What Will Be the Effect of Higher Interest Rates on Financial Stocks?

Although bond prices are staging a mild rally this morning in the wake of today's weak employment report, the course of interest rates seems to be undeniably higher.

The yield on the 10 year Treasury note poked above 3% earlier this week for the first time since July 2011. 

The yield on the 2 year Treasury note moved higher than 0.50% for the first time in a couple of years despite recent Fed announcements that point to a continuation of low short term rates for at least another year.

As the chart above shows, financial stocks have been strong performers over the past couple of years.  Using the Financial Sector exchange-traded fund (ticker: XLF), financial stocks have risen over +60% over the past two years compared to +42% for the S&P 500.

Bank stocks have benefited from a number of tailwinds.  Investor sentiment on the group was negative in the wake of the 2008 credit crisis, and valuations were at historic lows.  In addition, with the improvement in housing, mortgage volumes increased dramatically, as did other lending business.

Can the good relative performance continue?

Erika Penala of Merrill Lynch was in town earlier this week to discuss her views on bank stocks.  I have written about Erika on several occasions on Random Glenings, as I find her to be one of the most insightful bank analysts on Wall Street.

Erika pointed out that the effect of rising interests on bank stocks is more nuanced than many investors believe.

She noted that while many believe that a rise on longer term rates are always good for banks, if interest rates on short maturities increase by the same amount or more the effect on banks could be negative.

She distributed a handout titled "Debunking 8 Interest Rate Myths".  While all of her points were interesting, I thought I would highlight three:

• Over 50% of a typical bank earnings are NOT priced off long rates.  The simple view that rising rates on longer maturity assets like mortgages is not necessarily a prelude to robust earnings;
• Rising rates are not always good for bank stocks.  Historical evidence has been mixed, and the sector tends to underperform when short rates rise and outperform when the yield curve steepens.
• Rising interest rates do not always generate more bank revenue.  Bank revenue growth historically has been disconnected from rising interest rates on longer maturity bonds.  In addition, higher long rates could mean lower mortgage banking revenues.

Erika also reported that she had visited Wells Fargo in San Francisco a couple of weeks ago.  Wells is the largest mortgage lender in the United States, but they reported that mortgage volumes have dropped dramatically in recent weeks in the face of higher interest rates. While Wells felt comfortable that other parts of their business should help maintain earnings, there is no doubt that higher rates are hurting.

Checking In on J.M. Smucker's

 
As I mentioned in yesterday's post, I have spent the last couple of days at the Barclays Bank "Back to School" conference here in Boston.

My clients own stock in a number of the companies that presented this year:  Colgate; Procter & Gamble; Coca Cola Enterprises; and General Mills, to name a few.

But one of my favorites is J.M Smucker (ticker: SJM).

Smucker's, of course, is somewhat of an iconic American brand, thanks in part to its commercials which evoke nostalgia for a bye-gone era.  With taglines like "With a name like Smucker's, it has to be good", the company created a homespun image for its jams, jellies, peanut butter and a variety of other regularly used food items.

The company in recent years has undergone a major change in the way it runs its business, mostly for the good.  The stock has been a winner for investors, also, as the above chart shows.  The price of SJM has grown on average of +12.5% for the past five years compared to +10.3% for the S&P 500.

Over the last few years, SJM has bought several brands from Procter & Gamble, including Crisco Oil and Jif Peanut Butter, and managed to re-energize sales in a dramatic fashion.  Jif, for example, is now a $1 billion brand thanks to SJM's marketing initiatives.

The biggest acquisition for SJM in recent years, however, was its purchase of Folger's coffee from P&G in 2008.  I remember hearing SJM talk about the purchase at the 2008 "Back to School Conference".

At the time, SJM management said that while a purchase of this size seemed daunting - the $3 billion price tag was more than the total sales of SJM at the time, and they assumed a considerable amount of debt in the process.

But as I recall, management was very confident they could make the deal work, mostly because they had done their homework.  Management had spent 18 months in the field, learning everything they could about the coffee business. In addition, because they had such extensive experience in the "center of the store" grocery business, they knew how to market what seemed to be a tired brand to a whole new group of consumers.

This is fairly typical of the way the company is run, by the way. There are several generations of the Smucker family that is involved in running the company, and most of senior executives who share the last name of Smucker own a considerable amount of shares.  While they do not own the company, they run it as if it was still theirs, which makes them careful stewards of shareholder investments.

The coffee business has turned out to be another success story for the company.  In our meeting yesterday, management pointed out that coffee sales represent roughly $2.3 billion of revenues, or about 39% of the company's total sales. They have not only re-energized Folgers (focusing on the single serving K-cup that has become very popular in home coffee use) but has expanded its partnership with Green Mountain coffee and Dunkin' Donuts.

