamics that fostered acute fragility. The scope of annual mortgage credit expansion necessary to sustain the bubble (approx. $1.4 trillion); the increasingly suspect quality of the underlying mortgages prolonging the boom; the vulnerability associated with inflated home prices; and that much of the mortgage-credit was being intermediated through “AAA” marketable securities altogether created a quite tenuous situation. The stage had been set for a momentous change in market perceptions.

A major systemic crisis became unavoidable after the revelation of GSE accounting irregularities ensured that Fannie and Freddie would no longer provide the mortgage/MBS marketplace a “backstop bid.” Going back to 1994, the GSEs had repeatedly nurtured concurrent booms in mortgage lending and MBS speculation through their aggressive market turmoil-periods of MBS purchases and liquidity creation. Speculators had over the years become quite emboldened, but their source of liquidity in the event of trouble would be nowhere to be found in 2007.

Acute underlying systemic fragility is masked only by the massive issuance of government “money-like” credit.

I see ominous parallels to the mortgage/Wall Street finance bubbles with today’s Government Finance Bubble. First, the scope of “federal” government marketable debt issuance – approximately $2.0 trillion annually – has quickly reached massive proportions. Especially since little of this (“non-productive”) debt is financing real economic wealth creation, there is a rapid deterioration in the quality of debt being sold. There are clear Ponzi Finance dynamics in play. I would argue that the massive deficit spending has sustained incomes (May Personal Incomes up 1.3% y-o-y), purchasing power and general confidence in our system. But only ongoing massive fiscal stimulus will sustain the current maladjusted economic structure, while this massive inflation of government credit will over time have problematic inflationary consequences. Acute underlying systemic fragility is masked only by the massive issuance of government “money-like” credit. The issue is, at its core, more financial and economic than political.

One of the challenges of analyzing bubbles is appreciating that powerful forces inherently arise to perpetuate them longer than one would have initially believed analytically probable. The tech [dot-com] bubble went to incredible extremes – and then “doubled.” Ditto for the mortgage/Wall Street finance bubble. As an analyst, however, I have got to assume that the marketplace is today much keener to the problematic nature of Ponzi Finance Dynamics.

The foreign central banks’ “backstop bid” on U.S. federal obligations is in question.

The key to the rapid implosion of the mortgage/Wall Street bubble was the combination of its unwieldy scope and the disappearance of the GSE “backstop bid.” At $2.0 trillion, arguably we have quickly reached ample “scope” in the market for “federal” obligations. As for the “backstop bid,” foreign central banks have for some years now been massive buyers of Treasuries and agencies during periods of unwieldy global dollar flows. And with more comments out of China today, there is even greater support for the view that foreign appetite for our debt instruments is waning in the face of the unprecedented inflation in their quantity. Moreover, market perceptions have Treasuries as bulletproof.

I know better than to try to predict the timing of problems developing in the Treasury and currency markets. But I do see all the makings for the next problematic leg of this financial crisis. As I have written before, our nation’s predicament becomes much more problematic when perceptions turn against the Treasury/agency marketplace.


Nelson Peltz and Peter May have not hestitated to use leverage to acquire companies, and are decent enough operators to have lived to tell the tale. Recently they have acquired 22% of the now combined Wendy’s/Arby’s restaurant chain. A reasonable case can be made that the shares are substantially undervalued – although the case is not airtight, nor is it without some risk.

Peltz/May have hired a new president for the chain. Pamela Thomas Farber – daughter of legendary Wendy’s founder Dave Thomas and still the owner of 33 Wendy’s stores – says that for the first time since her father died she has had confidence in corporate management.

Confidence in the Wendy’s/Arby’s group has been shrinking like an overcooked hamburger on a sizzling grill. Declining sales at Arby’s, plus the company’s reluctance to specify how it will use most of the proceeds from a recent $565 million bond offering, worry investors. Since late April, Wendy’s/Arby’s stock (ticker: WEN) has slid more than 30%, to around $3.70.

But investor Nelson Peltz, who with his partner Peter May owns 22% of the shares, argues that “this is a phenomenal company that is truly misunderstood and was mismanaged for years. ... We think the company is significantly undervalued.” His assessment is not based on earnings – operating net is likely to be just 19 cents a share this year and 28 cents in 2010.

Instead, Peltz’s view reflects expected cash flow, measured by earnings before interest, taxes, depreciation and amortization (EBITDA). Based on analysts’ forecasts of annual growth, Wendy’s/Arby’s EBITDA should hit $420 million this year. And, if the company hits its mid-teens growth target, it should generate roughly $555 million in 2011. Historically, the fast-food group’s EBITDA multiple is 9 to 10 times – though today, only McDonald’s, which has far outpaced its rivals, rates close to a 9. Wendy’s/Arby’s fetches almost 6.

If investors put a multiple of nine on 2011 EBITDA, as Peltz suggests is reasonable, the company would be valued at $5 billion. After subtracting $1 billion of net debt and dividing by 470 million shares outstanding, the stock theoretically would be worth $8.50. That is a big if. But even a multiple of 7 would translate into a $6 stock.

While Peltz’s multiple assumption might be aggressive, his operational expectations are not. They do not include any benefit from putting the company’s substantial cash to work or from new products, better marketing or the reintroduction of breakfast slated for late next year.

Peltz and May, both Wendy’s/Arby’s directors, doubled down on their bet late last year, spending $205 million for 49.4 million shares at $4.15.

This did not escape the attention of some value investors, including Robert Gebhart, a partner at New York City-based money manager Grisanti Brown & Partners, which owns shares. He contends that, if the stars align, shares could reach $9 in three years.

Wendy’s/Arby’s was formed last September, when Arby’s, then owned by Triarc, an investment company controlled by Peltz and May, merged with Wendy’s. When announced, the all-stock deal was valued at $2.86 billion. Wendy’s shareholders received 4.25 Triarc shares.

Wendy’s was founded 40 years ago in Columbus, Ohio, by Dave Thomas, a food-industry veteran who tried to separate it from the pack by offering better food. Its hamburger patties are not frozen, and it offered salads before they became a staple at rivals. Wendy’s has floundered since Thomas, who had become its public face, died in 2002. Trian, an investment firm run by Peltz and May, bought a 5.5% stake in Wendy’s in 2005, when the shares traded mostly in the mid-teens.

Arby’s is smaller than Wendy’s – kicking in only about 1/3 of Wendy’s/Arby’s $3.7 billion of 2008 sales and about 35% of its operating income. Its specialty: roast-beef sandwiches. Last year, Wendy’s/Arby’s posted a loss of $3.05 a share, in large part on costs related to the merger.

Wendy’s/Arby’s Chief Executive Roland Smith aims to improve results at the company with $60 million in cost efficiencies and $100 million from boosting the 12% operating margins at Wendy’s company-owned stores, which vastly trail franchise stores’ 17%. (About 20% of Wendy’s are company-operated.) For its part, Arby’s should benefit from new products. It’s even considering a catering and delivery service for large orders.

