Friday, August 31, 2007

The Fair Value of the Dow Jones Industrials --Too Cheap

By Greg Donaldson and Mike Hull

By our reckoning the stock market, as measured by the Dow Jones Industrials, is significantly undervalued, maybe as much as much as 13-15%. We make this call based on the readings of our Dividend Valuation Model using the most recent data available.
The chart at the right shows the model going back to 1975. The blue line is the average annual price of the Dow and the green bars are the model's predicted values. The model uses only the dividends paid by the 30 companies in the Dow and long-term high-quality bonds.
We have previously explained that we believe the model has done a good job of indicating when the market was cheap and when it was dear.
Until the early 1980s the model indicated that values remained flat. This was a period when interest rates were shooting higher, and their ascent overwhelmed the modest dividend growth during the period.
During the mid to late 1980s and early 1990s the model said the market was undervalued, which turned out to be correct. Prices and values came into equilibrium in 1994 and 95, before prices went off into their tech fit -- and the model refused to go along.
Since the end of 2002, the model has signaled that the market has been undervalued.
The model's exact reading as of today is 13,980. That is based on dividends paid thus far in 2007 by Dow companies and interest rates at their current level. But this coincident pricing is not the way that the stock market operates.
During normal times, the market discounts what it can see, which is normally a year or so ahead. If we add in our projections of dividends and interest rates for he next 12 months, we arrive at a total return for he Dow of just over 14%. This would include the catching up of the current undervaluation and then achieving a fair value on next year's growth.
We think this is very possible if the Fed begins to cut rates. Importantly, we believe that kind of rate of return will come sooner rather than later, once the Fed makes it first rate cut. Think of it as being front loaded.
Our best guess is that the current gyrations in the stock market and headlines of this doom or that will provide cover for a new leg of the bull market that began in 2003 to begin.
We cannot see the future better than anyone else, but we are students of the past and that is how markets usually react, once a crisis is beginning to wane.

Sunday, August 26, 2007

Dividends Do it Again

The recent meltdown of the subprime mortgage business has caused stocks in the US, as measured by the S&P 500 Index, to fall by 1.9% over the last 30 days. That return, however, as poor as it is, is mild compared to the return of the average stock in S&P 500 Index, which has fallen 3.7%. This disparity between the rate of return of the Index itself and that of the average stock in the Index means that stocks with higher market capitalizations have performed better during the sell off than smaller members of the Index. In addition to the larger companies doing better than smaller companies in the index during the last 30 days, the rates of return by dividend yield is very telling. Indeed, breaking the 500 stocks into quintiles shows a remarkable inverse relationship between dividend yield and average loss.
  1. Top 100 highest yielding stocks -1.4%
  2. Next 100 highest yielding stocks -2.8%
  3. Next 100 highest yielding stocks -3.6%
  4. Next 100 highest yielding stocks -3.6%
  5. Lowest 100 yielding stocks . . . . . -7.1%

The inverse relationship is very tight with stocks with the lowest dividend yields performing the worst and stocks with the highest dividend yields faring the best.

One might conclude that this is the way it ought to be because higher yielding stocks are more mature and usually more creditworthy, but that would miss the point that many REITs and Banks are included in the highest yielding quintiles, and these sectors, initially, took a solid thumping before recovering.

My conclusion is going to sound familiar: dividend paying stocks are easier to value because a good portion of their rate of return is produced by their dividend, thus, in a manner of speaking they are more transparent.

Speaking of transparent, that will be the key word to describe the recent subprime mess. Too many companies were more deeply involved in the subprime market of one variety or another than they disclosed in their quarterly and annual reports. When management is playing fast and loose with their shareholders' capital and not disclosing it, it is a breech of trust and they deserve to be fired without benefit of the usual golden severance package. I'll have more to say on this in the coming weeks.

Friday, August 24, 2007

Barclays is Cheap

After Wells Fargo and Bank of America raised their dividends in early August by 12% and 14%, respectively, we said it was a clear sign to us that they were not in the eye of the storm of the subprime problems, and their stocks were too cheap.

