Tuesday, January 31, 2012

Investing in Utility Stocks

Investors in utility stocks enjoyed terrific returns in 2011.

The sector provided the best returns in the S&P 500 last year, gaining almost +15% in price and a total return of nearly +20%, according to Merrill Lynch.

Utilities offer investors two major attractions:  high dividend yield and stable business models. 

Despite last year's strong run, the dividend yield of the utility group is still nearly 4%, or more than double the yield of the 10-year Treasury note.

The economy may expand or wane; the Fed may or may not act; and the euro may or may not survive;  but we will all turn on the lights and heat our homes and offices.

However, utilities now sport the second highest P/E ratio in the S&P, and many strategists are suggesting that the group may lag the broader market averages in 2012.

I had the chance to hear the thoughts of Dan Ford of Barclays Capital yesterday. Dan has been following the utility sector for a number of years, and is, in my opinion, one of the top utility analysts around.

Dan still likes his group, even at these valuations.  He notes that dividends remain very popular with investors. Growth & Income mutual funds have been receiving large inflows of cash, and these funds typically have been large buyers of utility stocks.  Finally, with the Fed due to keep interest rates low for another two years, high dividend yields from "boring" utility stocks should continue to be popular.

Still, Dan urged more selectivity in utility investing in 2012.  The largest regulated utility stocks (such as the Southern Company) are already trading at record P/E multiples, and offer less attraction than some of the smaller utility names, in Dan's opinion.  He likes such stocks as CMS Energy and Edison International, which are less widely followed but are solid franchises.

My question to Dan concerned rate cases.  With interest rates so low, and the economy still struggling, will regulators continue to grant rate cases to their utilities that allow returns of 10% to 12%?

Dan thinks they will.  He notes that most of the rate increases are still modest, and mostly related to infrastructure improvement.  His team went back more than 30 years, and have found almost no cases of regulators reducing allowable rates of return simply because of the prevailing interest rates.

The risks to the group this year mostly relate to interest rates.  While most - including me - believe that interest rates will remain stubbornly low in 2012, a sudden rise in interest rates could negatively impact the group.  Regulated utility returns have historically been very closely tied to interest rates, so a change in the credit markets could hit the group hard.

In other words, utility stocks remain a reasonable investment for this year.

Monday, January 30, 2012

The Value of an Asset

You don't have to be involved in the investment management business to know that, in the end, an asset is really only worth what someone else will pay for it.

This seems almost too obvious, but I was reminded of this simple rule over the weekend.

There was an article in the New York Times yesterday about an ongoing debate in the classical music world.  Violins and cellos made by such old masters as Stradivarius command huge prices among the great musicians in the world:

Several factors put old Italian instruments on top. Superb wood, perfected design, the highest craftsmanship and special varnish all came together in Cremona and its environs from 1550 to 1750. The sheer number of years being played is a factor. Repeated vibrations have an effect on the wood’s structure, causing cells to break down in a way that produces a more flexible sound, some violin experts say. “By playing an instrument, it opens up its pores,” said the violinist and conductor Pinchas Zukerman, who plays a 1742 Guarnerius del Gesù. “The voice becomes purer and brighter.” 

The prices these instruments can command are daunting.  The piece notes that

...Stéphane Tétreault, an 18-year-old Montrealer who is being loaned the 1707 Countess of Stainlein Stradivarius cello that belonged to Bernard Greenhouse, a founding member of the Beaux Arts Trio, who died last May. The Greenhouse family sold the instrument two weeks ago to an anonymous patron in Montreal for an undisclosed amount, but one said to surpass the previous record of $6 million. 


I ran into Richard Ortner, head of the Boston Conservatory, at a benefit concert last night, and had a chance to talk to him about the price of instruments.

Richard emphatically confirmed the facts in the article, noting that string players can often amass debts similar to a home mortgage in order to secure one of the classic string instruments.

By contrast, said Richard with a laugh, players of metal instruments like a flute or horn get off pretty lightly; the top price for a flute, for example, is probably no more than $20,000.

Investing in stocks, in a way, also reflects the basic fact that any particular company is really worth what the collective market wisdom will pay for it.

The Financial Times on Saturday had a good piece about the strong rally in financial stocks that has occurred this month.

As some of my earlier posts noted, the fundamentals for bank stocks really haven't improved all that much from last year. European banks underperformed their American counterparts in 2011, but lately have rebounded sharply.

Investors have been encouraged that the actions by the Fed and the European Central Bank (ECB) will be sufficient to allow the European banks to survive and even prosper.  In particular, the ECB's Long Term Refinancing Operation (LTRO)
injected nearly 1 trillion euro into the banking system last month, which seems to have at least stabilized the financials for now.

So the value of bank stocks at this point can be hazy, but it seems to me that it really can't be argued on fundamentals alone at this point.  Prices are moving higher, and if the goal is to increase the value of your portfolio then you have to at least think hard about the banking group. As the article notes:

...{Thomas Moore, equity manager in Edinburgh, suggests that} investors ignored the power of the LTRO for a month and even now this is a lot of negative feeling about banks around. "There is a lot of pessimism out there. It suggests there is still scope for valuations to re-rate...

Similarly, credit analysts at Citi say: The fact that investors are so reluctant to commit to the rally and the effect of the LTROs makes it all the more likely that it continues for considerably longer than people envisage - or indeed, by more than is warranted by the fundamentals."


So the lesson from the classical music world can be applied to bank stocks:  whether you agree or not, prices are going higher, simply because that is the price that people are willing to pay.

Friday, January 27, 2012

The Rich Among Us

Presidential candidate Mitt Romney released his tax returns earlier this week.  In 2010, the former Massachusetts governor paid a tax rate of less than 14% despite making more than $20 million.

