Investment Lessons from Andrew Carnegie

A little more than a century ago, in 1901, Andrew Carnegie sold his family's interests in its steel enterprises to a group led by J.P. Morgan and Charles Schwab (no relation to the brokerage).

The consortium - which was retitled the United States Steel Company - immediately became the largest corporation in the world, with a market capitalization of over $1 billion.

The sales price was 12x annual earnings (interestingly, about where the S&P 500 is trading today). The total value of the transaction was $480 million, or about $13.7 billion in today's dollars (according to Wikipedia, by way of Gale Virtual Reference Library).

Carnegie's personal share of the transaction was slightly more than $225 million, which was paid to Carnegie in the form of 5%, 50-year gold bonds. According to Wikipedia:

The bonds were to be delivered within two weeks to the Hudson Trust Company of Hoboken, New Jersey, in trust to Robert A. Franks, Carnegie's business secretary. There, a special vault was built to house the physical bulk of nearly $230,000,000 worth of bonds. It was said that "...Carnegie never wanted to see or touch these bonds that represented the fruition of his business career. It was as if he feared that if he looked upon them they might vanish like the gossamer gold of the leprechaun. Let them lie safe in a vault in New Jersey, safe from the New York tax assessors, until he was ready to dispose of them..."

http://en.wikipedia.org/wiki/Andrew_carnegie

What made me think about Carnegie's transaction was how, in some ways, the world is still struggling to find the right combination of safety and yield.

In Carnegie's day, there was no Federal Reserve (which was actually started in 1912). Deposit insurance was unheard of, and bank failures were not uncommon. Government bonds were relatively scarce, and even if they were, the creditworthiness of the United States was not perceived as strong as other countries like Britain or Germany.

So it would make sense for someone looking to preserve great wealth to look for two key characteristics: first, it had to offer an attractive yield (5% sounds pretty good today!); and, second, it had to be absolutely secure (hence the gold backing).

Unfortunately there are no 5% gold-backed bonds available today. Moreover, the only place that investors can find any sort of relatively safe yield is in dividend-paying common stocks.

Bloomberg had an interesting article this morning noting that while dividend yields are attractive, there is plenty of reason to believe that corporate America can raise payouts significantly in the coming years, especially if stock market returns remain subdued:

Pressure is building for higher dividends as U.S. companies from Google Inc. (GOOG) to Valero Energy Corp. (VLO) sit on record cash stockpiles and payouts remain at three- year lows.

Standard & Poor’s 500 Index companies paid 27 percent of earnings in dividends in the second quarter, down from 30 percent in 2008 and below a 30-year average of 41 percent, according to Wells Fargo & Co. Company cash, equivalents and short-term marketable securities jumped 63 percent to $2.77 trillion in the same period, according to Bloomberg data.

http://www.bloomberg.com/news/2011-10-05/dividends-at-three-year-low-mean-pressure-builds-as-cash-rises.html

The article goes on to quote several investment professionals noting the extremely high cash levels that many corporations have stockpiled for fear of a repeat of the credit crisis of 2008.

Put another way, stock buybacks and hoarding cash are in some ways a bull market strategy. Investors have no problem not receiving cash directly from their investments so long as their stock investments are rising in value.

However, with the S&P down more than -17% over the past 5 years, and the papers full of recession talk, it seems logical to expect more pressure on company managements to return more cash to shareholders.

Unless we can convince someone to issue 5% 50 year gold backed bonds.

The Stock Market, or The Real Economy?

This quote appeared in yesterday's New York Times:

"We are coming out of this {recession}, I am virtually certain, " Mr. Buffett said. "I see figures on 70-some companies daily. I have a lot of information coming in and basically everything to with home construction is as bad as it has ever been, and everything else is getting better."

http://dealbook.nytimes.com/2011/10/02/others-go-but-buffett-stays-on-side-of-president/?pagemode=print

The papers are full of talk of the next recession. Economists and analysts are tripping over each other in cutting forecasts. Yet companies involved in business - including Warren Buffett's Berkshire Hathaway - are saying that commerce is actually not all that bad.

Buffett, by the way, was one of the first to say that we were heading for recession in 2008, so his track record on this stuff is pretty good.

Then there's this quote in this morning's Financial Times from Tim Solso, chief executive of US-based Cummins, which is the world's largest independent maker of diesel engines:

"I believe governments and the press have been too pessimist about what's happening in the economy. While I recognize the concerns about excessive public debt in Europe and the US, we {at Cummins} are probably experiencing greater opportunities for expansion than ever before."

