Wednesday, October 30, 2013

Eugene Fama on Fed Tapering: "It's a Net Neutral"

My wife and I are headed to Charlottesville, Virginia tomorrow to visit our daughter Caroline for the weekend. Caroline is a second year student at the University of Virginia.  My next post will be Monday, November 4.

Nobel Prize winner Eugene Fama was interviewed by CNBC's Rick Santelli earlier this week.

In his usual hysterical fashion, Santelli was trying to get Fama to say that interest rates were set to soar once the Fed ends its "Quantitative Easing" (QE) program.

Problem was, Fama doesn't believe it.

As you will see from the interview, Fama notes that he has been doing research on the possible effects on the credit markets once the Fed starts reducing its holdings of longer term Treasurys.

Fama doesn't believe the markets will be as roiled as Wall Street believes once the Fed stops buying.

He points out that the purchases of Treasurys have been financed by the Fed's borrowing activities in the short term market.  Thus, the $4 trillion in Treasurys that it holds have been financed by $4 trillion in borrowing.  Reducing one side of the ledger also reduces the other side, so the net effect should be relatively neutral.

Here's how Business Insider wrote about the exchange:

Santelli asked specifically about the effects of the Fed's quantitative easing program and the risks associated with it.

"What they are doing... the effects are being greatly inflated by the accounts," said Fama.

"What they've doing is issuing a lot of short-term debt — $85 billion a month — and using it to buyback long-term debt with the goal of lowering the interest on long-term debt," he added. "Now they take credit for lowering interest on short-term debt. But in fact what they've been doing should've raised rates on short-term debt."

Fama argued that the Fed was not affecting the economy that much.

Santelli, however, continued to pursue the idea that there are risks associated with the Fed's actions.

"They're basically neutral events," said Fama. "I don't think they do very much."

Tuesday, October 29, 2013

What's Behind the Slowdown in M&A Activity?

Andrew Ross Sorkin is out with a good column in this morning's New York Times about the lack of mergers and acquisitions (M&A) activity this year.

Sorkin points out that the combination of relatively cheap valuations, low interest rates and record high corporate cash balances would typically lead to an explosion in mergers. 

However, with the exception of a few high profile mega-deals (e.g. Verizon buying the rest of Verizon wireless from Vodaphone), the number of M&A deals are running at the lowest levels since 2005.

As he writes:

“{The lack of deals}  reflects the broad-based loss of confidence in the business community and their inability to make significant capital investment, be it M.&A. or capital spending, in large measure because of the uncertainty of tax and regulatory policy from Washington, D.C.,” said Doug Kass, founder of Seabreeze Partners Management. “Until Washington, D.C., grows more proactive, less inert in policy, this is likely to continue.”

But that may only be part of it.

What if the slowdown in merger activity isn’t cyclical, but secular? What if corporations have learned the lessons of so many companies before them that the odds of a successful merger are no better than 50-50 and probably less? Is it possible that the biggest deals have already been done?

There may be other reasons other than the usual suspects.

Small regional banks, for example, would seem to be ripe candidates for mergers. The costs of being a bank under much more regulatory scrutiny have risen dramatically, while low interest rates have crushed net interest margins.  Yet, as Sorkin points out, "Can you even imagine the outcry if a big bank merger were announced in this postcrisis world?"

David Rubenstein of the Carlyle Group gave an interview to the Associated Press yesterday.

Rubenstein - one of the most astute private equity financiers in the world - thinks that the recent government shutdown added to the lack of corporate confidence necessary to rekindle deal-making.

He also noted that while the official statistics indicate a recovery in the United States, real income growth for many people has been non-existent, creating a huge gap between Wall Street and Main Street.

As far as his world of private equity, he comments that while deal and fundraising activities are dramatically lower, causing the industry to change:

Q: What is the state of the private equity industry?

A: Deal volume is less than half of what it was in 2007 and fundraising is now 46 percent of what it was. One bright spot is that distributions (to investors) have just about fully returned to their pre-recession peak.