No one, I believe, has suggested that Romney did anything wrong.  Indeed, Floyd Norris in this morning's New York Times wrote that he probably paid too much taxes based on the current tax code:

But what really stands out is the mind-numbing complexity of tax laws, and about how hard it seems to have been for even the high-priced help Mr. Romney can afford to get things right. 

In one case, the trustee for one of the Romney trusts sent two letters to the Internal Revenue Service electing to use an apparently irrelevant section of the tax code, and in the process misstated the facts involved. 

That mistake did not affect the taxes owed, but another error was more significant. It appears that the return filed by that trust overstated capital gains realized by nearly $300,000, causing Mr. Romney and his wife to pay about $44,000 more in taxes than they owed.


As someone who still does his own taxes - albeit with the massive assistance of TurboTax - I can feel Governor Romney's pain when it comes to figuring out today's tax code.

I will leave it to you to decide whether it is "fair" that someone making millions of dollars a year pays taxes at a lower rate than most working Americans. Romney and other rich Americans are merely following the laws passed by Congress, which over the last few decades have nearly always focused on lowering taxes for the wealthiest Americans.

Tax rate aside, however, there is the question whether our societal values are skewed too far to people that know how to "work the system", as Warren Buffett was quoted earlier this week in an article that appeared on Bloomberg:

“It’s the wrong policy to have,” Buffett told Bloomberg Television’s Betty Liu in an interview today. “He’s not going to pay more than the law requires, and I don’t fault him for that in the least. But I do fault a law that allows him and me earning enormous sums to pay overall federal taxes at a rate that’s about half what the average person in my office pays.” ...

“He makes his money the same way I make my money,” said Buffett, 81. “He makes money by moving around big bucks, not by straining his back or going to work and cleaning toilets or whatever it may be. He makes it shoving around money.”


There have been other periods in our country's history when the wealthiest citizens were not so prized by the nation.  John Rockefeller, Henry Ford and Andrew Carnegie were envied for their wealth, but few really looked to them as role models.

The highest marginal tax rate in the 1950's - under a Republican president - was 90%, yet I can find little evidence that anyone found this progressive tax code all that unfair (or that economic growth was stifled in any way).

I think that one reason the ultra-wealthy among us remain iconic figures is that fact that they do not flaunt their riches in the same fashion as in earlier times.

Buffett, for example, still lives in the house he bought in Omaha in 1957. Steve Jobs of Apple lived modestly by all accounts, preferring a Zen-like existence which included few material possessions.  Others still are working despite having more money than they could possibly ever need, most recently Mark Zuckerberg of Facebook.

Then there's Bill Gates, the richest American who ever lived who has created the largest philanthropic organization ever existed.  Gates has been in Europe this week, and there was a good article about him in London Telegraph.

As the article notes, despite his vast riches:

Bill Gates has frugal tastes. Asked to name his luxuries, he lists DVDs, books and takeaway burgers. It is hard, however, to think that any fast-food outlet would get rich on Gates’s custom. During a long list of engagements beginning well before dawn, he consumes nothing but cans of diet cola. 
For America’s wealthiest citizen, austerity is relative. The retinue of staff and the private jet hint at a fortune said to be approaching £40 billion. As he told pupils at a south London school he visited this week: “If I hadn’t given my money away, I’d have had more than anyone else on the planet. Ninety-nine per cent of it will go.” 

It will be interesting to read years from now how history views our society's attitude towards the rich among us.  But what is striking to me is that a time when real income for most Americans have been stagnant that no one begrudges the kudos that go towards the wealthiest.

Thursday, January 26, 2012

The Fed Learns from Japan

Yesterday's announcement that the Fed would be keeping rates at essentially 0% until 2014 is fairly important, in my opinion.

Recent economic data has shown some improvement in the economy.  Unemployment is still too high, but at least the unemployment rate is moving lower, not higher.  Housing is also showing some signs of trying to find a bottom, helped by record low mortgage rates.  And bank loan demand is picking up, albeit from very depressed levels.

So it's interesting that the Fed is committed to an easy monetary policy rather than tightening, as so many were expecting.  Moreover, according to the New York Times, the majority of Fed governors may not want to raise rates until 2015:

...the Fed published for the first time the predictions of the committee’s members on when they would raise interest rates. It showed that 11 of the 17 members expected the Fed to raise rates by the end of 2014. Taken together, the documents suggested that the Fed expected to keep rates near zero until late 2014, but probably not any longer than that. 


To me, this shows that the Fed has taken the Japanese experience of the past two decades to heart.

In the 1990's, after the land and stock markets imploded, Japanese officials gradually reduced interest rates to almost 0% in an effort to try to revive their economy. This of course is very similar to what the Fed has done in this country.

However, the Bank of Japan was constantly looking  for opportunities to raise rates again, as many in Japan felt that low interest rates were imposing a harsh burden on savers.  So, every time economic data indicated that Japan's economy was reviving, the BOJ would start to raise interest rates. Unfortunately, the BOJ's move to tighten credit would usually interrupt the economic revival, and they would be forced to loosen credit again.

Fed Chairman Bernanke studied the Great Depression of the 1930's in great detail while he was a professor at Princeton. Because of his background, Bernanke was a fairly vocal critic of the BOJ's actions in the 1990's, because he felt their actions were either too cautious or too precipitous in raising interest rates too soon.

Hence yesterday's announcement.

To me, this means that savers are going to be forced to make a decision: keep their funds in a bank or money market account earning essentially nothing for the next few years, or invest some of their savings in stocks or bonds.  And with interest rates on bonds at 60 year lows, it seems more likely that we will eventually start to see more flows into the stock market.

I think that Bernanke's moves have mostly been good ones, even though many of this year's Presidential candidates have used the Fed and Bernanke as one of their favorite punching bags.