SJM is trading today at a significant premium to the S&P 500:  21x trailing twelve month earnings vs. 14x for the S&P.  As much as I like SJM management, buying the stock at today's levels is a fairly large leap of faith.

But as Warren Buffett often reminds us, it is better to buy a great business at a fair price rather than a fair business at a great price. And that might be the case with SJM today.

My Favorite Conference Presentation

The Sam Adams Awaits!

 I have been attending the Barclays "Back to School" conference for the past couple of days.

Every year the analysts at Barclays invite some of the leading consumer products companies to Boston to give presentations and updates on their business.  I have had the chance to hear from executives from Colgate; Procter & Gamble; and Kraft, among others.

However, one of my favorite talks occurred at the end of yesterday's session.  Boston Beer founder Jim Koch (pronounced "cook") gave a talk about the company he started 30 years. 

You may have even tasted his flagship product:  Sam Adams beer.

The craft beer industry has been booming for the past few years.  According to Koch, almost 24% of the beer sold in the United States is craft beer brewed mostly by small brewers.  Only 26% of beer sales in the U.S. are the so-called mass marketed brands such as Budweiser and Miller High Life.  The rest of the beer sales in the U.S. are light beers.

I remember when Koch started the company in 1984. His father and grandfather had both been master brewers. He started his career with the Boston Consulting Group, but soon saw an opportunity in manufacturing a more flavorful ale in the European tradition.  He originally brewed his beer in Pittsburgh, but eventually moved operations back to New England.

Koch went from bar to bar in the Boston area, trying to convince owners to carry his product.  One of his biggest challenges, as you might expect, was avoiding becoming inebriated, and not gaining weight. 

The rest, as they say, is history.  Sam Adams is the largest craft beer in its category, even though it only has a 1% market share of the U.S. beer market.

Yesterday was not the first time that I have seen Koch's presentation, but I always enjoy hearing his updates.

There are several things that make Koch's discussion stand out from most of the other conference presenters.  Most notable, however, is that he starts out his talk by pouring a beer, and toasting the audience.  As he said, "I am glad to see such a large crowd - I hate to drink alone!"

But don't believe for a minute that he is not one smart businessman.  He may stand at the podium sipping a beer and sounding like he is holding court at the local bar, but his stock (and his personal fortune) have been home runs:



It is estimated that Koch's share is now worth in excess of $500 million - not bad for a small brewery.

After Koch made his comments, attendees were invited to go to the back of the room and sample a Sam Adams.  Judging from the crowd in the room, and the happy tenor of the "after party", Koch (and Sam Adams) was a big hit.

Woody Allen On Financial Planning

 

My wife and I went to see the new Woody Allen movie "Blue Jasmine" last weekend.

It is a terrific movie. Allen's story is compelling, and lead actress Cate Blanchett gives an Oscar-winning performance.

Blanchett plays a wealthy New York City socialite whose life has fallen apart.  She moves to San Francisco to be with her sister after it turns out that her husband Hal (played by Alec Baldwin) has stolen millions from his clients, and the couple has lost everything.  I think that Allen based his script loosely on swindler Bernie Madoff, but his story is much richer.



As Forbes columnist Deborah Jacobs wrote in a piece published last month, Blanchett's character made a number of financial planning mistakes that contributed to her downfall.

Here's an excerpt:

7. Don’t sign a joint tax return. That’s the advice one of Jasmine’s friends offers after overhearing Hal talk about a pending business deal. “Every time I hear them, I feel they’re one step ahead of the Justice Department,” the friend says. When Jasmine replies, “I’d sign anything,” the friend chimes in, “It’s called looking the other way.”

What the friend seems to understand, but Jasmine doesn’t, is that filing separately helps protect a spouse from being held liable for the tax evader’s taxes, interest and penalties. If they file jointly, she (assume it’s the wife) might get similar protections using what’s called the innocent spouse defense, but it’s harder to prove.

Still she’s not protected if, as the friend implies, she knew her husband was a crook, Gopman says. That’s a question that affects not just tax liability, but financial responsibility for a spouse’s wrongdoing. Moviegoers wonder whether Jasmine knew her husband was running a Ponzi scheme, just as we’ve debated whether Ruth Madoff was complicit in Bernie’s operation. While babysitting for her sister’s children, Jasmine confesses to no one in particular, “You’d have to be an idiot not to think his phenomenal success is too good to be true.”

http://www.forbes.com/sites/deborahljacobs/2013/08/23/12-personal-finance-lessons-broken-down-in-woody-allens-blue-jasmine/