Mr. Solso went on to say that Cummins will be hiring 4,000 more employees next year, mostly engineers, or a 10% expansion of their workforce.

It seems to me that the real risk to the global economy is political, not fundamental.

Bank stocks are falling because investors correctly perceive that making profits when yields curves are flat and loan growth anemic will be difficult indeed. Moreover, the growing populist movement against bankers (coming to a town near year you!) makes it unlikely that policymakers will ride to the rescue of banks and brokers as they did in 2008.

Yet if you move away from the financial sector you find that conditions are far from dire. And while the stock markets continue to fall - adding to the gloom on Wall Street - the rest of the world is seeing reasonable growth.

Yesterday the Economist's blog has a good piece about all of this. The article notes that most recent pieces of economic data show an economy that continues to grow. Manufacturing, construction, even auto sales, are all surprising on the upside, defying the doomsayers.

And yet the risk remains that politicians will do their best to snatch defeat out of the jaws of victory:

A global economy with decent cyclical fuel and no obvious imbalances is being betrayed by politics. Policy has pushed us over the brink in the past when it was for our own good (ie, inflation was threatening). If it happens now, it will be the first recorded instance of it happening by obduracy instead of by choice.

http://www.economist.com/blogs/freeexchange/2011/10/economics-v-politics

Thus the challenge for investors: the stock market, or the real economy?

Investing for A College Education

My wife and I took our daughter Caroline for a visit out to the University of Michigan last weekend.

This excursion was a real treat for me. I graduated from Michigan in 1978, and with the exception of a few trips shortly after graduation, have not had the chance to return to Ann Arbor in over 30 years.

Caroline is a senior in high school, and is currently immersed in the college application process. She's also a good student, and is interested in biomedical engineering. We've visited a number of schools over the last few months, and she is quickly narrowing down the list of schools to which she is planning on applying.

(Caroline is also pretty savvy in dealing with her father, and let me know that while she had a very good impression of Michigan, she had not yet made up her mind.)

We had a great weekend, despite the cold weather that had come too early to Ann Arbor. Even my wife - a graduate of Colby College - was impressed, including the experience of attending a football game with 100,000+ Maize-and-Blue fans.

Besides offering a very nice trip down memory lane, the trip was an eye-opener for me in terms of how much the Michigan experience now costs students and their families.

Attending Michigan is not cheap, especially for out-of-state attendees. Michigan estimates that the full cost for one year for someone who is not a resident of the state of Michigan is in excess of $50,000 per year, which puts it in the same expense category as most of the Ivy League and elite East Coast schools.

By comparison, when I attended Michigan in the 1970's, the full cost was $5,000 per year, even though I too was not from the state.

Put another way, if Caroline attends Michigan, we will pay $45,000 more per year for essentially the same education experience as I had 33 years ago.

Michigan and other top-level schools can charge this tuition because there are so many families that are willing to pay this amount.

My alma mater said that it received over 40,000 applications for admission last year. The average GPA for this year's freshman class (which totaled around 6,800 in size) was 3.8 out of a scale of 4.0, and the median board scores were top quartile.

In other words, it seems unlikely that tuitions are going to fall any time soon, since demand for admittance from top-flight applicants is so strong.

The increase in tuition expenses amounts to a growth rate of 7.2% per annum, which is higher than the rate of inflation over the same time period.

So why am I bringing all of this up?

Well, if you have younger children who hopefully someday will attend a prestigious school like UM, you probably are investing money in something like a 529 plan. And you're probably facing one of the most difficult investing environments in the past few decades.

In my opinion, with bond yields below 2%, and cash returns mostly below 1%, the only asset class that will at least offer the possibility of matching the rate of growth in tuitions for the next decade or so is dividend-paying common stocks.

My opinion is really just based on math. The price/earnings ratio of the S&P 500 is around 11x trailing 12 month earnings, which is around the historic average. If stock prices can track the historic book value growth of around 5-6% per year, and dividends remain around 2% or so, it seems reasonable to expect that a longer term return for stocks should at least match the growth of costs of attending college.

In the meantime: Go Blue!

Red Sox, Black Swans, and Sure Things

Red Sox Nation is in mourning today.

Last night, the Red Sox just completed one of the worst - if not the worst - collapses in modern baseball history.

The Tampa Bays Rays - whose payroll is a fraction of the Red Sox, by the way - captured the wild card berth that only a month ago seemed as remote as snow in July.

The New York Times carried an interesting article this morning which put in statistical terms just how unlikely it was that Tampa Bay, and not Boston, would be the playoffs starting tomorrow.