The Washington Post carried a good piece this morning discussing the Chairman's almost zen-like calmness in the face of often withering criticism:

Newt Gingrich called Bernanke “the most inflationary, dangerous and power-centered chairman of the Fed in the history of the Fed.” Ron Paul accused Bernanke of “inflating twice as fast as Greenspan.” Mitt Romney joined the others in saying he wouldn’t reappoint Bernanke, who was first appointed by President George W. Bush.

On Wednesday, Bernanke allowed himself just a passing reference to such critics. “The low level of inflation is a validation,” he said. “There are some who were very concerned that our balance-sheet policies and the like would lead to high inflation. There’s certainly no sign of that yet.”

He deserves credit for keeping his equanimity as the Republican candidates abuse him. And, at long last, he has some results to show for the work he has done.


Wednesday, January 25, 2012

It's Never Been More Expensive to be Defensive

As regular readers of Random Glenings are aware, I have been very cautious in my approach to the financial sector for the past year or so.
I have also been cautious on global market, believing for most of 2011 that the best markets were to be found in the US.

But now perhaps the time has come to reconsider my position.

Ah, ha! you say.  I thought you were saying that the underlying fundamentals were terrible for the banks and insurance companies.  Low interest rates, meager loan growth, and massive debt overhangs - aren't they still weighing on the group?

Oh, and the euro issues are still very much with us, aren't they?

Well, yes.  But as famed economist John Maynard Keynes is reported to have once said:  "When the facts change, so do my opinions.  What do you do, sir?"

There are several factors that have evolved in the past few weeks to have caused me to seriously reconsider my bearish stance on the financial group and international investments.

The biggest one occurred last month, in Europe. As you no doubt read, the European Central Bank (ECB) pumped nearly 1 trillion euro in the large eurozone money center banks. These loans were made for a three year term, which essentially protects the banks until 2014.

Meanwhile, the Fed pumped hundreds of billions of dollars into the interbank lending market in Europe, averting a certain credit collapse.

While most of this money now sits on deposit - the euro banks remain determined to shrink their balance sheets, and improve their capital ratios - the truth of the matter is that the ECB and the Fed have apparently staved off financial Armageddon.

So disaster is off the table, for now, at least. Greece may yet default, but it seems more likely that the euro zone will limp along for at least for the next couple of years or so.

But a recovery is not yet being priced into the financial stocks, or in many markets across the globe. Sentiment is just too bearish.

Merrill Lynch's chief global strategist Michael Hartnett was in town yesterday, and I had a chance to hear his thoughts.  The story he told goes something like this:

Everyone across the global seems to share the same sentiment.  Stocks in the US will be in a trading range, and further upside from current levels seems limited. The euro zone is in free fall, and it is only a matter of time before Europe falls apart.  China is heading for a major slowdown, as are many other emerging markets. The only safe areas to invest are US Treasurys and dividend-paying US stocks.

Michael's perceptions are confirmed by valuations in the bond and stock markets.

Investors are still piling into Treasury notes, despite the fact record low interest rates.  The Fed is apparently going to keep its target funds rate at near 0% until 2014, yet corporations and individuals continue to pile into money market funds.

In the stock market, dividend-paying "safe" stocks are commanding a huge premium to every other sector, despite the fact that growth prospects in these sectors are every bit as turgid as those found in the financial sector.

For example, here are the forward price/earnings ratios of some of the sectors in the S&P 500 (figures provided by Merrill Lynch):

Telecom        16.4x
Utilities         14.4x
C. Staples      14.3x
Tech              11.7x
Energy           10.8x
Finance         10.4x

The reason, I would argue, that telecom and utility stocks are commanding the highest P/E ratios boils down to the fact that the sector offers high dividend yields.

But can you really argue that telecom should trade at a 50% premium to technology?

Now let's take a look at the world markets:

North America        12.0x
Asia Pacific             11.4x
Europe                      9.9x
Emerging Markets    9.4x

See the pattern?  A year ago it was an article of faith that investors should have a large portion of their investable assets in the fastest growing parts of the world - namely, the emerging markets.  However, investor sentiment has turned so cautious and bearish that only the most defensive stocks and bonds are favored.

The title of this piece says it all.

Being defensive may feel comfortable, but I suspect a few years from now we'll look back in wonder at investors happily locking in meager returns, and shunning opportunities that are staring them in the face.

Tuesday, January 24, 2012

Calculating Investment Returns

The calculation of returns from any asset class - stocks, bonds, funds, etc. - is on the surface a straight forward proposition.

The problem is the most conventional calculations don't take into account a number of other factors, including survivor bias, the timing of cash flows, or performance fees.

I was reminded of this challenge the other day when I was attending a presentation discussing the merits of hedge funds as part of an overall investment strategy.

The presenters were making the case that as a whole the returns for hedge funds investors have largely been superior to conventional "long only" investments in the market.

Moreover, according to their calculations, the returns have been achieved with less volatility, so the case for hedge funds should be self-evident.

However, as numerous commentators have pointed out, its not that simple.

Although there is nearly $1.9 trillion invested in hedge funds at the present time, the community is far from being homogenous. There are numerous different types of funds, for example, ranging from so-called macro funds (which bet on the direct of global markets) to relative value arbitrage (trying to gain based on price differences between related securities).

Then there is the problem of survivor bias.

Most funds start out relatively small, build a track record, and then grow as investors flock to the most successful hedge fund operators.

However, numerous funds start out, and then fail, as the results either do not attract new investor dollars or returns are not sufficient to earn performance fees.

Yesterday's Financial Times had a short piece about the disappointing returns for many in the hedge fund community, and what it has meant for compensation:

More than two-thirds of hedge funds are below their high-water marks, the point at which they are able to charge investors performance fees, according to Credit Suisse.

