What's Ailing Utility Stocks?

Last year, in 2011, utility stocks were the best performer in the S&P 500, returning almost +20% (including dividends) while the S&P produced a meager +2.1%.

This year, however, it has been a completely story.  As the above chart shows, utilities have badly lagged the broader market averages.  In fact, through the end of October 2012, the utility sector had been the weakest performer in the S&P 500 - a complete reversal from last year.

So what's going on?

Historically utility stocks have not fared well when interest rates have risen.  However, rates have generally fallen in 2012 - the 10 year Treasury yield was 1.9% at the beginning of the year, versus 1.7% today.

Could it be a potential rise in dividend tax rates?  Well, maybe.  Hugh Wynne at Bernstein wrote a piece earlier this week suggesting that the market is beginning to realize the negative impact that a rise in dividend tax rates will have on regulated utilities.

As a reminder, if Congress does not act before the end of the year, the maximum rate on dividend income will rise from 15% to 43.4% (39.6% top income tax bracket plus the 3.8% Medicare tax on investment income).  Capital gains rates, meanwhile, will rise from 15% to 23.8% (20.0% capital gains tax plus the 3.8% Medicare tax).


Wynne notes:

• The expiry of the Bush tax cuts would create a 20 percentage point wedge between the tax rates on dividends and capital gains.
• Regulated utility stocks, which historically have returned ~2/3 of their total returns to shareholders in the form of dividends, will be much more adversely affected by this change than other sectors with lower payout ratios and yields.

https://www.bernsteinresearch.com/brweb/view.aspx?eid=u7Z1B1htMAnFu7gmVhHogkrNuVKyiTFq34WWpP%2bEvXa2EQg7oZL2TSh7pODQdW75

Wynne goes on to write that his calculations suggest that regulated utility stock could fall by as much as -20% from today's levels in the worst case scenario.

I'm not sure I agree.  Telecommunication stocks (AT&T and Verizon) have been strong performers this year (up +15% YTD) and they too are usually bought for their healthy dividend yields. Other sectors that contain high dividend payers such as consumer staples stocks have also turned in a respectable performance this year.

I would suggest that the threat of increased regulatory pressure on utilities is weighing heavily on the stocks this year.

If you look at the chart above, the path of the performance of the group almost directly matches the tug of war between the two Presidential candidates.  In particular, the spike in utility stocks matches very nicely with the bounce in the polls that Governor Romney enjoyed after the first Presidential debate.

But more recently, with the re-election of President Obama, the stocks have moved sharply lower.  Correctly or not, the Obama administration is widely viewed as being anti-coal.  Since half of our nation's electricity comes from coal-fired plants, perhaps the markets are anticipating tougher new environmental regulations in 2013, which will put significant cost pressures on the companies.

In short, the combination of higher dividend tax rates, and more regulation, have made 2012 a tough year to be an investor in utilities.

Beating Those Post Election Blues

As you might imagine, I've been getting lots of calls today about the investment implications of the elections. 

Wall Street is already casting its verdict - the market is down almost -2.5% this morning, making it one of the largest drops this year.

I have been urging clients to focus on what we actually know, and not on fears of what may or may not happen in an Obama second term

As we approach the close of the third quarter earnings season, there has been a constant theme of "miss on revenues, beat on earnings" from corporate managements.  Most commentary has been cautious, as would be expected, but the actual data has been encouraging.

Here's what Merrill Lynch wrote earlier this week:

3Q earnings update: EPS exceeding both our & analysts' ests. 

Last week, 105 S&P 500 companies reported results, bringing the total to 378 (or 82% of 3Q earnings). More companies posted positive EPS surprises in Week 4, with the majority of companies in Consumer Discretionary, Consumer Staples, Financials, Health Care and Tech all beating analysts' bottom-line forecasts....

Unless EPS results deteriorate meaningfully from here, 3Q will no longer see a YoY EPS decline, which would have been the first time this occurred since 2009. Additionally, Non-Financials earnings are now only expected to decline only 1% YoY this quarter, compared to expectations of a 3% decline when reporting began. 