Smith hired David Karam as Wendy’s president last year. Karam also had bid for Wendy’s and was among the larger and more successful franchisees. Pamela Thomas Farber – daughter of Wendy’s founder and the owner of 33 Wendy’s in Ohio – says that she has known Karam all her life, and that now, for the first time since her father died, she has had confidence in corporate management.

The $565 million bond offering, however, is a bone of contention. Out of the proceeds, Wendy’s/Arby’s will use $132.5 million to repay some of its bank debt. As for the remainder, it has said only that the money will be used for general corporate purposes, meaning anything from working capital to acquisitions to dividends and buybacks.

Some investors fret that the new company did not need the money. Wendy’s/Arby’s is expected to generate more than $100 million of free cash flow, and had $137 million of cash and $116 million in investments at the end of the first quarter. Its next payment on notes, $189 million, is not due until 2011; and $250 million of bank loans are not due until 2012. So Howard Penney, an analyst at Research Edge, calls the bond deal a “head-scratcher.”

But Peltz and May stress the importance of financial flexibility in today’s environment. “Our philosophy is that when money is available, you take it, and take the risk out of your balance sheet,” says Peltz. Losing a few cents per share in earnings from interest expense is worthwhile, he adds, because the extra cash will enable Wendy’s/Arby’s to do what it wants when it wants.

Smith seems to be focusing on growth. Arby’s, he says, could go from 3,500 stores to 5,000, and even Wendy’s, with 6,000 stores in the U.S., could add 1,000 without seeing sales cannibalized. The bond deal could help build new stores and refurbish old ones.

Some of the new stores will carry both Arby’s and Wendy’s under one roof. Several will be open by year end. The company just struck an agreement with a franchisee to build 135 dual-branded stores in nine countries in the Middle East and North Africa during the next 10 years.

The joint stores let the chains leverage their real estate by sharing a parking lot and seating area. In Ohio, one outlet that housed both Wendy’s and a Tim Hortons doughnut shop saw sales volume of more than $3 million annually, compared with the $1.4 million at a typical Wendy’s or about $1 million at a Hortons. And average margins were three percentage points higher than the average individual operation’s, says May.

A new store can provide a 20% return on invested capital, which would justify the recent bond’s hefty yield of 10.5%.

Breakfast offers another growth opportunity. About two years ago, the company began its latest attempt at serving breakfast – but not to raves. (It had unsuccessfully tried it before.) Last year, new managers under Smith pulled breakfast from most Wendy’s, depressing same-store sales comparisons. Now, they are developing a new breakfast menu that will appear in some markets in late 2010 and roll out across the country in 2011.

Smith notes that breakfast accounts for about 20% of store revenue at Burger King and 25% at McDonald’s.

Some investors suspect Trian will direct the company to use some bond proceeds to pay a special dividend or buy back stock. The rumors were inflamed by a recent agreement under which Wendy’s/Arby’s will pay Trian a quarterly $250,000 fee for Trian’s advice on acquisitions, financing, investment banking and initiatives to increase shareholder value. Wendy’s/Arby’s also will pay Trian a $900,000 fee to assist in selling noncore assets, with a bonus if proceeds exceed expectations. In addition, Wendy’s/Arby’s invested $75 million with Trian. It plans to take out its money before 2010 and will pay Trian a $5.5 million withdrawal fee. These arrangements make some analysts – Penney among them – fear Peltz and May are using Wendy’s/Arby’s as a cash cow.

But early withdrawal fees are standard in the fund industry, and the advisory fees Wendy’s/Arby’s pays to Trian will replace fees that the company otherwise would have paid to investment bankers. Trian employs four people in addition to Peltz and May that provide financial services to Wendy’s/Arby’s. “They are getting their money’s worth,” says Peltz.

As for a dividend, Peltz says paying a special one would be foolish, but he does not rule out a buyback, given his view that the shares are cheap. Some analysts worry the company could become overleveraged, particularly if it does a buyback. After the new bond deal was announced, Standard & Poor’s revised the outlook on Wendy’s/Arby’s single-B-plus-rated debt to negative, while Moody’s cut the rating on the Wendy’s International unit to single-B2.

The company does have an often-overlooked asset: It owns 700 stores without encumbrances, says May. Since land for new stores costs $750,000 to $1 million, the property might be worth more than $1 a share. Back that out, and Wendy’s stock is valued around $2.70 – less than a quarter-pound burger at one of its New York restaurants.

That makes them look appetizing, regardless of what intentions investors ascribe to May and Peltz.


Chemed is an old combination of hospice care and plumbing – but not forever, and maybe not for long. A breakup could benefit shareholders.

Chemed has two distinct principal businesses: The Roto-Rooter national plumbing services company, and hospice unit Vitas. Both are decent cash-generating businesses. In the high 30s Chemed’s stock is trading at between 11 and 12 times 2009 earnings estimates – pretty reasonable. The stock traded at close to 65 in late 2007.

Vitas benefits from the crop of aging baby boomers, claims Barron’s, “and increased acceptance of hospice care, and is a safer bet if the economy struggles.” The U.S. Department of Just-us has subpoenaed Vitas’s patient records and procedure manuals going back to 2003. Such investigations can drag on, creating uncertainty for shareholders no matter how routine such investigations may be. Roto-Rooter’s business has also fallen with the recession. [Before calling them to clear a clogged drain we suggest first trying a bottle of Draino or the like, followed by using a toilet plunger.]

Is there any synergy between the two businesses? Ah, no. Management claims to be looking to optimally time a spinoff. Hedge fund MMI Investment has acquired 3.5% of Chemed as is agitating for the spinoff to happen sooner rather than later. Chemed is not new to the spinoff idea, having divested business units in 2002 and 2005.

MMI and others would also like to persuade management to rein in spending on things such as a private jet, purchased last November for $8.6 million, equal to 36% of Chemed’s 2008 capital expenditures. MMI also claims, as part of the “insular management” picture it is attempting to paint, that the average tenure of Chemed’s directors is 16.7 years. Chemed has recently added two independent nominees to its slate.

So not a story without warts, but the stock is cheap, the underlying businesses are above average in quality, and outside pressure for value realization is mounting.

Chemed has an identity crisis. It is A diversified conglomerate with an un-conglomerate-like market cap of just $863 million. It runs North America’s largest and best-known plumbing service – Roto-Rooter – but earns 70% of its revenue from hospice care.

The split personality has not won over the perplexed public. Shares (ticker: CHE) trade at a 23% discount to the health-care services sector because investors worry about a plumbing unit hitched to the housing market. Yet when they recently bid up housing-related stocks in hopes of an economic rebound, investors seemed to view Chemed as a health-care play. Its shares are up 12%, to about 38, since March 9, versus 46% for home builders.

Investors’ conception of Chemed should come into sharper focus shortly, even if its clunky structure remains for a while. Chemed acquired its Vitas hospice unit five years ago and this February became eligible to spin off tax-free either it or the plumbing operation – the two remaining units from what was a broader set of businesses. An opportunistic hedge fund, MMI Investments, recently amassed a 3.5% stake and is pushing to break up the company. It went so far as to field five board nominees but withdrew those candidates late last week – after several proxy firms recommended investors vote for Chemed’s directors.