As a result, the private equity firms have also re-tooled themselves. There is much more hands-on work with the companies than there ever was before, and far less financial engineering.

A number of the firms have gone public as well. While they're not household names, they are now publicly traded and operate in a different model than they ever did before. You also see much more emphasis on investing outside the U.S.

The one bright spot in all of this may be from a contrarian standpoint, as Doug Kass says in Sorkin's New York Times piece:

And while mergers may be a good barometer of boardroom confidence, Mr. Kass says it is a poor indicator of the economy and the market.

“Never lose sight that business leaders are much like retail investors,” he said in an email. “They buy (invest and take over) high and sell low! As such, and based on history, they are very lagging indicators.”

Monday, October 28, 2013

The Big Winner in Obamacare: Healthcare IT?

A couple of weeks ago I met with a very smart client who happens to work in the healthcare field.

We were discussing which areas, if any, would be the ultimate financial beneficiaries of the implementation of the Affordable Care Act a.k.a. Obamacare.

The news for most sectors seems to be mixed.  The pharmaceutical companies, for example, will probably benefit from more product demand.  However, with the government becoming even more involved with drug pricing, and the continued push towards generics, the new law will probably be a net neutral for Big Pharma.

The same could be said for most of the other areas of health care - hospitals, medical devices, and so on.

However, my client strongly felt that healthcare information technology (IT) - delivering quality care to patients more efficiently - would be a huge beneficiary.

This is not a new concept, of course.  The stocks of companies involved with providing IT systems to the healthcare system have soared in recent years, as you can see from the chart of healthcare IT industry leader Cerner above.

Yet my client felt that the improvements in healthcare IT were only beginning.

Doctors and other medical professionals are constantly challenged to get a full picture of a patient's medical history, often under stressful situations.  Integrating a wide variety of different systems to get crucial information needed for diagnosis and treatment is a massive challenge.

Forbes carried an interesting piece written by Greg Satell pointing out that improving healthcare IT is not simply a matter left to the technology field. 

Sharing information is vitally important to making the system work, for example, yet often there is a reluctance to make past medical history available.

In addition, highly trained medical professionals are often reluctant to work with computer programs like IBM's "Watson" - which is perhaps the world's most advanced cognitive computing system to date  - in making diagnostic and treatment decisions.

Yet many are arguing that this is a crucial step to delivering better medical results in a more cost-efficient manner.

Here's an excerpt:

We like to think of innovation being solely about great ideas and technology, but social networks are just as important.  As Sandy Pentland, one of the world’s most foremost data scientists puts it,  “We teach people that everything that matters happens between your ears, when in fact it actually happens between people.”... the years to come we will all have to learn to collaborate with machines. What we have come to regard as expertise is really the ability to recognize the patterns specific to a particular field and pattern recognition is something that computers are beginning to excel at.

Dr. {Lynda Chin of MD Anderson Cancer Center} sees technology taking the medical profession in two directions. First, she sees that time researchers now spend on information processing—a task that humans are notoriously bad at— will be spent imagining how they can push the envelope.  Second, clinical physicians will be able to focus more on human interaction with patients.

Friday, October 25, 2013

"I'm So Bearish I'm Bullish"

The title of today's post comes from Michael Hartnett, chief investment strategist at Merrill Lynch.

As I mentioned earlier this week, I went to see Hartnett on Tuesday when he gave a lunch presentation to a packed room.

I have written about Hartnett's views on several occasions, so I am obviously a fan.  While his work is less quantitative-driven than several other analysts, he does have a unique way of turning macro trends into interesting market thoughts.

His theme recently has been "I'm so bearish, I'm bullish".

Hartnett points out that while Wall Street mostly recovered from the credit crisis, Main Street America continues to struggle.  Real income growth has been negligible, and the unemployment rate remains stubbornly high.