…and revenue beats picked up a bit in Week 4 

Overall, 52% of companies have beaten on EPS, 37% have beaten on sales, and 26% have beaten on both. Reporting trends improved across all categories in Week 4, with 53% beating on EPS, 41% beating on sales and 29% beating on both.

http://rcr.ml.com/Archive/11219467.pdf?w=dglen%40bpbtc.com&q=dvz3yf6ovJTfYXx3MdyaFA&__gda__=1352306518_ff41abffd72394e830fe65e2e8ba9457

Housing is clearly picking up, and auto sales remain robust.  U.S. energy costs remain among the lowest in the world, and U.S. wages are also competitive. Corporate America is in good shape.

Stocks are also reasonably valued relative to history.  However, compared to the alternatives - bonds and cash - stocks remain incredibly attractive.

Dividend yields on many high quality companies are higher than most investment grade corporate bonds, offering appeal for income-oriented investors.

Company balance sheets are stuffed with $1.6 trillion of cash reserves, which not only will act as a buffer for any economic downturns but also could be a catalyst for M&A activity.

Finally, regardless of how you voted yesterday, it is worth noting that Obama has actually been pretty good for stocks.  The S&P 500 has more than doubled from the time he took office, albeit off a very depressed base.  Despite what might have been said during the campaign, there doesn't seem to be a lot of evidence that he is anti-investor.

It is also good news, in my opinion, that Ben Bernanke will finish his second term. The Fed Chair has been a friend to the investor, even if his policies were not necessarily targeted to the stock market.

Governor Romney had indicated that he would have replaced Bernanke, but it would now appear that Bernanke will stay in place for a couple more years at least. Short term interest rates will still low until at least 2015, and the monetary spigots will remain wide open.

My real concern is that fact that nothing has really changed in Washington: Democrats control the White House and the Senate, while Republicans still are the majority in the House.  The lack of bipartisan cooperation makes the danger of the "fiscal cliff" more real, with its concomitant negative impact on the economy.

Hopefully cooler heads will prevail, and some sort of budget agreement can be reached before year-end. 

Will The Rails Continue To Chug Along?

Yesterday I went to hear Ken Hoexter, transportation analyst at Merrill Lynch.

I have written about Ken on several occasions on this blog, and for good reason. He has been following the rails, truckers and shippers for years, and has made a number of good calls on the stocks.

In March 2009, for example, while the investment world was focused on the immediate economic problems, he upgraded the whole railroad sector, and the stocks subsequently doubled or tripled in value.

Ken has remained steadfastly bullish on the rails since 2009, and I was curious as to whether he was having any second thoughts at this juncture.

The short answer: No.

Ken remains a fan of rail stocks, but is being slightly more selective. He particularly likes Union Pacific and Kansas City Southern.  CSX has struggled due to its reliance on coal shipping (utilities continue to have large stockpiles of coal due to last year's warm winter weather) but Ken thinks the stock is cheap enough (trading at 10x P/E) to warrant investor attention.

The rail story is pretty straightforward.  Shipping by rail remains the most fuel-efficient way to move cargo, rail revenue has remained steady despite the uneven pace of economic growth.

More importantly, however, is the fact that all of the rails have become vastly more efficient when it comes to their operations. The internet allow the rails to optimize their use of their fleets, so that cars and engines are almost constantly in motion, and fuel use is optimized.  In addition, greater use of automation means less wage pressures.

Over the past 6 years, Ken noted, the rail industry has made over 800 basis point improvement in their operating ratios.  This trend is expected to continue.  As recently as 2008, for example, Union Pacific had an 77% operating ratio. In 2012, UNP's operating ratio will be 68%, and management told analysts a couple of weeks ago that they expect to be at 65% within the next couple of years.

From a shareholders vantage, this is obviously good news. As long as revenue trends remain reasonable, earning will continue to move higher.

I asked Ken:  What would make you change your bullish stance?

Ken replied that he would become concerned if competition among the rail companies pushed pricing to less profitable levels.  Most rails today quote their customers an annual rate increase around the rate of inflation, plus a little more.  If this pricing discipline goes away, Ken said, it would change the attractiveness of the group.