The problem? Even critics of the board – which one institutional shareholder describes as “very entrenched” – think MMI was overeager, and most are not convinced that a spinoff is the right move in this still-fragile market.

So why consider Chemed shares today? Both Vitas and Roto-Rooter are solid businesses that are undervalued. Chemed shares trade at just 11.3 times 2009 earnings estimates, well below 14.7 times for health-care services. The bigger Vitas unit benefits from the crop of aging baby boomers and increased acceptance of hospice care, and is a safer bet if the economy struggles. And should the economy rebound swiftly, the case builds for spinning off a unit into a more welcoming market.

Another worry: the Justice Department has subpoenaed Vitas’s patient records and procedure manuals going back to 2003. Analysts say such investigations are not uncommon, though they can drag on for a long time. (A 2005 probe was inconclusive.) Still, the inquiry has caused uncertainty for shareholders.

Roto-Rooter has suffered recently as Americans put off drain cleaning and other discretionary spending. Its plumbing jobs fell 6.9% last quarter, but Chemed raised prices to limit the revenue decline to just 0.2%. This cyclical business should rebound with the economy, and until then, steady cash flow and market dominance make it an acquirer in a landscape dotted with Mom-and-Pop shops.

The same could be said of Vitas. Admissions fell 6.9% in the latest quarter, but longer patient stays helped nudge revenue up 5%. “For the most part, Chemed has stockpiled cash but has not done any significant deal on the hospice side lately,” says RBC analyst Frank Morgan, who sees potential acquisitions in this weak economy.

The threat of health-care reform weighs on Vitas, and the government has proposed cutting Medicare reimbursement to hospices by 1.1% this year and 2.1% in 2010. Analysts question if such cuts will be implemented, given their drastic impact on smaller, nonprofit hospices, but Chemed can withstand them by tightening wages. “Eventually, we could see a change in reimbursement that can cause consolidation in this very fragmented industry, but that will be a positive for Chemed and could provide another growth leg,” says Oppenheimer analyst Michael Wiederhorn. He thinks the shares could be worth 52 in 12 to 18 months.

Until then, investor scrutiny might persuade management to rein in spending, especially on things like a private jet, purchased last November for $8.6 million, equal to 36% of Chemed’s 2008 capital expenditures. The 2001 Hawker 800XP replaces a 30-year-old plane and is leased out when it is not used, a Chemed spokesman points out. Still, the line between a justifiable perk and indulgence can blur in a recession.

So what do hospices and plumbing have in common? The question sounds like a set-up for a punch line, and management has shrewdly shifted discussion from “whether” a spinoff will occur to “when” it might. Even Chemed’s bankers at JPMorgan and Lazard Freres admit the two are “inherently different and do not yield traditional synergies” beyond some financial flexibility. “An ill-timed separation,” cautioned CEO Kevin McNamara in a recent letter to investors, “could destroy stockholder value in the current economic environment.”

Agitating for a spinoff is a much-used tactic in MMI’s repertoire. It has pushed for split-ups at companies from Brinks’s (BCO) to Unisys (UIS) – and the multiples it relies on to argue that the sum of Chemed’s parts is worth 55 to 62 are conveniently generous. But Chemed management’s boast that it delivers strong returns is just as lofty: Shares have risen 62% in the past five years. Still, that is well behind health-care services’ 106% gain.

Shrill claims and mud-flinging are common when activist shareholders rattle cages, but Chemed is not as possessive as MMI paints it to be; it has divested businesses including Patient Care in 2002 and Service America in 2005. Still, according to MMI, existing directors have squatted on this board for an average 16.7 years. With investors watching closely, Chemed has recently added two independent nominees to its slate. Slowly but surely, change is coming to Chemed.


Not just the ratio of price-to-earnings but the ratios of price-to-sales and price-to-book.

Ken Fisher has been writing his Forbes column for 25 years now. Not a bad run. This is stretching the old memory, but we recall that his initial emphasis on using a stock’s price/sales ratio (PSR) as a valuation tool was a bit of an innovation back then. Fisher’s reasoning for using the PSR included that it was harder to manipulate sales than earnings. When looking abroad, which is far more important now than it was in 1984, the PSR was also a useful device for cutting through cross-national accounting differences. To use the tool effectively one needs incorporate profit margin analysis, at which point PSRs become especially useful when comparing stocks within an industry group.

Today Fisher recommends incorporating a mixture of analytic tools, including PSR, the tried and true P/Earnings and P/Book ratios, as well as P/Cash Flow. You will not find us arguing with the basic idea. We would recommend adjusting certain ratios, including the PSR, for a company’s capital structure. High debt loads distort PSR calculations.

This issue marks the 25th anniversary of my column in Forbes. That is a long run in columnland. It has been a blast. Thanks for your attention. Reviewing my first year’s columns, I pondered: What would I still say? What would I say now that I did not then?

In the still-say mode: Avoid overpaying. Use multiple valuation metrics – not just the ratio of price-to-earnings but the ratios of price-to-sales and price-to-book. Compare a company with both the whole market and peers. Buy quality cheaply. The title of my second column was “Glamour Doesn’t Pay,” meaning that the higher growth rates of the most obviously desirable companies did not justify their premium prices. Still true.

I have done well over time but made lots of mistakes, too. Learn from your mistakes. My December 31, 1984 column, “Big Bloopers of 1984,” was a sort of mea culpa, along with lessons learned. The editor liked the notion well enough that a few years later he began requiring all columnists to issue annual retrospectives.

A constant in my approach to investing: You should think politically but unconventionally. Last month I was arguing why Obama will be good for stocks.

Think about size. There are times for big stocks, others when small ones are better buys, and times, like now, when size does not much matter.

In the did-not-say-then category: Invest globally. The column started out with a domestic focus. That does not work in a more globalized economy. Including foreign holdings gives you more opportunities and better diversification.

Originally I thought Republican. Now I am an equal opportunity politician-hater.

There are times to go to cash, but they are rare. This column has recommended pulling back in three bear markets, beginning first in June 1987, then beginning in September 1989 and then in February 2001. Good calls, but then I was dead wrong with a bullish stance in 2008. Usually getting out is the bigger risk.

In the early days I promoted the idea of spending time in libraries to gain facts that other investors did not have. Not many people did that kind of research, so it worked. We have a reverse problem now: too much information that is too accessible and not too reliable. There is a lot of mischief and manipulation on the Internet, masquerading as fact or as casual commentary. Beware.

Every month for 25 years (except when I was bearish) I have brought you fresh stocks. Here is another batch.

Yanzhou Coal Mining (12, YZC) is the only Chinese coal stock you can buy. The company extracts 35 million tons annually. Coal is to China as oil is to America, the motivating force of the economy. Superbly managed and rapidly growing, Yanzhou will benefit from rising prices as the global economy recovers. It sells at 8 times my estimate of 2009 earnings, 5 times cash flow (in the sense of net income plus depreciation) and 1.8 times annual sales.