Using data from a statistical sports service called FanGraphs.com, here's how implausible last night's outcome was:

The following is not mathematically rigorous, since the events of yesterday evening were contingent upon one another in various ways. But just for fun, let’s put all of them together in sequence:

The Red Sox had just a 0.3 percent chance of failing to make the playoffs on Sept. 3.

The Rays had just a 0.3 percent chance of coming back after trailing 7-0 with two innings to play.

The Red Sox had only about a 2 percent chance of losing their game against Baltimore, when the Orioles were down to their last strike.

The Rays had about a 2 percent chance of winning in the bottom of the 9th, with Johnson also down to his last strike.

Multiply those four probabilities together, and you get a combined probability of about one chance in 278 million of all these events coming together in quite this way.

http://fivethirtyeight.blogs.nytimes.com/2011/09/29/bill-buckner-strikes-again/?hp

And yet there it is: the Red Sox are out.

My point of mentioning all of this today is not to belabor the obvious pain that Sox fans feel, but more to point out that in investing, just like in sports, "sure things" often turn out wrong.

At the beginning of this year, for example, interest rates were poised to rise, or so most economists believed. By early February 2011, the 10 year Treasury stood at 3.75%, and the sages nodded their collective heads with the wisdom that the bond vigilantes were administering a 2x4 to the US government and its profligate ways.

So now, with the 10-year Treasury now yielding 2%, it would appear that interest rates have fallen against all odds.

Economists like to call improbable events "black swans" after the economist Karl Popper. Popper's insight was that finding all available swans are colored white does not mean that there aren't any swans colored black. Instead, it just means that black swans are less likely than white.

It is the unlikely events - black swan events, if you will - that create the most havoc in the world. By considering the possibility of an event that seems unlikely - a Red Sox collapse, or lower interest rates - opportunities can arise.

Just ask Tampa Bay this morning.

What's Really Driving this Market?

This has been a very frustrating market for managers who pay attention to fundamentals.

Correlation of stock price movements now stand at record highs - nearly 0.9, according to some estimates. This means that the vast majority of stock portfolio returns are currently based on the beta (i.e. volatility) of your stock positions are relative to direction of the markets.

Corporate fundamentals remain reasonably good. Most companies I hear these days are reporting that business trends are favorable. In addition, corporate balance sheets are in very good shape - in fact, one could argue that many companies have too much cash (e.g., Berkshire Hathaway).

Dividend yields on stocks are attractive relative to bonds. Given the large number of well-capitalized companies trading at reasonable valuations and paying a healthy dividend, one would think there would be a rush to stocks.

But that obviously hasn't been the case, because in today's market only one factor seems to matter: government policy.

It has been slowly dawning on me that it could just be that most of the direction of the stock market in the next few weeks will not be driven by earnings or interest rates. Instead, the fate of the eurozone, or the direction of American fiscal policy, will determine returns.

Put another way: if the euro collapses, or if the bailout package is seen as weak or too tepid, the world's stock markets are likely to move sharply lower. On the other hand, a more aggressive move by the major European players could lead to nice stock market gains.

Yesterday, for example, I headed over to the local offices of Merrill Lynch to hear from their health care services analyst. He was accompanied by another Merrill analyst someone whose sole job is to follow Washington politics.

The room was packed. Portfolio managers from all sorts of firms were in attendance: mutual fund managers, institution managers, hedge funds - you name it, they were all there.

However, for nearly an hour, there was only one topic discussed: Washington.

Although initially I was a little frustrated - I was there to hear about stocks - it also became clear most in attendance realized that the opportunity in the health care sector (as well as many other areas) will be dependent not on current company fundamentals, but rather on government reimbursement policies for healthcare.

Here's the way that commentator Dan Greenhaus put it yesterday on the blog Business Insider:

To repeat a story we have been telling for some time now, and repeated last night, market participants serve at the pleasure of policy makers.

While some might argue otherwise, today was yet another example in our opinion... early market gains -- the S&P 500 was up by nearly 3% while the Russell was up by nearly 4.4% - were generated in part by European headlines but so was the late day swoon.

The Financial Times reported in an article titled Split Opens Over Greek Bailout Terms that as many as seven Euro area countries were looking for larger private sector involvement (PSI) in the second Greek bailout.

You can read the story for yourself but one thing is certain; the financials went from being among the market leaders to, ignoring a last minute rally, the worst performer on the day... Easy come, easy go.

Read more: http://www.businessinsider.com/policy-is-whats-moving-the-market-right-now-2011-9#ixzz1ZFvAJ05J

Oh, C'mon Warren, Just Pay A Dividend, Already

Berkshire Hathaway announced yesterday that it was instituting the first ever stock buy-back program in the company's history.