The chart at the right shows that both stocks have recovered smartly over the last two weeks, as it has become clear that, indeed, neither is likely to take big losses. As we write this, however, we believe both stocks may be still as much as 15% undervalued based on the long-term relationships between their dividend growth, interest rates, and their stock prices.

We want to add another stock to the list of banks that we believe has been unfairly punished by the recent liquidity crisis. Barclays Bank is a London-based bank with offices spanning the globe. They have three world-class divisions: banking, capital markets, and asset management (ishares Exchange Traded Funds).

The stock has fallen by nearly 20% over the last 60 days on fears of Barclay's involvement with sub-prime loans, private equity, and hedge funds. There is no way for us to know their precise exposure to these groups, but the company has repeatedly stated that they are not experiencing any large scale losses.

Barclays recently raised their dividend by nearly 18%. A dividend hike of that magnitude is real money since they now yield over 5%.

The chart at the right is Barclay's Dividend Valuation Model. The blue line is the actual annual price over the last 15 years, and the green bars are the model's predicted values. The chart shows a close association between the model and prices over the last 15 years and a predicted 2008 value of just over $55.

From today's price of approximately $49, including the dividend, our model is suggesting that Barclay's may be even more undervalued than BAC or WFC.

Barclays has been in business since 1736. With that kind of longevity, we believe they might know a thing or two about how to navigate financial storms. Their AA bond ratings ensures access to the capital markets and minimizes liquidity issues.

The bank has been in a pitched battle with the Royal Bank of Scotland to acquire ABN Amro, a Dutch banking giant. We believe that the market is worried that Barclays may be dragged into a bidding war. In our minds, Barclays had done a lot of things right over the past 270 years. We're inclined to follow with their judgment with ABN Amro.

Tuesday, August 21, 2007

Energy: The New Y2K -- Boeing, Toyota, and United Technologies

While we are grappling to understand the height, width, and breadth of the mortgage crisis, another crisis that we have detailing has fallen off the front pages: the energy crisis. Here's why we have been describing energy as the next Y2K:

  1. 9-11 was a harsh lesson in the Islamists' visceral hatred of our Western way of life, and the fiendish extremes to which they would go to harm us.
  2. The internecine fighting in Iraq, if anything, should be a constant reminder that the terrorists seek to destroy anyone who stands in their way, even their own people.
  3. Katrina showed how fragile our refining and energy distribution systems were.
  4. Too much of the American, yes the Western, way of life is held hostage to energy; and too much of the world's energy supply is in countries who hate not just Americans, but any country that follows an open society of free markets and democracy.

The recent sell off has hit almost all stocks and sectors. During this sell off, we have been nibbling on the three stocks that we believe currently possess the best technology and products to dramatically reduce energy consumption, without abandoning out our way of life-- Boeing, Toyota, and United Technologies. These three companies currently have products on the market that can reduce energy consumption by up to 50%(compared to older technologies) in planes, automobiles, and heating and air conditioning systems, respectively.

Here's our bottom line, and we are borrowing from a press release by the World Business Counsel for Sustainable Development (WBCSD): There is a talk about "green" this and "green" that, but, thus far, most individuals, companies, and governments have done very little to diminish energy consumption.

Energy conservation may seem like an oxymoron, but we believe that a true cost-benefit inflection point is near, when people will realize that the technology is available and affordable here and now to dramatically reduce energy consumption.

The reason we call this an Energy Y2k is because when that day comes, there will be a mad rush to get aboard the new technology. We don't know what will cause it, and we have no special skills at seeing the future, but no individual, corporation, or government can live beyond its means indefinitely.

In saying this, we are not talking about doomsday or end-times. We are just saying that there are technologies available that offer people some insurance against rising energy prices, resulting from uncertain energy supplies, and the wisest course of action may be to own both the new technologies and the companies who own them.