Suntech Power Holdings (17, STP), also Chinese, is the largest maker of solar cells using silicon wafers. Its products are 10% more efficient than those of competitors. It sells at 14 times my estimate of 2009 earnings and 2.5 times book value.

Brazil’s Votorantim Pulp & Paper (11, VCP) is down 63% from its 2008 peak. It is the leader in paper made from eucalyptus pulp, with big exports to emerging markets. It sells at 8 times my estimate of 2009 earnings, less than 5 times cash flow, one times book value and 1.6 times sales.

India’s Infosys Technologies (35, INFY) delivers data processing services like software development, systems integration, product engineering and testing. Even in this weak economy it is growing, increasing both the number of customers and revenue per customer. It costs 16 times a reasonable forecast of 2009 earnings and yields 1.2%.

Cruise lines suffer mightily in a recession, since vacations are a deferrable purchase, but come out of it roaring. One I like is the Miami, Florida firm Royal Caribbean Cruises (13, RCL). It sells at 10 times depressed 2009 earnings, 40% of book value, 40% of annual revenue and three times likely cash flow for this year.

Precision Cast Parts (81, PCP) in Portland, Oregon makes tricky metal castings for aerospace, automotive and power generation markets. I told you to buy quality cheaply; this firm fits the bill. Over the past 10 years it has been expanding revenues at a 12.3% annual pace. It sells at 11 times 2009 earnings but in a few years will see a somewhat higher multiple and much higher earnings.


Want to avoid getting burned buying into the latest asset bubble? History suggests shunning stocks and buying corporate bonds.

As Forbes columnist Bernard Condon puts it: “Generations of financial advisors have pounded into investors the notion that stocks are the asset class to own for the long run, that bonds are the dowdy preserve of widows and orphans.” But findings are starting to emerge which challenge the old idea that stocks outperform bonds by an appreciable margin “over the long run.”

Moreover, we recall seeing another piece which pointed to the conclusion that stocks did do quite well if you bought them cheaply, but otherwise do not expect much. The “long run” will not bail you out of buying expensive stocks. And Condon claims that while stocks may not be expensive now, neither are they great values – selling at about their long-term average P/E ratio based on smoothed earnings.

Instead, Condon recommends corporate bonds – a recommendation which has been seen in these pages often (e.g., here) of late. The spread on investment-grade corporates over comparable Treasurys peaked at 6.1 percentage points during the height of the credit scare. Now the yield spread has narrowed to 3.1 percentage points, which is still wider than the 2.5-percentage-point peak in 2002 during that year’s kind-of recession.

Morningstar calculated that the total return on the S&P 500 was 7.7% annually over the 20 years ending mid-June, versus 8.7% for 10+ year Treasuries, 7.5% for junk bonds and 7.2% for investment-grade bonds. So stocks generated a very small return premium over investment-grade bonds – not a very good deal for far higher volatility.

Junk bonds look cheap as well. Their 9.5% yield premium over Treasurys is twice their 15-year average and wider even than it was during the depths of the Great Depression.

If you got out of stocks earlier this year, you are probably kicking yourself right now. The market is up by a third from its low, and investors are clearly betting that a semblance of normalcy has returned and an economic recovery is nigh. But before jumping back in, you should consider one of the big questions hanging over the securities market. If a recovery is indeed coming, just what kind is it likely to be? And are equities the best way to enjoy it?

Equities are no longer cheap.

The economic rebound will be feeble at first. That is the considered opinion of many market watchers, including Jeremy Grantham, chairman of the Boston money management firm GMO. He thinks we are in for “seven lean years” of anemic growth as debt-strapped Americans rediscover the virtue of thrift. He is buying stocks, but cautiously. The U.S. market as a whole faces a future of skimpy profits and lackluster returns, he figures. And even if you do not buy his grim forecast, there is another reason the winnings will not come easy for investors now: Equities are no longer cheap.

If you want to hold on to that money stashed away for retirement or for the kids’ college, do not try to ride the market momentum up. Let fundamentals drive your investment decisions instead. On that score, bonds are looking better than stocks these days.

Generations of financial advisors have pounded into investors the notion that stocks are the asset class to own for the long run, that bonds are the dowdy preserve of widows and orphans. Stocks are even harder to resist at a time when they are on a tear. But even the most valuable assets are only a bargain if you buy them cheap.

With equities, the most venerable measure of value is the price/earnings ratio. Based on prewriteoff earnings over the past 12 months the S&P 500 is trading at a P/E of 18.5. That is not too far above the 34-year average of 16.8. Measure on the basis of net, or reported, earnings, which include one-time charges, and it is trading at a stratospheric trailing multiple of 134. ...

Of course, earnings are so erratic these days that looking back or ahead one year probably does not give much sense of value. Smooth out earnings by looking at the long-term P/E, which captures a decade’s worth of inflation-adjusted data, and the market is trading at a multiple of 16. That is right around its average over the past 130 years and suggests stocks are reasonable but hardly cheap. Reasonable, that is, as long as you have faith that corporate America will soon resume the earnings power it had over the past decade.

To do so, stocks would have to defy a prolonged hangover from “leveraged prosperity of Gatsby-like proportions.” That is according to economist David Rosenberg of Gluskin Sheff & Associates. During the recent cycle corporations derived 40% of profits from financial activities, and household debt relative to income and to assets hit record levels, he noted earlier this year. Like Grantham, Rosenberg predicts three to seven years of low economic growth amid elimination of $6 trillion in private sector debt, asset liquidations and a rise in savings rates to levels of 10% to 12%. Bonds, not stocks, are the place to be, he says.

Now consider corporate bonds. One key measure of their value relative to other asset classes’ is the so-called equity risk premium. It gauges how much of an incremental return investors have demanded in the past to stick with highly volatile stocks, rather than shifting to relatively stable bonds.

Since 1926 the equity premium has averaged 6.5 percentage points above the rate on long-term U.S. Treasurys, according to Ibbotson Associates. The 3.8% yield currently on 10-year Treasurys implies that stocks will have to deliver total returns in the double digits to prevent investors from fleeing to other asset classes. That would require the S&P 500 to outdo its own performance over the past half-century of 9% average annual gains.

Corporate bonds look like better values than either Treasurys or equities. In November the spread on investment-grade corporates peaked at 6.1 percentage points over comparable Treasurys. The implication was that the world was coming to an end. The world is still here, and the yield spread has narrowed to 3.1 percentage points, according to Barclays Capital. Even so, it is still wider than the 2.5-percentage-point peak in 2002 amid the previous recession. To justify today’s level, this recession would have to get far worse (and presumably take down stock prices with it).

“The market is expecting an 8% default rate [on investment-grade corporate bonds], but I don’t think we will get there,” says Simon Ballard, an analyst at CreditSights. His worst-case scenario: 5% annual defaults on BBB and better bonds, versus a Great Depression peak of 1.6%.

With the recent collapse in stock prices still searing, and the S&P 500 at the same level it was a dozen years ago, the debate is raging anew over whether stocks are worth owning at all. In the 40 years through February investors would have earned more sticking their money in 20-year Treasurys than in stocks, Robert Arnott of Research Affiliates argued recently in the Journal of Indexes. His report on the topic, under the tongue-in-cheek title “Bonds: Why Bother?,” [also see this Finance Digest posting, which uses Arnott’s findings] has garnered 10,000 hits.