This means that Federal Reserve policy will remain very accommodative. Heir apparent Janet Yellen seems to favor the current Bernanke policies of using monetary policy to try to increase employment.

Meanwhile, corporate America seems to be doing just fine.  Record profit margins have continued.  Corporate cash surpluses represent about 2% of GDP according to Hartnett, which is also at record levels.

In fact, Hartnett views can best be summed up by this quote that I saw on the blog Business Insider:

"If the central bank stays accommodative and earnings keep doing what they’re doing, why not?"

That's from Dan Greenhaus of BTIG from his latest note to clients....

There aren't any huge, obvious risks on the horizon (Europe isn't blowing up, the U.S. fiscal fights have been pushed back and the GOP probably won't take a stand the way they did this month). Earnings are doing fine and there's no inclination that any major central bank is in the mood to tighten policy.
So obviously the thinking is to buy stocks. Why not?

Besides being bullish on equities, Hartnett sees real estate being a winner in the next couple of years.

On the other hand, he thinks that interest rates will gradually increase over the next 18 months as more signs appear that the global economies are finally showing signs of strength.  Such an environment would obviously be bad news for bonds.  Rising U.S. interest rates would also increase the value of the dollar, which would be negative for emerging market stocks as well as gold.

Thursday, October 24, 2013

In the Long Run, Everything is a Toaster

I loved the way that John Authers started his "Smart Money" column in this morning's Financial Times:

In the long run, everything is a toaster.  This is one of the more memorable lines delivered by Professor Bruce Greenwald, who teaches the class in Value Investing at Columbia Business School that was once taught by Benjamin Graham, and taken by Warren Buffett.

The comment is a classic put-down by value investors against the overhyped hopes of rival "growth" investors.  Great innovations may make money for a while, they say, but eventually they will be commodified and compete on price, like everyone else - much like a toaster.

Authers goes on to discuss how Cisco - the router company that once sold at a multiple of 200 times earnings in the height of the dotcom bubble - is now trading at a discount to the S&P 500 (15x vs. 18x for the broader market index).

At the same time, Authers points out that Cisco is a much stronger company than it was a decade ago.  It pays a dividend, tells investors that it has more capital than it needs, and strengthened its core business.  In short, it has all of the attributes that a true value investor would typically desire, yet few seem to have any interest.

Cisco is only one of any number of tech companies that trade at very attractive multiples.  Apple and Microsoft are available for only 12x earnings, pay attractive dividends, and continue to put up growth rates that most of corporate America would envy.  IBM is offered at less than 10x, pays a dividend, yet has been widely panned by Wall Street for delivering third quarter results below Street expectations.

Meanwhile, over in the consumer staples space, tepid growth is rewarded with high multiples.  Coca-Cola, for example, trades at a multiple that is nearly 50% higher than large cap tech, yet it growth rates are projected to be less.

Why the anomaly?

I thought Authers captured it well in his last paragraph:

Big technology companies, with their high public profile and large market caps, are unusual candidates to be value stocks. But in this case, the value may be hidden in plain sight.  Either way, it is time to consign the dotcom bubble to the history books.  Technology has matured, and the market looks as though it may have exaggerated the extent to which it has matured. There is good reason to expect more interest from value investors in large technology stocks.

Wednesday, October 23, 2013

The Mind of a Short Seller

Jim Chanos
I was going to write a post about seeing Merrill Lynch's global strategist Michael Hartnett yesterday.

However, the Financial Times this morning carried a link to an article from the Yale Alumni Magazine about famed short seller Jim Chanos.

It's an interesting read, and so thought I would bring it to your attention.*

I have never been comfortable betting on stocks to move lower.  Shorting a stock not only requires being right on the fundamentals, but having the intestinal fortitude (and financial resources!) to have the prices move higher even though "they shouldn't".

If you buy a stock, and it moves lower initially, a true investor is not worried.  Stock prices never move in a straight line, and investing for the long term has historically been a profitable enterprise.