The main source of income for hedge fund managers is their share of investment profits, typically 20 per cent; but if a fund drops in value, the manager must recoup past profits before charging any more performance fees...

...Just over a third of event funds, which seek to trade around corporate activity such as mergers, or long-short equity funds that pick stocks, are at least 10 per cent below their high-water marks.


And what about the timing of cash flows?

An obvious example of this is famed hedge fund manager John Paulson, who made more than $5 billion betting on the collapse of the US housing market. Paulson's incredible track record was compiled while his funds under management were relatively modest by hedge funds standards.  However, once word spread of his midas touch, Paulson attracted huge amounts of assets.  But then last year, after several ill-timed bets on bank stocks, Paulson's investors lost 40% of their funds.

So the question becomes:  What were the returns for Paulson's investors?

Author Simon Lack writing in his new book Hedge Fund Mirage:  The Illusion of  Big Money andWhy It's Too Good to be True walks through the math of why returns for most hedge fund inveors have not been as attractive as advertised.

Say an investor places $1 million with a hedge fund at the beginning of the year.  The fund has a terrific year, gaining +50% for the next 12 months, meaning the closing account value is $1.5 million.  Net profit to the investor:  $500,000.

Terrrific! says the investor.  Let's add another $1 million to our investment, since the fund is clearly a winner. The investor now has a total of $2.5 million invested in the hedge fund.

Unfortunately, the next year turns out to be a disaster - the fund is down -40%.

The investor's $2.5 million is now worth $1.5 million.  Since he had put a total of $2 million with the hedge fund, the loss of $500,000 means that his investment return is now -25%.

However, under conventional reporting standards, the hedge fund will report an average annual return over two years of +5% (+50% for year 1 and -40% for year 2).  While this is mathematically correct, the actual investment experience has been considerably more disappointing than reported.

While Lack is specifically targeting the hedge fund community in his example, I think you could also make the same mathematical argument for any investment. For example, Fidelity's Magellan Fund produced terrific returns for its investors in the early years, when it was relatively small, but only index-like returns when it grew to nearly $100 billion in size.

I haven't even begun to discuss the whole question of hedge fund fees - which are generous, by any standards - but the whole issue makes me wishing there was a better way to figure out investment results.

Monday, January 23, 2012

Job Market Blues

The New York Times has run several articles over the past few days that have provided a glimpse into some of the reasons behind our stubbornly high rate of unemployment.

The Times had a long piece "above the fold" on yesterday's front page discussing technology giant Apple.

Apple is valued by the stock market at roughly $400 billion, which makes it essentially tied with Exxon Mobil for being the largest company (by market cap) in the United States. 

According to the article, Apple earned nearly $400,000 per employee last year, a level of profitability that surpasses Google, Exxon or Goldman Sachs.

However, rather than focus on Apple's "insanely" great products, the authors discussed the company's manufacturing facilities, most of which are located in at a place called Foxconn City, located in China.

Here's a brief description of Foxconn:

To Apple executives, Foxconn City was further evidence that China could deliver workers — and diligence — that outpaced their American counterparts.
That’s because nothing like Foxconn City exists in the United States. 

The facility has 230,000 employees, many working six days a week, often spending up to 12 hours a day at the plant. Over a quarter of Foxconn’s work force lives in company barracks and many workers earn less than $17 a day. When one Apple executive arrived during a shift change, his car was stuck in a river of employees streaming past. “The scale is unimaginable,” he said.


It's not just that Chinese workers will accept miserable working conditions for low pay; they also offer foreign companies an incredibly deep poor of engineers and other technically-trained workers that this country simply cannot:

Another critical advantage for Apple was that China provided engineers at a scale the United States could not match. Apple’s executives had estimated that about 8,700 industrial engineers were needed to oversee and guide the 200,000 assembly-line workers eventually involved in manufacturing iPhones. The company’s analysts had forecast it would take as long as nine months to find that many qualified engineers in the United States. 

In China, it took 15 days. 

In a depressing contrast, back at American colleges and universities, more attention is being paid to athletics, at the expense of academia.

Ohio State, for example, just hired famed football coach Urban Meyer at a salary of $4 million per year, and numerous perks including the use of a private plane.

Meanwhile, research grants are being reduced by university administrations looking for ways to contain costs.

Here's an excerpt from the Times this morning:

{Ohio State Physics Professor Gordon} Aubrecht says he doesn’t have enough money in his own budget to cover attendance at conferences. “From a business perspective,” he can see why Coach Meyer was hired, but he calls the package just more evidence that the “tail is wagging the dog.” 

Dr. Aubrecht is not just another cranky tenured professor. Hand-wringing seems to be universal these days over big-time sports, specifically football and men’s basketball. Sounding much like his colleague, James J. Duderstadt, former president of the University of Michigan and author of “Intercollegiate Athletics and the American University,” said this: “Nine of 10 people don’t understand what you are saying when you talk about research universities. But you say ‘Michigan’ and they understand those striped helmets running under the banner.”


The article goes on to describe the near-fanatic following that successful big-time collegiate athletics has engendered on many college campuses today, often at the expense of students studies.

Meanwhile, in the Far East, colleges and universities pay scant attention to athletics, believing that students should focus on their studies.

Finally, this whole move to manufacturing offshore has reduced the negotiating power of the typical American worker.

Lockouts have apparently become more common in many businesses, as company management has gained the upper hand in many wage negotiations:

“This is a sign of increased employer militancy,” said Gary Chaison, a professor of industrial relations at Clark University. “Lockouts were once so rare they were almost unheard of. Now, not only are employers increasingly on the offensive and trying to call the shots in bargaining, but they’re backing that up with action — in the form of lockouts.” 

The number of strikes has declined to just one-sixth the annual level of two decades ago. That is largely because labor unions’ ranks have declined and because many workers worry that if they strike they will lose pay and might also lose their jobs to permanent replacement workers. 