True, Arnott picked an especially unfavorable end point for stocks to conclude his study. But he may be on to something in suggesting that bonds are unfairly maligned as equities’ “dull cousin, hidden in the attic.”

The S&P 500 returned only 7.7% annually over the 20 years through June 17. That was a full percentage point behind the 8.7% for Treasurys with maturities of 10 years or more, only slightly ahead of junk bonds’ 7.5% returns and investment-grade bonds’ 7.2%, according to Morningstar.

To earn their returns, bondholders have had to put up with far less volatility than stockholders. In the three years following the 1929 crash, stocks rallied 110% before hitting a Depression-era low in 1932, notes Steven Romick of mutual fund FPA Crescent. Japan’s Nikkei index pushed into bull market territory (with gains of 20% or more) eight times in the 13 years following its 1989 peak, he notes. It recently closed at 9840, 75% below its high and arguably still in bear market mode 20 years later. The recent U.S. stock rally will likewise prove “ephemeral,” suspects Romick.

Instead of stocks, he favors bonds, mostly junk. He admits that defaults, already running at an annual 9.2% rate, could hit new highs but figures that by selectively buying he will be more than compensated for that risk. The 9.5-percentage-point yield premium above comparable Treasurys is twice the junk bond market’s 15-year average and wider even than it was during the depths of the Great Depression.

“I will get double-digit returns a year over the next five years,” he says. “Stocks will return only in the single digits.”

What is not to like? The risk that inflation will spread from stocks to other areas of the economy, for one. As inflation raged, investment-grade corporate bonds posted real returns of -4% annually in the seven years through 1979. As elsewhere in investing, it pays to hedge.


Stephen Peak is a Graham & Dodd type value investor who looks for low PE’s plus some prospective growth to give him a decent return whether or not there is multiple expansion. His universe of European stocks provides no shortage of candidates these days.

London money manager Stephen Peak considers fear his best friend. At age 52, and with only a high school education, Peak has spent three decades using his wits and contrarian instincts to ferret out bargains in places where many investors are rushing for the exits.

Even so, Peak eschews branding his $427 million (assets) Henderson European Focus Fund a value play. Nor does he think there is much inspiring about Europe these days. Nothing, that is, but the attractive, unloved stocks. By Peak’s definition, attractive means companies that have low price/earnings ratios and enough earnings growth to make you rich even if the P/E never budges. Peak is equally keen on firms with new managers, acquisitions and strategy shifts that offer promise but that most other investors are not intrepid enough to bet on. “When humans are fearful, they make mistakes,” he says. “I want to get on the other side of the fear.”

Such thinking has proved a winner for Henderson European Focus, which Peak has run since its 2001 creation. The fund has returned 7.8% a year over the past half-decade, beating its index and category averages by about two percentage points each. Big bets on commodity producers caused Peak to lag far behind in 2008, when the fund lost 56%. It rebounded 51% through June 18 and has again outpaced its benchmark and most rivals. With a front-end 5.75% load and 1.46% expense ratio, Henderson European is not cheap. But Peak’s record suggests he is worth a listen.

In March, as markets were hitting multiyear lows, Peak began buying Italian automaker Fiat (FIATY.PK) at $7.07 a share. With global auto sales collapsing, he saw earnings multiples as meaningless. Peak liked Fiat’s focus on making fuel-efficient vehicles. Further down the road, Peak expects Fiat’s Chrysler buyout to bring its cars back to North America. “U.S. consumers want a one-liter [engine displacement] car rather than a Hummer,” he says.

The self-educated Peak became a stock picker in 1975, as the U.K. was emerging from its worst economic crisis in decades – a time not unlike the present. He saw stocks quickly double, which he claims gives him an edge over young peers who fail to see adversity as a buying opportunity.

Of course markets can move just as quickly in the opposite direction. Peak, who has been with Henderson Global Investors for 25 years, is quick to admit he loitered too long in commodity stocks last year.

Last year he took a close look at Carlsberg. The Danish brewer had fallen out of favor after loading up on debt to buy control of BBH, a Russian brewer. Peak became convinced BBH was a quality operation that would benefit from Russians’ migration from cheap vodka to beer. He began buying shares in January at $30.55. He has since sold shares for between $45 and $51. Recent price: $65.25.

French supermarket chain Carrefour is another big holding. Peak began buying it in February at $35.44, and shares have risen 16% since then.

Another intrepid buy is Switzerland’s Temenos. When it went public in 2001, Peak shunned the banking software developer because its shares were trading at an earnings multiple of over 100. Peak began buying at far lower multiples in 2007 and held on, even as the stock tumbled. The shares have nearly doubled since March to a recent $15.42.

Peak has not given up on commodity producers, which account for half his top 10 holdings. His biggest commodity holding is Centamin Egypt, a gold miner yet to produce an ounce of gold. The company was initially a loser for Peak shortly after he began buying in 2003. Although he has lightened up, he still has $32 million in the company.


To hedge against U.S. inflation and a weak dollar, Ihab Salib buys high-quality foreign debt. But that is not the only way to skin the cat.

Non-dollar currency foreign bond funds are one way to bet on the return of high inflation and a weakening dollar. Unless you are a major player this meanings investing in a foreign bond mutual fund or ETF. Forbes finds some candidates among the former for your interest.

Here is a scary scenario: The government’s financial bailout and economic stimulus work all too well. After flooding the economy with dollars, the Federal Reserve tries to reverse gears, but, alas, prices spiral out of control and the dollar collapses on foreign exchange markets.

Ihab Salib, who manages the $100 million (assets) Federated International Bond fund, plus another $3.4 billion in institutional money, has been betting on just such a turn of events since late last year.

Salib has laid bets that countries whose central bankers have cut interest rates and propped up domestic banks the most – namely the U.S. and the U.K. – will see their currencies suffer.

On the rising end of the equation will be the currencies of countries that have not been printing money like wallpaper. That includes the European Union and Australia. The latter will also enjoy the benefit of sharply rising commodities prices. Commodities are typically dollar denominated and rise in price when the U.S. currency weakens.

Salib, a 44-year-old Egyptian native, had something of an insider’s view of the likely hangover from profligate fiscal and monetary policy. Before joining Federated a decade ago, he spent five years in UBS’s asset management group helping central banks manage bond portfolios.

From his vantage point, the dollar currently faces a legion of threats. At first blush, some of them might even look like good news. Although the U.S. economy still appears to be in recession, for instance, investors are beginning to regain their confidence and flee the safety of Treasurys for riskier assets, including foreign securities.

Salib says the bull market for foreign bonds is just beginning, however, and getting in now will put investors a step ahead when inflation and a depreciating dollar really begin to bite. Even if he is wrong and the dollar retains its value, owning a smattering of foreign debt will provide diversification and, in many cases, pay you higher yields than you would earn back home. Salib’s fund currently yields 4.3%, versus 2.7% for the Vanguard Intermediate Term Treasury fund.