Sunday, August 19, 2007

Barron's Drive-By Shooting of Cramer

Maybe the city where you live has enough drive-by shootings that they don't spark much interest anymore. Where I live, Evansville, Indiana, population 150,000, however, drive-by shooting are very rare, and when they happen, everyone knows it wasn't a crime of passion or of larceny, gone wrong, but a professional job. As I was passing through the Atlanta airport today, I noticed that Jim Cramer of CNBC's "Mad Money" and the was on the cover of Barron's weekly. Barron's cover and lead stories were all about shooting the "jester", or as I call him the "edutainer" of Wall Street. They had gone back to the beginning of the "Mad Money" show and measured how an investor would had of fared had they followed all of Mr. Cramer's touts on the air. The news wasn't good. Barron's crowed that investors would have been better off to have shorted his picks. The charts and graphs were interesting reading and everyone likes to see the sages knocked around every now and then. But as I sat there waiting for my 2 hour-over-due plane, it occured to me that this past week saw billions of dollars evaporate in one of the worst meltdowns of the markets we have seen in a long time. Indeed, the country's largest home mortgage company, Countrywide Finance, may have come within a heartbeat of going bankrupt. And in this time of great volatility and uncertainty, Barron's had chosen not only to do a drive-by shooting on Mr. Cramer, they had put it on the front page. Three things bothered me about Barron's actions:
  1. Touch: Good grief what a lousy idea to focus on the Jester when the stock and bond markets of the US and the world were reeling, and people genuinely wanted to know what was going on.
  2. Times: It is common knowlege that investors are increasingly getting their investment news from the web and not the traditional financial media. It is also well known that, Mr. Cramer's online investment site, is very successful and widely respected. Barron's own website seems to be in a constant state of reintroduction.
  3. Timing: The thought is almost too delicious to utter. Could it be that the editors of Barrons were trying to show their new boss, Rupert Murdoch, that they can sucker punch the competition with the best of them?

I know Mr. Cramer is an edutainer because reprints this blog from time to time, and our investment style is as far from his, as Indiana is from New York. We are long-term dividend oriented investors. Our average holding time is 5 years, Cramer's holding time is measured at most in months, if not days, yet Jim Altucher of the Daily Blogwatch often mentions our site to provide a long-term conservative perspective.

I am truly hoping that this is not the first example of the "new" Barron's hard-nosed financial reporting. It is out of touch, it is a cheap shot, and the timing reeks of -- let's show off for the new boss.

I would like to suggest to the folks at to do an long-term analysis of the track record of Alan Abelson, Barron's long-time feature editor. When he has been bullish, go long the S&P 500, when he has been bearish, short the S&P 500. My guess is that the results will be ugly. In my mind, Mr. Abelson has predicted 7 of the last 2 bear markets.

Booya, Jim, the blue-bloods are attacking the blue collars. This is what you probably always wanted.

Friday, August 17, 2007

Thank You Mr. Bernanke, But We Want More!!

In Thursday evening's blog, we made the case that the Fed needed to cut rates and fast. Friday morning, much to our surprise and delight, they did just that. However, they only cut the discount rate, which applies almost entirely to banks, and not the fed funds rate, which banks use to set rates they charge to their customers. The half percent drop in the discount rate from 6.25% to 5.75% will provide needed liquidity to the banks and has stabilized the markets -- for now. In our judgment, however, unless the Fed cuts the fed funds rate they will continue to be knee deep in "dragons" (see Thursday's blog). Here's the problem as reported by A buyer in 2005 with poor credit and limited means might have signed on for a $200,000 2/28 hybrid ARM[adjustable rate mortgage], locking in a fixed rate of 4 percent for two years. After paying $955 a month, the bill would now be set[in October]to spike to $1,331, a 39 percent increase. According to, there are $50 billion of these hybrid mortgages coming due in October alone. Many of these homeowners will not be able to afford the new higher rates and will join the ranks of people trying to sell their properties. With too much real estate already on the market the odds are high that the real estate situation may worsen in the months ahead. If the Fed cuts the fed funds rate, banks will cut their prime rates. Since many adjustable rate mortgage rates are directly or indirectly tied to the fed funds rate, that would mean that the upcoming interest rate reset for the aforementioned mortgage holders will be much more modest than it would be without the rate cut. We believe that the real estate issues in the US are still mostly contained within the subprime arena. The problems, however, threaten to spill over into the prime mortgage market if too much real estate comes on the markets as a result of defaults caused by these adjustable resets. The Fed can say that they are not in the real estate business, but if they do not offer some sort of palliative to the subprime market that will keep people in their homes and paying their mortgages, a broadening real estate slump could derail the economy. In our minds, the time to deal with the problem is now and not when it is a full blown crisis. A cut in the fed funds rate will also assure consumers and, more importantly, employers in the US and the world that a recession is not likely.