Not so with selling short.  Stock prices can't move lower than zero, but they can go up a great deal.

Most business school students learn the story of famed short seller Robert Wilson who once lost millions in the 1990's shorting Resorts International when he got squeezed out as the stock rose from $5 a share to $190 a share (Wilson, by the way, went on to a fabulously successful career).
Finally, I am basically an optimist by nature, so hoping something goes wrong is contrary to my personality.

Chanos is different, as this article points out.  Not only is he willing to do the analysis and legwork necessary to ferret out opportunities, but he is emotionally tough enough to be able to hang on to positions which may not work initially in his favor.

He has been fabulously successful selling stocks that he doesn't own.  After nearly losing his job early in his career when a short sale recommendation initially went higher (but eventually went to zero), Chanos today manages $5 billion, and earns millions for himself in the process.

Here's an excerpt:

Though Chanos doesn’t put it quite this way, short-selling goes against some of the most basic proclivities of the financial marketplace—not to mention human nature and, some would say, God. It is an article of faith among investors that stock averages rise over the long term, and even market professionals tend to believe that their own chosen stocks will turn out, like children in Lake Wobegon, to be above average. Moreover, for those who go long—that is, buying and holding stocks—the potential gain is limitless (at least in theory), while the potential losses are limited: once a stock hits zero, you can’t lose any more on it than you’ve already lost. The really treacherous thing about short-selling is that it works the other way around. It’s the losses that can be limitless. And the agony can go on for months or even years as a bad company, puffed skyward by a charismatic CEO and a chorus of fawning analysts, ascends into the stock market heavens.

Beyond the financial pain, short-selling also exacts a psychological toll. Stock markets are “giant positive reinforcement machines,” says Chanos, and they’re built for the sole purpose of selling stocks. “So almost everything is positive, everything is bullish.” For short-sellers, that means the rest of the market is constantly shouting (sometimes literally and in the most personal terms) that they are wrong. And studies show “that people’s rational decision-making breaks down in an environment of negative reinforcement,” says Chanos. Good short-sellers “drown it out. It means nothing to them. But I think most people can’t do that.”

*Please come back tomorrow to read about Hartnett's latest thoughts.

Tuesday, October 22, 2013

Investors Are Paying A High Price for Dividends

courtesy:  Mebane Faber Research
Most Wall Street strategists agree on the overvaluation of high dividend paying stocks.

One of the more obvious sectors that seem vulnerable would be the utility group.

The fundamental outlook for much of the utility industry looks weak, in my opinion.

Investor demand for companies that pay above-average dividends from a relatively stable source of earnings has spurred the utility sector to near-record high valuations:

Meanwhile, the industry is facing challenges on many fronts.

Growth in electricity use has been tepid, despite most improvements in the economy.

If interest rates rise next year, as many expect, utilities will fare poorly.  Higher bond yields would present stiff competition to utility stocks.

Regulators are looking hard at the utility allowed rates of returns, and in several cases have already pushed returns lower.

Capital demands to meet new environmental standards has also been high in recent years.

Finally, the price of alternative energy sources (notably solar) have fallen dramatically in recent years, making cleaner generating power competitive with traditional sources.

I asked UBS's electric utility analyst Julian Dumoulin-Smith yesterday if there is still a bull case to be made for his group.

As a group, no, Julian responded. 

There are a few special situations that might be interesting.  He likes Northeast Utilities (ticker: NU) due to its strong position in transmission.  He also likes Duke Energy (ticker: DUK) due to its friendly regulatory environment, as well as the coming divestiture of Duke's Ohio generating operation.

But in general Julian was unenthusiastic about the stocks in his group.

That said, it is not just the utility sector that is trading at historically high multiples.  Many consumer staples stocks, as well as a few telecommunications stocks, are also trading at relatively rich valuations due to their attractive dividend yields.

Take a look at the chart above courtesy of Mebane Faber research.  Dividend stocks all generally screen as unattractive yet investors do not seem to care.

For now.