“If you only invest in the U.S. you get 25% of what is out there,” he says of the market for developed countries’ bonds. “If you are looking for balanced, diversified exposure, it is not prudent to ignore 75% of the world.”

Salib got his start in finance in the back office at Bankers Trust in New York City. After a few years working as a trust accountant, wanderlust got the better of him. In 1989, at age 24, Salib quit, sold his possessions, which consisted of little more than a car, stereo and leather jacket, and strapped on a backpack. He spent the next year and a half wandering through Europe, North Africa and Asia and nursing his $13,000 in savings.

Salib was in Australia in 1990 when the money ran out. His brother wired enough for him to buy a ticket home. With a deeper understanding of the world beyond American shores, Salib found his way back to Wall Street and his bond market job at UBS.

His interest in faraway places remains, but these days Salib quenches it mostly with 6 a.m. phone calls to European brokers and late evening reviews of Asian trading.

This year he has been buying European and Australian government debt. Among his top holdings are euro-denominated bonds issued by France that mature in 2035 and yield 4.5%. Another favorite is high-grade European corporate debt from issuers that either have explicit government backing or provide vital services that are likely to elicit state support in a pinch. 60% of Salib’s holdings are AAA rated, another 30% AA.

He sees safety in size. Much of Salib’s corporate debt was issued by a home country Goliath. That includes a 7.125% bond maturing in July 2011 from Deutsche Telekom. He has also picked up bonds from Daimler and chemical maker Henkel. General Electric, a participant in the U.S. government’s Troubled Assets Relief Program, also fits Salib’s profile of being too big to have much chance of failing. But instead of buying its domestic debt, he picked up pound-denominated GE bonds maturing in 2016 and yielding 6.4%.

Some telecom bonds are already in the money. In January Salib bought Telecom Italia’s 7.875% bonds due in January 2014 at 100 and Electricité de France’s 5.125% bonds due in January 2015 at 99. They recently traded at 110 and 106, respectively.

Bonds issued by Metro AG, Germany’s largest retailer, have not worked out so well. Although Metro’s supermarkets are largely immune to drops in consumer spending, it has suffered from an ill-timed foray into electronics retailing. Salib bought Metro’s 7.625% bonds in February at 99 and dumped them in late March at 95.

Salib concedes it is not easy to separate winners from losers in his inflation and dollar depreciation scenario. That is because central bankers in countries that formerly abstained from quantitative easing are starting to drink the Kool-Aid. Recent converts include central bankers in Switzerland and Canada.

Buying foreign bonds is not the only way to hedge against a weak dollar. If it is inflation that worries you the most, you could get inflation-indexed U.S. Treasurys, now yielding 1.85% for 10-year maturities. If it is the weakness of the dollar in foreign exchange markets that is the issue, you could simply make sure that the international stock funds you own do not hedge currency exposures. Example: The Vanguard Total International Stock Index fund does not hedge currencies, so a fall in the dollar makes its shares go up.

Yet another approach is to buy U.S. bonds and then make a side bet against the dollar in futures markets. You can do so by selling us Dollar Index Futures on the IntercontinentalExchange against a basket of six major currencies. Each contract is valued at about $81,000 and requires investors to put up $2,261 in margin. Discount brokerage commissions and bid/ask spreads are very reasonable. Futures profits are taxed as 60% long-term capital gains and 40% ordinary income.

Over the past 10 years the Federated International Bond fund has averaged a 4.7% annual return, versus 5.4% for the return (in U.S. dollars) on the JPMorgan Global Government Bond Non-USD index. The fund charges a 4.5% upfront load; its 0.89% annual fee is below the 1.13% international bond category average, according to Morningstar. The fund pays overseas withholding taxes, which investors can use to claim a credit in the U.S. For low-cost alternatives, see the table below.


Tokyo property values never came anywhere near to replicating the Japan bubble peak prices of 1989, but they were not immune from the worldwide property mania that ended 2006/07. And now property values have slumped, once again, along with real estate the world over.

Now the vultures are waiting for banks and other distressed property holders to start unloading their unwanted properties, just like eventually happened following the 1989 peak. This may take a little time, but there is a big backlog of distressed assets building up. Fortunately Tokyo is still a desirable location, so when the dams breaks there will be vulture investors waiting – if the price is right.

What is the “right” price? Non-trophy property, small office buildings that crowd the streets below the skyscrapers sell for a few million dollars and offer cap rates of close to 10% – a substantially higher number than the low single-digit lending rates for financing the buildings. In other words, the property price is more than supported by rental returns. Now that sounds like an attractive entry point for buying real estate ... or any investment asset.

In the midst of a Tokyo mini-property boom in 2006, Japanese investment fund DaVinci Advisors inked Asia’s biggest real estate deal that year when it bought most of the Pacific Century Place tower, a high-rise built in 2001 next to Tokyo Station. In return for a reported $1.7 billion that it paid to Hong Kong’s richest business tycoon, Li Ka-shing, it got the 32-story tower’s office space – not including the retail space at the bottom and the several floors occupied by the Four Seasons hotel at the top.

After the global financial meltdown, the value of Japan’s commercial property, like that practically everywhere, slumped. And someone’s big losses could be others’ big gains.

DaVinci may be lucky if it can offload that pricey office space for a little more than half of what it paid just three years ago, say real estate pros. And if in the next few months it cannot refinance as much as $1.6 billion in loans from the deal, then DaVinci founder and biggest shareholder Osamu Kaneko may have to do just that. Kaneko, 62, is a 40-year real estate veteran in Japan and the U.S. who set up DaVinci in 1998 with backing from pension funds and life insurers, mostly in Japan and the U.S., and with money from local banks.

Pacific Century Place is not his only financing headache. He also needs to roll over loans on an imposing office block in the Shiba Koen district of Tokyo, a building known locally as “the battleship.” Once, it was the headquarters of defunct retailing giant Daiei – itself a victim of overexuberance in frothy times. Kaneko’s fund declined to discuss how it would get new loans for these two properties.

Expectations for a flood of distressed real estate have run high, as a dam on bank credit takes a heavy toll on property companies in Japan. Of 17 listed companies that have gone belly-up this year, 11 have been real estate-related. In March property manager Pacific Holdings – not connected with the Pacific Century site – filed for bankruptcy, with close to $2 billion in debt to lenders, including Japan’s biggest bank, Mitsubishi UFJ Financial Group. The latest property firm to collapse was condominium developer Joint Corp., which pulled down its shutters on May 29, with liabilities totaling $1.7 billion.

Mark Brown, a real estate analyst at research firm JapanInvest, dubs those failed companies “new-age developers” – firms, he explains, that grew big as Japan’s Tokyo-centered mini-property bubble reinflated over the past decade. Established outfits such as Mitsubishi Estate or Mitsui Fudosan, he notes, are in better shape.

But what should have been a surge in distressed properties spilling onto the market is still just a trickle. To blame for the drought may be the collective finger of Japan’s banks plugging the dike. By hesitating to cut off credit to wobbly borrowers and grab their assets to auction off, lenders can avoid having to admit that they have overextended lending. Government pressure on banks to buoy struggling developers gives them another excuse to the keep credit spigots open.