Thursday, August 16, 2007

Sally Forth Mr. Bernanke, Sally Forth

By Greg Donaldson and Mike Hull Terra incognita is a beautiful Latin word that means: "the unknown lands". As Wikipedia says, however, its simple meaning over the years has taken on a sinister quality, because of the word's use in map making. Wikipedia explains that cartographers labelled "unexplored or unknown regions"(terra incognita) with "Here be dragons". Unknown lands, then, are not lands of potential milk and honey or amber waves of grain, they are places where dragons roam. In the recent market selloff, all financial companies have become terra incognita, and thus, knee deep in dragons, whether or not they have subprime loan problems. When Merrill Lynch goes from reiterating a buy on Countrywide Credit on last week, to issuing a sell on Wednesday and using the words liquidity crunch and bankruptcy as the reasons, we realize we are not in a charted territory. There is no way to see a daily map of Countrywide's financial position. We suspect not even the Countrywide people actually know what is going on, particularly after Merrill's call. And we strongly suspect that the list of banks willing to loan Countrywide money is now a lot shorter than is was last Friday. The dragons are on the loose and they will continue to devour company after company until the full extent of the less-than-prime mortgage market is known, and that could be awhile. For this reason, it is time for the Federal Reserve to get into the dragon slaying business. They need to cut rates and cut them now. Don't wait for the next meeting, don't wait for the economic data to show weakness, don't wait for inflation to go to zero. Cut rates now and be prepared to cut them again if the overall stock markets do not calm down. Unless the Fed does this, investors will continue to be left guessing where the dragons will strike next, and the banks will tighten credit farther and farther, which will practically assure more dragons will be loosed. The reason the cartographers put dragons in the unexplored lands was because no explorer had had the courage or resources to go into that unknown land and say that there were no dragons to be found. That is what the world needs Ben Bernanke to do. He needs to stick out his neck and show the world where the dragons are and are not, and he does that best by cutting rates to assure investors that a recession is not on the horizon. In our judgment, this crisis will end when the Fed begins to cut rates. It's just a question of how long before they have the courage to act.