But for now:  Get on board!

Seth Klarman On Value Investing

Most investors have never heard of Seth Klarman, but if you are in the investment business you almost certainly have.

Mr. Klarman's hedge fund (named "Baupost Group") manages $27 billion, making it the ninth largest hedge fund in the world.  He is a classic value investor, looking for companies that are selling well below what he and his colleagues think they are worth.  Once he makes an investment, he typically will hold onto a position for years.



Here's what the Economist wrote about Klarman in July 2012:

HEDGE-FUND bosses rarely double as cult authors. But an out-of-print book by Seth Klarman, the boss of the Baupost Group, sells for as much as $2,499 on Amazon. A scanned version of “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor” has been circulating around trading floors. One hedgie likens Mr Klarman's book to the movie “Casablanca”: it has become a classic.

 

 

Why are Wall Street traders such avid readers of Mr Klarman? Baupost, which manages $25 billion, is the ninth-largest hedge fund in the world. Since 2007 its assets have more than tripled, as other funds have wobbled. Baupost has had only two negative years (in 1998 and 2008) since it launched in 1982, and is among the five most successful funds in terms of lifetime returns (see chart), a particularly striking record given its risk aversion. Long closed to new investors, Baupost counts elite endowments like those of Yale, Harvard and Stanford among its clients.

http://www.economist.com/node/21558274 

Klarman rarely gives interviews, but he did an appearance with Charlie Rose last fall that is worth a look.

While I think the whole interview was interesting, I was particularly struck by how much emotional discipline seems to play in his work.  Once he makes an investment, he professes to be unconcerned about its subsequent price movements.  In fact, Klarman says, he does not even have a Bloomberg terminal on his desk.

Klarman quotes one of Warren Buffett's famous quips. Stocks are one of the few things in the world that people want to buy but then get upset when the prices move lower.  To people like Klarman and Buffett, lower prices present an opportunity for investors with the discipline to not allow the market to dictate their behavior.

Klarman also notes that investor timing is too often determined by their mood.  The average investor rarely achieves the same results as the funds in which they invest because they tend to buy when times are good, and sell when the outlook turns sour. This, Klarman says, is the direct opposite of how investors should behave.

In a period that seems fraught with uncertainty and worries - fiscal cliff, Euro worries, economic weakness - Klarman's advice certainly resonates.

Corporations Continue To Stockpile Cash

source: The Economist

According to Merrill Lynch, European stocks are trading at historically cheap levels:  11x  P/E, with a dividend yield of 3.9%.

Only stocks in the "BRICs"(Brazil, Russia, India and China) trade at cheaper levels.

By comparison, the U.S. market is trading a 13x P/E, and a dividend yield of 2.2%.

In other words, despite a +20% rally since June 1, stocks in Europe continued to trade at depressed valuations, reflecting the continent's somber mood.

When stocks are trading at such low levels, and if corporations have sufficient cash, you would expect a wave of corporate stock repurchase programs. Share buybacks are a way for companies to return cash to investors without having to increase dividends.  In addition, share buybacks boost a company's earning per share during times when other projects may not offer much appeal.

But according to the Financial Times this morning, European managements would rather stockpile cash reserves earning little or no interest rather than try to boost the share price of their companies.

Here's what the FT wrote:

The total amount of announced buybacks across Europe in the 12 months to the end of October stood at $590m, compared to $2.8bn this time last year, Thomson Reuters data showed.  This is close to 2009 lows of about $400m and pales in comparison to pre-crisis peaks of $3.8bn. At the end of the second quarter earnings season, the total for the preceding 12 months was just over $800m.

http://www.ft.com/intl/cms/s/0/0b39dde0-240e-11e2-94d0-00144feabdc0.html#axzz2B4TDSdDW

According to the latest issue of the Economist, European companies are not alone in their caution. Across the globe, corporations are sitting on huge stock piles of cash, preferring to err on the side of caution rather than be caught short as many were in the 2008-09 credit crunch.