Japan’s banks “have room to manipulate numbers and do not have to take losses until next year,” says Kristine Li, a bank analyst in Tokyo for KBC Securities. The balance of a loan minus the value of the collateral property represents the loss, but the assessment of the value of that collateral may be higher than the market price if lenders can argue that cash flow from existing rent agreements remains strong. In other words, Japan is not enforcing the mark-to-market accounting standards now in vogue in the West. By stashing those buildings rather than flogging them, they can maintain those valuations.

Japan’s banks hold about $70 billion in nonrecourse loans, and loan-loss provisions to cover them are minimal, notes Li. If properties had to be marked to the price investors would be willing to pay, it could pose a credit risk to the banks, and that might hobble efforts to shore up their finances by raising capital through stock offers and bond issues. Refinancing those loans could also trigger this reckoning, hence the fix that investors such as Kaneko are in.

Mitsubishi UFJ lost $3.7 billion in the last business year in the wake of the global financial meltdown. Its nearest competitor, Mizuho Financial Group (MFG), posted a $5.9 billion net deficit, while Japan’s third megabank, Sumitomo Mitsui Financial Group, lost $3.7 billion. All three forecast a return to profit this year.

If Japan’s big banks are unable to tap investors, their only recourse would be taxpayers’ cash – and with it bureaucratic control more stringent than the state scrutiny that the likes of Goldman Sachs, Morgan Stanley and JPMorgan are squirming under in the U.S. It is not an appealing option. The memory of mandarin manipulation is still vivid in the memories of Japan’s banking executives. It is still only a few years since lenders – forged from the merger of half a score of banks that huddled together when a $1 trillion tsunami of bad debt washed over them a decade ago – paid back $60 billion they begged from state coffers.

And hanging on may pay off. If the government goes ahead with a proposal to buttress a sagging property market with a reported $10 billion fund mined from postal savings accounts that would be used to buy properties from or offer loans to shaky real estate firms, lenders would effectively get state help without any strings attached.

The fate of DaVinci’s two big properties will be a test of how willing lenders are to let the market decide. Shinsei bank, one of DaVinci’s main credit arrangers for its 2006 purchase, declined to say what if anything it would do to help the Japanese fund refinance.

For future investors, too, that also means having to play a waiting game. “When the banks are ready to have a haircut, that is the time for investors to move in,” says Toshi Masui, who heads international heavyweight Colony Capital in Tokyo.

When distressed Japanese property went on sale a decade ago, asset prices in the rest of the world were inflating. Sellers this time round must vie with others in the U.S., Europe and other parts of Asia. According to American research firm Real Capital Analytics, the cumulative value of distressed property globally had risen to $85 billion in the first quarter of this year from only $2.7 billion a year earlier. Two-thirds of that is in the U.S. Yet despite the competition, Japan is still going to pull in investors, figures Paul Huff, a lawyer at Skadden, Arps in Tokyo who specializes in distressed real estate. Tokyo is, he says, a major international market and extremely stable. “There is a lot of kicking the tires,” says Huff, who predicts a “deluge” of deals.

Proof of that attraction can be found in the interest shown by private-equity vulture Lone Star Funds, which is trying to snap up the remains of a Japanese real estate fund, New City Residence, that failed in October with more than $1 billion in debt. Although shareholders of the fund have welcomed the American suitor, creditors have yet to approve any deal, leaving room for other bidders to best Lone Star, which is not commenting.

The big bankruptcies and the big buildings that go under the auction hammer are likely to dominate property market chatter, but the best opportunity to make money from distressed Japanese real estate will not be towers such Pacific Century Place that punctuate Tokyo’s skyline, says Fred Uruma, who runs investment firm Touchstone Capital in Tokyo.

Instead, juicy returns will come from the multitude of small office buildings that crowd the streets below them. Known locally as pencil buildings because the tiny parcels of land on which they stand force their owners to build tall and narrow, they sell for a few million dollars and offer return, or cap rate, of close to 10%, which at almost double the average rate is appetizing when lending rates are only a few points. In the past decade or so, real estate deals in Japan tallied to about $350 billion, estimates Uruma, and that means, potentially, a large pot of distressed assets – if you are willing to wait, that is.

How long till properties start shifting in a big way? “Summer,” predicts Uruma.


Refiners are doing better now than they were a year ago, even though gas prices are lower. Their stocks are still cheap.

Oil refinery stocks trade like pork bellies, fluctuating wildly with short-term movements of the “crack spread” – a measure of the margin between feedstock and final product prices. The crack spread is not correlated with crude oil prices to any reliable extent. Refined product prices fell even faster than crude oil prices the second half of last year, leading refinery stocks to fall even further than the market itself. In short, they got hammered. Now refining margins have recovered. Is a bet that the stocks will now move up a good speculation?

Valero is the largest independent refiner. Its stock is trading not far above its 52 week low. Cheap, right? Well the company is also selling shares, for the stated purpose of funding acquisitions. Maybe private transactions in refinery assets are done at lower multiples than where Valero’s depressed stock is trading, which would justify the equity offering. But we would like to know just how careful management’s calculation was on that matter before jumping in to the stock. We do not want to see empire building funded with expensive capital.

The price of crude oil, $147 per barrel last July, was down to $36 by Christmas. Was this sharp decline in raw material costs a boon to oil refiners? Far from it. While the price of oil was falling, the price of gasoline was falling even faster. Refiners’ profits vanished.

Look closely at the cyclical patterns in the refining business and you will see that declining ingredient costs do not ensure higher profitability. The key factor is the “crack spread,” the difference between the price of refined products and the price of oil. (The allusion is to the catalytic cracking of long oil molecules into shorter gasoline molecules.) Crack spreads march to their own beat. As it happens, spreads are widening at the moment, and I predict that they will widen further as the economy pulls out of the recession. This is a good time to be buying shares of refiners like Valero Energy (17, VLO).

When you want to predict the profitability of the refining business, do not start with crude oil supply and demand. Look instead at the supply of refining capacity and the demand for it. Think of it this way: Refiners are not so much selling fuel as selling refining services. They can charge a lot for that service (that is, collect a high spread between unrefined and refined petroleum) when demand for refining is brisk and supply tight. Demand is strengthening, as drivers get back behind the wheel. Supply is limited by the fact that it takes years to get operating permits and build a new refinery.

Gasoline represents approximately one-half of the yield from the refining process, so investors pay particular attention to this part of the business. The other main outputs are diesel fuel, jet fuel and heating oil.

We all remember well the howls of protest last year when gasoline topped $4 per gallon. Given the surge in oil prices in 2008, gasoline prices should have gone even higher. Because they did not, refiners faced falling profits. By late 2008 the crack spread turned negative, meaning that the more fuel refiners produced, the more money they lost.

Today the situation is quite different. U.S. crack spreads are fat, in the neighborhood of $14 per barrel of crude that goes into the process. I expect both refining volume and profits to increase as the world resumes economic growth. This is why I believe that now is an opportune time to pick up some of these depressed refining stocks, as positive crack spreads during the recovery boost profits.