Sunday, August 12, 2007

Mike Hull Responds to a Client's Concerns

Mike – My thoughts regarding the financial stocks are as volatile as the market lately. One day everything looks great -- the next day it's a disaster. Is there a calmer and more reasoned perspective? Thanks, Bill Bill, You must be setting me up for something. That's ok. I always love your questions. "Is there a calmer and more reasoned perspective?" (than one day everything looks great -- the next day it's a disaster, especially for the financial stocks) I think so. No, of course there is. Absolutely. That perspective lies in what we know, what's inevitable, and what we own. What We Know We could load up both sides of the bear & bull aisle with what we know and probably make a pretty good case that the economy and the market will find their way to healthy paths. The economic data already collected doesn't show much weakness, outside of housing: While growth in most areas of the economy has slowed, consumer spending continues to grow, as does business investment and industrial production. With a very low unemployment rate and loads of demand from a strong global economy, it would take a housing crash or a run-away credit crunch to throw the U.S. into a recession. Our view from the beginning cast doubts that the housing troubles would be wide-spread. Yes, it's a problem, but the bulk of the problem is falling upon a few large states where sub-prime lending was prevalent and where speculation needed to stop. And, yes, some of the more greedy finance firms fueling this will see their capital evaporate. Has this led to a credit-crunch. Absolutely. Banks are built to protect themselves from risk. Credit will get tight. This won't be fun. Yet, credit-worthy borrowers will still find cash available to them. And that leads us to "What's Inevitable ..." What's Inevitable First, both U.S. corporations[banks included] and emerging economies have built up significant reserves over the last five years. Both have accumulated immense and unprecedented profits since 2003. If they need it, capital will be available. Second, at the beginning of last week, Dick Green of said it so well: "The Federal Reserve's first priority is to act as the nation's central bank, and to ensure liquidity in the banking system. If the Fed feels that there is an unwarranted restriction of credit, they will act." In other words -- It's Inevitable. The Fed will not let these credit fears run our economy aground. They just demonstrated that in a big way: 1) On Friday, they announced that they stand ready to provide liquidity to banks with unusual or extraordinary credit needs who cannot find funding through normal channels. 2) And, they began walking the talk by infusing $38 billion into the U.S. banking system on Friday. The European, Japanese, Canadian, Australian and other central banks injected nearly another $100 billion to their banking systems. As Greg said in Friday's blog, the Fed has not stepped in to bail out bad loans; it has stepped in to ensure that the gyrating markets don't cause the banking system to freeze up. Will they do more of the same if they see the need? Absolutely. It's inevitable. It's their job. What We Own But, while I've danced around it, your question was really expressing concern for the financial stocks. Calling the total return for financial stocks this year (dividends +/- price changes) dismal would be an understatement. The five banks we hold in your portfolio have dropped 9.2% in price. With the dividends received so far, that return has been pared to - 6.8%. And, therein lies the key. The U.S. banking system will survive. It's inevitable. And, I'm betting, as you would, that the five banks you own will still be thriving well after you are comfortably into retirement. The "key" I mean to emphasize here is that whether you are living off this fund or not, we will own these banks (at least four of them) because we want them producing (dividend) income for you. Regardless of where the market takes their prices in the short-term, we believe, as they do, that they will continue to deliver good dividend growth. Over the last five years, those five banks have increased their dividends on a compounded annual basis by an average of 16.8%. They currently have dividend yields between 3.3% and 6.0%, average 4.8%. That alone makes them look like great bargains to the long-term investor. I don't see the risk as whether these banks could see their stock prices drop further this year or not. The biggest risk by far is that you or I would decide we didn't have the patience to watch these volatile stock prices and cash out at these prices. The last thing I want to take a Pollyannic approach to this. The reading I've done this weekend shows me that more than a few reputable people watching this truly fear the subprime-loan-housing-bubble-burst-credit-crunch will spread far enough to cause a recession. The Fed's Friday actions should help calm the markets, but it may not be enough to calm all the fear that is moving the market. The ride could get even bumpier from here. Yet, that same reading tells me the Fed has enough tools at their disposal to stem the tide and keep the economy on course. This isn't the bursting of the tech bubble in 2000. It is not the Asian Contagion of 1998. It is not 9/11. In each of these instances the Fed stepped in and kept the banking system lubricated. Ben Bernanke has gone so far in his writings to advise that the 1929 stock market collapse and following depression could have been avoided if the Fed had provided enough liquidity. I have to believe he'll be there for us now, but I believe it will take some patience. This won't end Monday. Mike

Friday, August 10, 2007

Fannie Mae -- A Pictures Tells . . .

Why would the price of the company loaded with more home mortgages than any institution in the world be moving higher over the last month when it seems the US real estate market is in the process of vaporizing?

The chart at the right is of Fannie Mae, the quasi-government home mortgage company and largest holder of US home mortgages in the world. For you technicians, you see a classic divergence over the last month with Fannie Mae - FNM, moving higher and the SP 500 moving lower.

Surely the chart must be wrong. Why would FNM be moving higher at a time when many stocks with no connection to real estate at all are falling?

The answer is that there is not a problem with the "prime" mortgage business in the US, so FNM's loan portfolio, which averages about 80% of the value of the underlying houses, is very secure. FNM is moving higher because the problems in the subprime market have tainted the available supply of credit for all housing. This has prompted FNM's CEO and many congressmen to ask that FNM's statutory lending limit be raised, both in the amount they can loan in an single transaction, as well as, the size of their total loan portfolio. In essence FNM is moving higher because the odds are good that they are going to be able to --yes--make more mortgage loans.