Here's what the Economist writes:

Japanese companies’ liquid assets have soared by around 75% since 2007, to $2.8 trillion, according to ISI Group, a broker. Cash stockpiles have continued to grow in Britain and Canada, too, to the immense frustration of policymakers there. “Dead money” is how Mark Carney, the Bank of Canada’s governor, has described the nearly $300 billion in cash Canadian companies now hold, 25% more than in 2008. Mr Carney admonished them to “put money to work and if they can’t think of what to do with it, they should give it back to their shareholders.”

http://www.economist.com/news/finance-and-economics/21565621-cash-has-been-piling-up-companies%E2%80%99-balance-sheets-crisis-dead?frsc=dg|a

Unlocking at some of these worldwide cash hoards could potentially lead to a significant boost in global economic growth, and more stock market gains.

But the prevailing depressed mood among global CEOs makes that unlikely to occur any time soon.

Who Makes Money in Alternative Investments?

Fellow portfolio manager and occasional Random Glenings reader Rich Sipley passed along an article to me that appeared in Tuesday's New York Times.

As I have written several times on RG, returns on hedge funds have generally not met expectations.  The "silver bullet" of alternative investments as a panacea to under performing expectations has not materialized, and investors are getting restless.

The article that Rich sent me discussed the move by a prominent hedge fund named the Endowment Fund to limit shareholder redemptions.

The Fund - started in 2003 by Mark Yusko, former chief of the endowment for the University of North Carolina at Chapel Hill - has delivered disappointing returns, which has lead to a investor clamor for their capital.

How have the numbers been?

Here's what the article says (I have added the emphasis):

For the 12 months ending late August, the fund was down 2.5 percent, compared with an 18 percent gain in the Standard & Poor’s 500-stock index and a 0.9 percent decline in the average hedge fund. Over the last five years, the Endowment Fund returned 5.7 percent annually, lagging the 7.7 percent gain by the S.&. P. 500 and the 7.3 percent annual gain by the average hedge fund. 

http://www.nytimes.com/2012/10/31/business/endowment-fund-run-by-mark-yusko-limits-withdrawals.html?pagewanted=all

Redemption's move to reducing the ability to redeem assets - called "gating" in industry speak - is one of the first in the industry, but may not be the last. Investors were promised better investment returns in return for less liquidity, but as the returns have lagged the move to head to the exits has grown.

If gating becomes more common, this could create a major public relations industry for the industry, if not reduce the attractiveness of alternatives.

Rich has noted that I have written several pieces in the past questioning the investment merits of alternative investments.

For example, in a note I wrote on July 12, 2012 (http://randomglenings.blogspot.com/2012/07/dumb-money-hedge-funds-cant-even-beat.html)  I highlighted a news report published on the CNBC website on the poor recent returns of the hedge fund community:

They are supposed to be the smart money—the best of the best—yet they can’t even beat a basic Treasury bond fund. 
 
Hedge funds as a group are badly underperforming this year, which could lead to a series of redemptions, closings and rethinking of the lofty fee structures the managers of these alternative vehicles enjoy.

The Bank of America Merrill Lynch global diversified hedge fund composite index returned just 1.3 percent in the first half of 2012, well below the S&P 500’s 8.3 percent gain.

Funds that focus on betting against stocks performed the worst, falling 7.1 percent as a group, according to the report.

http://www.cnbc.com/id/48137300

So who makes money in alternative investments?

Returning to the Times article:

But the fees investors have paid the Endowment Fund for its lukewarm performance have been considerable, up to about 3.5 percent a year. Additionally, the underlying funds can receive as much as 25 percent of any profits they make. 

On top of that, some of the fund’s investors who came in through Merrill Lynch financial advisers may have paid as much as a 2.5 percent upfront fee, similar to what is charged for other funds, according to internal Merrill Lynch documents.

To be sure, it is easy to criticize any manager for underperformance.  However, when you are taking a 3.5% annual fee, and 35% of any profits, and still not delivering on performance, it seems clear who the real winners are in the alternative investment universe.