Lockouts, on the other hand, have grown to represent a record percentage of the nation’s work stoppages, according to Bloomberg BNA, a Bloomberg subsidiary that provides information to lawyers and labor relations experts. Last year, at least 17 employers imposed lockouts, telling their workers not to show up until they were willing to accept management’s contract offer.


Little wonder, then, that attacks by presidential candidates on countries like China have hit a very responsive nerve among the electorate.

Friday, January 20, 2012

An Inconvenient Disconnect

It is an old Wall Street axiom that the markets in the short run are voting machines, but in the long run weighing machines.

"Nothing But Blue Skies Ahead!"

Stocks or industry sectors can enjoy investor popularity for a period of time based on a particular mood shift among investors.  However, in order to make longer-term investment sense, the fundamentals of the stocks have to catch up with the share price.

The markets continue to have a good tone.  As I noted yesterday, the S&P 500 is off to its best start in 25 years, and most clients seem considerably more relaxed than just a few months ago.

However, I am becoming a little troubled by the disconnect by the rise in the overall market and the increasingly negative tone of analyst comments.

I wrote a long email to some of my fellow colleagues here at Boston Private Bank, reflecting some of my concerns. 

The overriding issue, it seems to me, is that stocks are being bought because the potential returns from most other asset classes are so unappealing. 

The best performers last year, for example, were found in the dividend-rich utility and consumer staples areas.  It's not that the business prospect for these companies is all that great; no, instead the fact that they pay relatively high dividends and are generally household names (think Colgate; Coca-Cola; and Southern Company) make them appealing to investors.

Meanwhile, the Wall Street analysts I respect are saying, "Hey, wait a minute - some of these stocks don't deserve to trade at a premium valuation based on their fundamentals." 

Typically Street analysts are more optimistic than the general public, but now I am getting the impression that we are in an opposite situation.

I got some strong reactions to my mildly cautious email yesterday.

One manager basically told me, look, the markets are a forward-looking animal, and that stocks may be anticipating better economic times ahead.  A better economy will lead to upward revisions in earnings forecasts, which will make today's prices look more reasonable.

Maybe, but I have been through this before, as my email suggested:

Stocks are off to their best start since 1987.  Since I’m probably the only one on the team that was investing 24 years ago, let me tell you what happened.

Stocks kept moving higher for most of the year, but so too did bond yields. The fundamentals did not support the move in stocks, but no one seemed to care.  Then came October 1987 – stocks fell by -25% in one week, if my memory serves. Panic ensued.   Clients were not amused.

I actually have very fond memories of 1987 – as a bond manager, we made huge returns in the fourth quarter, since we were very long our benchmark.  But since I don’t do bonds anymore (directly, at least), I don’t really care to go through all of this again.

They say that famed hedge fund manager Michael Steinhart used to sell all of the stocks in his portfolio at the end of the year, and then start reinvesting the proceeds, to make sure that he really wanted to hold onto the stocks in his accounts.

The market seems very complacent, in my opinion.  I think everyone is sick of talking about the euro, deficits and banks, and are buying stocks because everything else offers essentially no return.

Ned Davis Research reported that stock short interest is at the lowest levels since 2000.  I think the hedge funds got smoked in the fourth quarter – especially October – and are mostly long at this point.

So here’s my problem: While I might agree that stocks will offer superior returns on a longer term basis, I am having trouble getting excited about the near-term prospects:

Consumer staples - +30% premium to historic valuation.  Uninspiring fundamentals. Sector analyst at Citi Wendy Nicholson just said this AM that she would not buy any of the names, and Bryan Spillane at Merrill said basically the same thing on Tuesday when I saw him.

Consumer discretionary – the consumer is probably OK at this point, but names like McDonald's and Nike have already had huge moves.  Are they still a buy?

Health care –  The analysts at the UBS conference we attended a couple of weeks ago were basically negative on everything in each of their eight sectors.

Industrials – I saw analyst Jason Feldman at UBS yesterday, who I think is pretty good.  His point was that to buy his stocks here you have to model a pretty strong second half pick-up in 2012, no European recession, and some euro stability.  Is this likely?

Utilities –  big premium to historic valuations based on good dividend yields.  Fundamentals don’t really support prices – just yield-hungry investors;

Financials – this group is having a strong January, but has anything really changed?  Slow loan growth, bloated infrastructure, and potential legislative headwinds all weigh on the prospects for many financial stocks.  Ned Davis had a piece that noted the short interest on the group fell from 39% seven weeks ago to 27% now.  Also, most managers are underweight, which means like me that are slightly panicky that financials are now working.  But has anything fundamentally changed?

Energy – seems to me this group only works well if Iran closes the Strait of Hormuz.  Natural gas prices are low, and there’s too much inventory.  Warm winter doesn’t help.

Tech – largest weight in the market, at 20%. Everyone loves Apple, but with a market cap of $400 billion it is hard to see this stock continuing to grow as fast as it had been.  Many publicly-traded tech stocks are mature businesses; the faster growing companies like Facebook are all private.

Telecom – do you really think the long term business prospects for AT&T and/or Verizon are all that thrilling?  I think like utilities these stocks are being bought for yield.

Thursday, January 19, 2012

The Market Melts Up

Last August, when the stock market was in the midst of one of its worst quarters in the past decade, I wrote several pieces suggesting that investors should look past the concerns of the day and focus on the longer term fundamentals.

Here's an excerpt from a piece I wrote on August 8, 2011, titled "Seven Reasons Not to Panic:

Weak economic data. S&P downgrades US debt. Eurozone in crisis. Gold soars above $1,700.

Stock markets tumble around the world, and the S&P 500 has lost more than 11% since the end of April... 