In my judgment traders are jumping to huge conclusions that US housing is collapsing; it is not. High risk mortgages are in big trouble, but Fannie Mae and other prime mortgages lenders, such as the banks, are well protected by the equity in their outstanding mortgages. Furthermore, the overall US housing market is protected by the solid US economy and the low unemployment rates.

The traders are panicked and stocks are flying all over the place. Do not confuse that with the strength of the underlying economy, or the value of the average stock. Cooler heads, however, are starting to step forth to diminish the confusion. The Federal Reserve just announced that they stand ready to provide liquidity to banks with unusual or extraordinary credit needs who cannot find funding through normal channels. They also bought $19 billion in mortgage backed securities from banks. The Fed is now firmly in the game, and I believe the markets will begin to calm down. The Fed has not stepped in to bail out bad loans; it has stepped in to be sure that the gyrating markets don't cause the banking system to freeze up. That's their job. I'm glad to see that they are finally doing it.

I own FNM, but this is not a recommendation. I am just using it to make the above points.

Wednesday, August 08, 2007

An Update on the Valuation of Berkshire Hathaway

Berkshire Hathaway, recently, released its earnings for the second quarter and the numbers were impressive, again driven by their insurance divisions. As I studied the data, it quickly dawned on me that BRK-A has had a remarkable run in earnings and book value growth since the Katrina trajedy.

I also heard the echos of Warren Buffett during those days foretelling exactly what has happened. BRK-A with it AAA bond ratings and its penchant for taking risks --at a price--that more risk averse firms could not or would not take, would become even stronger as a result of the Gulf-coast hurricanes.

Now our country is facing another crisis. This time self-inflicted. The big banks and pools of money in this country are backing away from much of the less-than-prime mortgage companies, and without funding, these companies are falling like dominoes.

Berkshire Hathaway owns lots of building related businesses, but the one that intrigues me is manufactured-homes giant, Clayton Homes. In that business, Buffett has a whole company that is used to dealing with credit issues in the subprime arena.

With all the big banks pulling the plug on the subprime loan business and with a company in his portfolio that has trained and experience people used to dealing with subprime issues, it is not a stretch to think that Mr. Buffett may show up on the scene somewhere in the current subprime mess. That is how he does things.

He was quoted once as saying that he likes to make investments that are like shooting fish in a barrel . . . with the water drained. Well, Mr. Oracle sir, in the subprime mortgage business, the water has left the tank. You do the picking and we'll go with you.

With the new earnings and book value data, I have updated our valuation model, as shown above on the chart. The year-ahead projected value shown in the green stripe is over $128,000 per class A share. That would translate into almost $4,200 per class B share.

As usual the model's prediction is based on my guesses about earnings and book value growth over the next year, but you can see that the fit has been pretty tight, over the last 15 years, between the model and the actual prices of BRK-A.

We own the stock in our Capital Builder Investment style.

Thursday, August 02, 2007

Pepsico: The Right Thing

It has been a complete mystery to us why Pepsico has had such a flat year price wise when their earnings and dividend growth has been so outstanding. Over the past 12 months price growth
for PEP has only risen just over 5%, while earnings have grown nearly 13% and dividends have grown 18%.

We always caution clients that even though there is a tight correlation between dividend growth and price growth for many stocks, that it may take two to three years for price growth and dividend growth to come together.

In the case of PEP, however, the last twelve months seemed primed for the second-largest soft drink company in the world to be a big winner. It has been gaining market share from long-time rival Coke; it has benefited from the weak dollar; it is the leader in non-carbonated beverages, the fastest growing segment of the soft drink business; its Frito-Lay division is continuing to extend its brand; and the Quaker Oats division, which was a part of the Gatorade purchase, has been adding new products at a rapid pace.

The only reason I can see for the lacklustre performance was the retirement of Chairman Steven Reinemund. Everyone remembers that when Coke's Chairman Roberto Goizueta died in the late 1990s, the company would flounder for nearly a decade before finding a leader that the Coke army would follow.