Here' s an excerpt from a Bloomberg story about the decision:

{Berkshire} is authorized to repurchase stock for the first time in four decades as long as its price is less than 1.1 times book value, or assets minus liabilities, according to a statement yesterday. The level is 29 percent below Berkshire’s average of 1.55 since 2000, almost the same discount investors are getting in the S&P 500, according to data compiled by Bloomberg. Shares of Omaha, Nebraska-based Berkshire fell to $100,000 for the first time in almost two years on Sept. 22.

http://www.bloomberg.com/news/2011-09-27/buffett-buyback-shows-s-p-500-passes-berkshire-book-value-test.html

Not surprisingly, Berkshire's stock jumped over +7% yesterday on the news. After all, it's not often that you get a clear message from Warren Buffett that he thinks his company's stock is more attractive than many other alternatives.

Now, far be it from me to question the The Oracle, but my clients and me (all of whom own shares of Berkshire) would have preferred the company to pay a cash dividend instead.

Buffett has authorized a cash dividend only once since he took over Berkshire in the early 1960's. In 1967, Berkshire paid a $0.10 dividend to shareholders, but Buffett quickly ended the payout.

Over the years, Buffett has joked about the decision to pay a dividend: "I must have been in the bathroom" he likes to quip. Since then, for a number of reasons - either tax-related or his own investment acumen - he has been steadfast in his refusal to reinstate the dividend.

But times have changed, and so has his investor base. Yields are paltry everywhere you look, and while I know that his investors can always sell shares to raise cash, it might be just as easy to return a little cash to his loyal investors.

Dividends are taxed at 15% currently - the same rate as long-term capital gains rate. True, in 2013, dividends are scheduled to return to ordinary income tax levels (meaning a maximum of 39.6%, at the highest income level), but at this writing the future of tax policy is uncertain at best.

Berkshire is estimated to have more than $77 billion in cash and cash equivalents at the end of the second quarter (according to Whitney Tilson of T2 Partners, a hedge fund whose largest holding is Berkshire shares). This staggering sum is about 43% of Berkshire's market cap, and could very well be one of the reasons that Berkshire's stock has struggled (after all, why pay a multiple of earnings for a stock that has so much cash?).

Look at this way, Warren: your shareholders will be able to contribute a little more to reducing the federal deficit.

The Pain of Low Interest Rates

The Fed's announcement of "Operation Twist" has gotten mixed reviews so far.

The Fed is attempting to boost the housing market by selling some of its shorter maturity holdings and buying longer maturity Treasury and mortgage-backed bonds.

The hope is that lower mortgage rates will increase the affordability of housing, as well as allowing more homeowners to refinance their existing mortgages.

Problem is, it not clear that mortgage rates are what ails the housing market, as the Washington Post notes this morning:

...Despite historically low interest rates, the very people most in need of the kind of relief that could come from refinancing their homes have found it difficult to qualify.

Even as the Fed undertook new measures, a study released by the central bank this week found that tight lending standards and the continuing drop in home prices prevented 2.3 million homeowners from refinancing last year. A combination of high unemployment, stricter lending requirements enacted after the financial crisis and the sheer number of borrowers who owe more than their homes are worth continues to thwart many Americans from taking advantage of rock-bottom rates.

http://www.washingtonpost.com/business/economy/fed-drive-to-lower-mortgage-rates-may-fall-short/2011/09/22/gIQAMHYirK_story.html?wprss=rss_business&wpisrc=nl_wonk

Investors, meanwhile, are receiving incredibly paltry returns on their bond portfolios. For the life insurers, for example, this is a very serious problem, as Reuters points out:

The Federal Reserve's latest move to stimulate credit for consumers and businesses, known as Operation Twist, is likely to threaten the earnings of some of the country's largest insurers for years to come...

...The problem is that returns on insurers' investment portfolios can't keep pace with the obligations they have accumulated from torrid sales of annuities and life policies over the past few years...

Insurers were demonstrating sound financial management in purchasing long-term bonds with the premiums they collected to balance their long-term obligations. But if the Fed's Operation Twist is successfully executed it will push long-term rates lower and, according to some experts, force insurers to retrench on product sales.

http://www.reuters.com/article/2011/09/23/us-insurance-interest-rates-idUSTRE78K5VL20110923

A long time ago, a very wise investor told me that markets move in the direction that causes the most "pain".

Right now, lower interest rates would be a very painful scenario for most investors, so perhaps that is the direction we're heading.