... Finally, at times like this, it is worth remembering Warren Buffett's axiom to "Be greedy when others are fearful, and fearful when others are greedy".

When you see so-called smart money investors stashing funds in Treasury Bills yielding 0%, or even paying custodian banks like Bank of New York Mellon a fee to place deposits, you have to believe that a lot of bad news is already priced into the markets.

In my opinion, for the longer term investor, stocks represent the best combination of yield and potential capital appreciation.

I see little or no value in shorter maturity bonds yielding less than 1%. 


(The S&P finished the quarter with a loss of -14%, so perhaps a little panic in mid-August would have been appropriate.  On the other hand, thanks to a strong stock rally in October 2011, stocks regained all of the prior months' losses to finish the year with a modest +2.1% total return.)

Which brings us to today.

The same factors that were apparently causing the markets to swoon a few months ago - euro crisis; S&P downgrades; financial turmoil - are now being greeted with a collective yawn by the markets.  Indeed, the S&P is off to its best start to a year since 1987, according to Bloomberg:

U.S. stocks are off to the best start in 25 years as investors speculate Federal Reserve Chairman Ben S. Bernanke has done enough to insulate the economy from Europe’s debt crisis. 

The S&P 500 has gained 4 percent, the most since it rose 10 percent over the first 11 days in 1987, according to data compiled by Bloomberg. Stocks are overcoming earnings that trailed estimates by the widest margin in three years as improvements in hiring, manufacturing and car sales extend the biggest fourth-quarter advance since 2003.


Interestingly, despite the ebullient mood on Wall Street, the credit markets are still signalling distress in the global financial system.

Yields on high quality government bonds remain far below the levels of a year ago.  Ten year Treasury notes, for example, offer investors a yield of just 1.9%, almost half the 3.5% yields of a year ago.

Many analysts are warning that the advance in stock prices is not justified by company fundamentals.

For example, industrial analyst Jason Feldman of UBS told me and a few other investors in a meeting yesterday that the recent advance in share prices of names like General Electric reflect overly optimistic assumptions about 2012. 

Consumer staples analysts Wendy Nicholson of Citigroup - one of my favorite analysts - left a voicemail to clients this morning telling them to avoid all of the stocks in her sector.  According to Wendy, stocks like Colgate and Procter and Gamble do not reflect the weakening trends in their underlying fundamentals.

Finally, only 47% of the companies in the S&P that have reported earning thus far have beaten expectations. This is the lowest level in years, according to Bloomberg.

While welcome, this month's rally has occurred on relatively low volume and listless trading.  Like the old western movies - when cowboys would say things like "It's quiet - too quiet, if you ask me" - it is worrisome that complacency seems so widespread.

And as I wrote last August, the second part of Warren Buffett's axiom "be fearful when others are greedy" may in fact be the best advice for now.

Wednesday, January 18, 2012

Pity the Poor Analyst

Wall Street analysts have long been the target of investor skepticism.

It seems like it is almost a rite of passage for business school professors to publish papers deriding the Street, pointing out that analysts are usually too bullish on the companies they follow.  A typical academic analysis will point out that many Street analysts will have "buys" on 70% or more of the stocks they follow, which usually proves to be overly optimistic.

Far be it from me to defend Wall Street, but I think that some of the criticism is somewhat misguided.

To begin with, anyone that makes an investment decision based solely on (free) Street research deserves what they get.  In any other business - autos, appliances, etc. - the consumer assumes that any research they get from their salesperson is biased.  Why should the Street be any different?

Wall Street analysts are trapped in a system where they are forced to serve several  masters.  Even if they are pessimistic on the prospects for the companies they follow, downgrading a stock's rating can often career limiting.  Wall Street, after all, is in the business of selling stocks and bonds; why would you tell your customers not to buy your products?

Company managements can become very unhappy if analysts write uncomplimentary reports.  I have had numerous analysts tell me stories of how they have been denied access to senior managements of companies they follow in the aftermath of a ratings downgrade.  No access to senior management presents a formidable challenge to an analyst following a particular group.

I was reminded of the plight of the typical Street analyst when I attended a lunch meeting yesterday.

This respected analyst follows the food and beverage companies. The stocks in his group have done very well in the past year. Investors have flocked to stocks like Coke; Pepsi; General Mills; and Kraft in search of high dividend yields and relatively predictable business models.

Problem is, the stocks today in general appear to be "fully priced" (to use Street lingo), with the P/E multiples on most stocks at roughly +30% premiums to historic averages.  In particular, when you consider that most of the growth from the food and beverage group has come from the emerging markets, it seems likely that the economic slowdowns in places like Brazil and China will hit the companies.

But here's the rub:  of the 26 stocks this analyst follows, fully 14 are rated "buy"; 7 rated "neutral"; and only 5 "sell".

So I asked the analyst:  What gives?

Well, he said with a rueful smile, in my company 's rating system, only 25% of my coverage universe can be rated "neutral".  In addition, our global strategist is recommending overweighting the stocks in my group.  And, finally, names like Coke are so widely held among client portfolios that if I ever put a "sell" on these stocks, management and the brokers would go crazy.

Hence the apparent bullish stance on the group.

Cavaet emptor.

Tuesday, January 17, 2012

Does Anyone Care About Eurozone Downgrades?

Lots of news coming out of Europe over the last few days, most of it negative.

As you no doubt read, last Friday Standard & Poor's not only downgraded several eurozone countries, but also the European Financial Stability Facility (EFSF). 

Another ratings agency - Fitch's - announced that it was almost certain that Greek would be defaulting on its debt by the end of February, and Greek debt is now trading at 30% of face value in the secondary market.

Interestingly, though, the markets took all of the news with a collective shrug.  It appears that the term I mentioned last week - Eurofatigue - remains firmly in place in the market's collective psyche.