The big oil producers are, for the most part, big refiners, too, but their refining profits are overshadowed by what happens to the supply and demand for crude oil. Among the independent refiners, Valero, which operates 16 refineries capable of processing 3.1 million barrels of crude oil per day, is the largest. It also runs seven ethanol plants recently purchased from a distressed seller, useful since gasoline must be blended with that fuel under orders of the federal government. Two years ago Valero was priced at $75 and the company earned $8.08 per share. Thanks to higher prices for refined fuels, revenues surged 25% in 2008 to $118 billion, yet Valero lost $2.16 per share because of the contraction in crack spreads. The stock got murdered.

Now Valero appears to be on the path to recovery. Gasoline prices are down from a year ago, but spreads are up. First-quarter earnings of 59 cents per share were a pleasant surprise. More recently, however, the stock was clobbered right after management projected a loss of 50 cents per share for the quarter ending June 30, a loss due partly to extended downtime at two refineries. It did not help matters when management also announced plans to issue up to 46 million more shares of common stock. Valero will use the proceeds from the issuance to fund acquisitions. Given the depressed prices in the industry, this could prove to be a shrewd long-term move. This stock should be considerably higher one year from now. The yield is 3.5%.

Tesoro Corp. (14, TSO) operates seven plants that process 660,000 barrels of crude daily. It specializes in processing the easier-to-refine but more expensive light crude oil, but boosted its first-quarter production of heavy crude – a gooier grade that delivers a wider crack spread. I expect earnings of $1.20 a share this year for Tesoro. The dividend yield is 2.8%.


Bob Prechtor is sticking to his deflationist guns, even as others are forecasting hyperinflation. His framework is clear enough: While credit is being destroyed you have, by definition, deflation. When most of the system credit is finally destroyed, only then is hyperinflation a possibility. We are not there yet.

It is so tempting to become one of the herd calling for more inflation and even – dare we say it? – hyperinflation. The problem is that what looks like the easiest call on the planet is likely to be the wrong call. In this excerpt from Bob Prechter’s latest issue of The Elliott Wave Theorist, he explains why he still firmly stands on his statement that the world economy is in the early stages of the “greatest deflation ever.”
Excerpted from The Elliott Wave Theorist by Bob Prechter, published June 11, 2009:

Inflation vs. Deflation

In recent days, at least six very famous and globally respected financial gurus announced that the dollar has begun a phase of hyperinflation, and many lesser lights have echoed their feelings ...

Despite the impressive brain power behind some of these statements, I maintain the opposite opinion: that the world’s financial system is in the early stages of the greatest deflation ever. Just before the March low in the stock market, we were able to call for a respite in the trend, so the calls for inflation that this rally has rekindled appear to us as a normal development. Investors typically fight the last war. Economic bears today are inflationists because they fear a bigger version of the 1970s. Paul Krugman (with whom I disagree on virtually everything) on May 29 quoted an economic historian on the sentiment of the early 1930s, when the inflationary ‘teens were likewise burned into people’s memories:

“... during the early years of the Great Depression ... many influential people were warning about inflation even as prices plunged. As the British economist Ralph Hawtrey wrote, ‘Fantastic fears of inflation were expressed. That was to cry, Fire, Fire in Noah’s Flood.’ And he went on, ‘It is after depression and unemployment have subsided that inflation becomes dangerous.’”

The latter statement above is exactly what Conquer the Crash said:

“While I can discern no obvious forces that would counteract deflation, after deflation is another matter. At the bottom, when there is little credit left to destroy, currency inflation, perhaps even hyperinflation, could well come into play.”

Consider also that more inflation is the easiest call on the planet. The presumed forces of external causality are clear as can be: We all know that Bernanke is an inflationist. We can see that the Fed and other central banks are offering unlimited credit. We can see that the government is spending money at a record rate. And we know that nothing tangible backs the dollar. But simple logic based on external causes does not work in predicting financial markets.

No one was predicting hyperinflation in 1999 and 2001, when the dollar was topping and the metals bottomed; on the contrary, at that time it was “obvious” that the Fed had the monetary system under control, there was a “New Economy,” and stocks were the only smart investment. At the 2008 all-time highs in commodities, everyone knew the opposite: inflation had been soaring since 2001, the dollar was crashing, and it was “obvious” that the Fed was engineering a powerful inflation. That was right before commodities fell more in eight months than at any time in modern history. Many of the hyperinflationists quoted above are career contrarians, as I try to be; but a forecaster should be quite concerned about the true extent of his contrariness if the evidence for his being correct were cycling right along with that for the average (bullish) economist, which is exactly the position of today’s believers in hyperinflation: Every time the markets rally, the opinions of both groups feel right.


He’s Got Gamma

An ace trader suggests ways to invest around volatility shifts.

Jeff Shaw is probably the most powerful options trader you have never heard of. As senior trader for Timber Hill, the market-making unit of Interactive Brokers he holds enormous sway over the price of every put and call traded in the U.S. options market. His judgments directly influence the prices of 1,700 stock and index options – which translates into real-time quotes on about 240,000 puts and calls.

And so many other traders reference Timber’s prices to see if theirs are correct, and that only amplifies Shaw’s power.

Starting as an American Stock Exchange clerk, Shaw has been at Timber since 1984. Now he has one of the world’s most commanding views of the options and stock markets – from a small trading floor in a plain building in Greenwich, Connecticut.

Shaw has been seeing what most others have no way to see: During the past week, institutional investors have started selling stock options that expire in December 2010 and buying others that expire in September and October 2009.

What does the action suggest? That some 2010 options are overpriced – as implied volatility is so elevated as to suggest that the credit crisis will not abate. Shaw says September ‘09 options’ volatility on the Standard & Poor’s 500 Index is as much as 20% lower than that of December 2010 options.

The longer-dated index volatilities imply stock-market moves exceeding 2% each day through 2010. But that seems unlikely, amid nascent signs of economic and corporate-profit growth.

So why the disconnect? The answer is to be found in options-pricing-model peculiarities.

“As the market slows down, that leads to lower front-month volatilities, as pricing models used by most market makers sense that historical volatility is dropping,” Shaw says, yet “it takes more time for longer-term volatilities to incorporate the recent relative calm in their prices.”

In October 2008, during perhaps the worst of the credit crisis, the Chicago Board Options Exchange’s Market Volatility index (VIX) peaked at 89. Volatility has sharply declined since then, lowering options prices – but the smoothing effect will not show up as quickly for the longer-dated options.

This quirk leads some traders to essentially sell the future in order to finance near-term positions predicated on the Standard & Poor’s 500 Index’s bursting from its 880-to-940 trading range.

To be sure, such trading is not for everyone. But buried in these complications of pricing models, and in the differences between historic and implied volatility levels, is the thinking of some very sophisticated traders, which can help investors better understand market crosscurrents.

“Think of the market now as becoming a tightly wound spring,” Shaw says. “Eventually, it will break out of its range. And when it does, owning gamma – or short-term options that are more sensitive to price movement – will be profitable against long-term, higher-volatility options.”