It could just be that no one really cares all that much about what American rating agencies think about the debt markets; after all, interest rates on US Treasury 10 year notes have fallen by nearly 100 basis points since the US was downgraded by S&P last July.

European political reaction to the credit downgrades was outrage, as could be expected.  However, rather than argue with the S&P analysis (as the US did last summer), the Europeans want to take it a step further; they want to regulate the agencies, according to Reuters:

LONDON, Jan 16 (Reuters) - Standard & Poor's credit rating downgrades of nine euro zone countries will fuel attempts by European Union lawmakers to slap stricter curbs on sovereign ratings...

...the EU is going further than the United States or what was agreed globally by the G20 to rein in agencies. The bloc's latest legislation is largely directed at the global market dominance of the "Big Three" ratings agencies: S&P, Moody's and Fitch Ratings.

{European Union financial servies chief Michel} Barnier said in a speech in Hong Kong on Monday he wanted to see rating agencies operate in full transparency.

"I am surprised time and time again by the timing agencies choose to make such announcements," Barnier said. "I think it would be right for agencies to take better account of the unprecedented efforts being made by government".


The markets may not care now, but it seems likely that unless current trends change, they will eventually.

Writing in the Financial Times over the weekend, columnist Wolfgang Munchau points out the true significance of the rating changes;  eurozone policy makers seem helpless to stop the downward spiral of many of its members:

Even economic reforms, necessary as they may be for other reasons, cannot solve this problem.  This is another European illusion.  We are now at the point where effective crisis resolution would require a strong central fiscal authority, with the power to tax and allocate resources across the eurozone.  Of course, it will not happen.

This is the ultimate implication of last week's rating downgrades.  We have moved beyond the point where a technical fix would work.  The toolkit is exhausted.


Friday, January 13, 2012

Euro Fatigue

For the second half of 2011, nearly all market discussions began and ended with some sort of comment about the euro.

Now, however, even though the euro situation is far from "solved", it seems that the collective market has turned its attention to other discussions.

Writing in yesterday's Financial Times, columnist James Mackintosh pointed out that the conventional view in the investment world is, "America good, Europe bad.  The US economy is surprisingly strong, while Europe is perhaps already in recession." But, as Mr. Mackintosh points out:

No wonder investors prefer the US, with the S&P 500 up 15 per cent, including dividends, since Europe's autumn bottom.

But wait! Eurozone shares, including dividends, are up 15 per cent too. Charts of the two are almost indistinguishable.


However, while the equity market may be weary of worrying about euro, the crisis is far from over, at least as far as the credit markets are concerned.

Earlier this week, Switzerland was able to sell 15 year bonds with a yield of less than 1%.  US Treasury yields continue to move lower as well, as worried investors flock to our bond market in favor of security.  Here's the story from yesterday's Bloomberg:

The Treasury sold $21 billion of 10- year notes at a record low yield as speculation France may lose its top credit rating amid Europe’s debt crisis bolstered the refuge appeal of U.S. government securities. 

The bonds drew a yield of 1.90 percent, compared with a forecast of 1.928 percent in a Bloomberg News survey of nine of the Federal Reserve’s 21 primary dealers. The bid-to-coverratio, which gauges demand by comparing total bids with the amount of debt offered, was 3.29, versus an average of 3.11 for the past 10 auctions. 


Then there are concerns about Hungary, another euro block country in serious fiscal straits.  Here's an excerpt from New York Times columnist Paul Krugman's blog:

The markets have issued a judgment on Hungary as well. Last week, the forint reached an all-time low against the euro and Hungary was unable to sell short-term government bonds in the markets. Its 10-year bonds must promise a nearly 10% yield, unsustainable over the long haul. . After Europe showed yesterday that it was ready to pressure Hungary into complying with its demands, Hungary’s short-term bonds must now promise nearly the same yield as its long-term bonds, but that is an improvement over not being able to generate any acceptable bids for short-term debt at all. .


Oh, and what about that money that the European Central Bank gave the large European banks at the end of last year to avoid a credit crunch?

Well, it turns out that the banks just took the funds and stuffed them into reserves.  None of them apparently have any interest in resuming lending activities to bolster the European economy:

Banks are hoarding the European Central Bank’s record 489 billion-euro ($625 billion) injection into the banking system, thwarting attempts by policy makers to avert a credit crunch in the region. 

Almost all of the money loaned to 523 euro-area lenders last month wound up back on deposit at the Frankfurt-based central bank instead of pouring into the financial system, according to estimates by Barclays Capital based on ECB data. Banks will use most of the money from the three-year loans to meet their refinancing needs for this year and next, analysts at Morgan Stanley and Royal Bank of Scotland Group Plc estimate.


Now, there are a few hopeful signs:  Spanish and Italian government bond yields, for example, have moved sharply lower after successful bond auctions.

However, the fundamental problems facing the euro zone have not disappeared, despite the fervent wish that they will.

Put another way, the end game has not yet been played.

Thursday, January 12, 2012

Are Hedge Funds the Solution to the Public Pension Crisis?

The investment landscape has been frustrating everyone over the past few years,  particularly for those tasked with coming up with investment strategies for public pension plans.

Bloomberg reports this morning, for example, that the pension actuary for New York City will be recommending that the City reduce its assumed pension return assumption from 8% to 7%.  While this might seem logical - the plan has earned less than 4% per annum for the past decade, after all - it does have significant financial consequences:

New York's chief actuary is recommending that the city’s $115.2 billion pension plans lower their assumed annual rate of return on assets to 7 percent from 8 percent, which would open a funding gap of at least $2 billion next year, according to two people familiar with the proposal. 

The article goes on to note how much pension costs have grown in the past decade:

New York's pension costs have increased to $8.5 billion this year -- including the reserve -- from $1.5 billion in 2002, when Mayor Michael Bloomberg first took office, representing almost 13 percent of the $66 billion budget for fiscal 2012.


One major problem, of course, is the relatively meager return from stocks over the past few years.  Bonds have been a big winner for the past decade, but with interest rates now at 60-year lows it is difficult to make the case that bonds will provide attractive total returns in the next few years.

So alternative assets classes have jumped to the attention of nearly every plan sponsor. But do the alternatives to stocks and bonds actually deliver the goods?

In short:  mostly no.

Take hedge funds, for example. There have been numerous articles and books written recently that fund managers have done a relatively poor job at delivering the returns that the sector once promised.

Writing in Monday's Financial Times, columnist Jonathan Davis cites a new book about hedge funds that has just been published.

Named The Hedge Fund Mirage, author Simon Lack uses his many years of working with hedge funds at JP Morgan to uncover the basic truths about the sector.

According to Mr. Davis, here's the basic thrust to Lack's book:

In fact, concludes Mr. Lack, while many hedge fund managers have prospered from hefty fees, the bulk of their investment gains have not been shared with clients.  On an asset-weighted basis, measuring cash invested to cash returned, hedge fund investors in aggregate, while narrowly beating the average return from equities, would have made more money over the past decade from investing in government bonds, and even from Treasury bills.


There are lots of reasons for the disappointing returns from hedge funds, but one of the biggest reasons is the size of the industry.

When the hedge fund industry was just starting, potential returns could be startling, simply because there was so little competition. Now, with nearly $2 trillion in the hedge fund sector, managers not only are struggling for good ideas, but the shear size of the funds they manage forces them into making large "macro" economic bets which have unfortunately mostly not proven to be successful.

And so the search for investment solutions continues.

Wednesday, January 11, 2012

Will Rising Dividend Yields Woo Back Reluctant Investors?

In 1949, Benjamin Graham published a book called The Intelligent Investor.

Graham - who was Warren Buffett's teacher at Columbia Business School, and is widely cited as being the founder of modern stock security analysis - was attempting to explain to wide audience why at least some of their savings should be invested in common stocks.

He had a tough audience.  As Graham noted in his introduction, fully 80% of Americans surveyed in 1948 thought that common stock investing was too risky for the average citizen. 

This was not too surprising, if you think about.  After the stock market crash in 1929, the market briefly recovered, then collapsed in the wake of the Great Depression. The market recovered during World War II, but the broader market averages were essentially only back to where they were 20 years before.

I remembered Graham's book,  and his survey, when I read this article on Reuters this morning.

Titled "Generation Yikes:  Why Young Savers Are Avoiding Stocks", the piece discussed the fact that younger workers - who should in theory have the longest time frame for investing - are largely shunning the stock market.

According to the article, a survey done by money manager MFS Investment Management found that fully 52% of Generation Y investors (those under the age of 31) say that they will never be comfortable investing in stocks.

The article goes on:

...the MFS survey, which asked investors which asset classes they would deem an "excellent or very good place to invest." The only area on the rise: Safe harbors like bank CDs, savings accounts and money markets. As for stocks, from February to October of last year, that number was sliced in half: Only 18 percent of Americans now see equities as a very good place to put their money.

Judging from fund flows, that dire sentiment is having very real effects on asset allocation. Retail investors pulled almost $37 billion from stock funds in 2010, and more than $101 billion over the first 11 months of 2011, according to the Investment Company Institute.


I'm not suggesting that we are totally in the same situation to the late 1940's - valuations are not as low as they were back then, for example - but there might be some similarities.

For example, stock dividend yields in the 1950's were far higher than bond yields.  No one would think of taking the risk of buying a stock without getting a handsome cash return every year.

So perhaps dividends will begin to increase significantly, as companies are forced to part with some of their massive cash hoards in order to entice more interest in their stocks.

This was the thrust of an article titled "Dividends Rise in Sign of Recovery" in this morning's New York Times.  The author noted that some of best performing stocks last year offered some of the highest dividend yields:

If analysts’ forecasts come true, that trend will continue later into the year, as companies release more of their cash and try to win over investors still hesitant about putting their money back into stocks.

“The idea is beginning to percolate a little bit in management suites that paying a bit higher percentage of your earnings in dividends might be a way to a higher stock price and better benefits for shareholders over all,” said Edward F. Keon, portfolio manager for Quantitative Management Associates.


Although dividend-paying stocks were big winners last year, I think they will continue to be favored by cautious stock investors in 2012.

Tuesday, January 10, 2012

Coin Flips, Samuelson's Problem, and Stock Market Investing

I love this anecdote that Daniel Kahneman wrote about in his book Thinking, Fast and Slow:

The great Paul Samuelson - a giant among the economists of the twentieth century - famously asked a friend whether he would accept a gamble on the toss of a coin in which he could lose $100 or win $200.  His friend responded, "I won't bet because I would feel the $100 loss more than the $200 gain.  But I'll take you on if you promise to let me make 100 bets."

Kahneman goes on to describe why Samuelson's friend was so clever.

The outcome of one coin flip is, of course, a random event.  Over time, however, it will almost certainly be true that heads will come up 50% of the time, which means that:

Matthew Rabin and Richard Thaler pointed out that "the aggregated gamble of one hundred 50-50 lose $100/gain $200 bets has an expected return of $5,000, with only a 1/2,300 chance of losing any money and merely a 1/62,000 chance of losing more than $1,000".

So why am I bringing this up today?

Historically investing in stocks has been a money-winner. According to the brokerage firm Franklin Templeton, looking back over the last 85 years, stock market investors have made money 71% of the time on an annual basis (including 2011, by the way). And for a 10 year period, stock market investors have made money 95% of the time.

The simple solution to investing, then, is to stay invested.

Like Samuelson's friend, you know the longer you play the market, the more likely you are to gain profits.