Will the story repeat itself with Pepsico? I'm betting it won't. Pepsico is a much more decentralized company with many powerful brands contributing to the overall success of the company. Coke was much narrower in its product line and much more centralized in its management style.

Goizueta became a bigger-than-life Wall Street CEO, and the admiring-analysts drove Coke's price to the moon, even though the evidence was clear that Pepsico was catching them in many key parts of the world.

Indra Nooyi is the new CEO of Pepsico. She has had a string of successes at Pepsi, and her management style will come more into view in the years ahead, but Reinemund built a very deep bench of potential replacements should she not be able to lead the charges.

Now that the management change has been made, Wall Street appears to want to sit on it hands and wait for Ms. Nooyi to impress them. I think that will be a mistake because Pepsi's brands and deep pool of management talent will continue to propel them almost no matter who is the nominal CEO of the firm.

This may sound like I have some doubts about Ms. Nooyi. I do not. I have studied her resume, and it is impressive, but I have no idea how she will do in her new job. There are always risks in top management changes, but I think the risks are diminished when a company has the positive momentum that Pepsi has.

The Dividend Valuation Chart above shows that PEP is undervalued. Our model's best guess for the year ahead price is shown in the green striped bar at the far right. That price is nearly $80 per share, which is nearly 20% higher than the current price. You know that I can't see the future, but I would not be surprised if PEP reached $80 in the year ahead. With all of the worries about real estate, subprime loans, and the strength of the US banking system, Pepsi's worldwide presence selling a relatively inexpensive product, which has remarkable profitability just might be the "right thing."

Wednesday, August 01, 2007

Real Estate and Mortgage Woes Do Not Mean a Recession is Inevitable

Yesterday American Home Mortgage, a specialized mortgage company, lost 90% of its value, when its lenders refused to advance the company more funds to meet its reserve requirements and lending demands. When the news was announced, the Dow Jones was higher by over 100 points, after the news hit, the market immediately turned lower and finished down over 100 points, wiping out hundreds of billions of stock market value.

The question that everyone is asking is how much more bad news are we likely to get from the mortgage and real estate businesses, and do their problems have the potential to endanger the banking systems and the economy?

Here’s my short answer. From what I read, American Home Mortgage’s –AHM -- biggest problem was that their banks pulled the plug on them because of the falling values of AHM’s underlying collateral, so it was not necessarily a case of them being swallowed up in sea of bad loans.

The big banks and investment banks in the US, in an effort to protect their own assets, have begun to cut off additional loans to all but prime mortgage credits. This will likely lead to more headlines for specialized mortgage lenders who are forced into bankruptcy because of being cut off by their lenders. So the answer to the first part of the question is the mortgage mess will be with us for a while, yet.

Having said this, I do not believe the odds are very high that the problems of the subprime and specialized mortgage lenders will cause severe damage to the major banks in this country or to our overall economy. My reason for saying this is that the banks in this country entered the year 2007 in as a good a financial position as they have been in 20 years. The best way to look at this is to compare the cumulative financial condition of the major banks at the beginning of 2007 with their condition when they entered the last period of financial stress, which was in the late 1980s—to early 1990s, resulting from the S&L debacle and a severe pull back in corporate profitability.

The table shows that there is little comparison between the financial position of the major banks today and that of 1989.

Today the banks’ equity capital as a % of assets is 60% higher than it was in 1989; non-accrual loans (loans on which the bank is not receiving
payment), at 0.5% of total loans are only about 20% of what they were in 1989; the banks’ current loan loss reserves (money that is set aside to cover potential losses) is 274% of their actual loan losses, compared to 1989, when loan loss reserves were only fractionally higher than actual losses at 102.5%. Finally, At the beginning of 2007, actual loan losses were only 2.3% of equity capital compared to an 11.2% rate in 1989.

The bottom line is the banking system is strong, and I believe it can withstand the current real estate and mortgage problems very well.

The stock market is retreating because of fears that the banking system will be threatened by the current mortgage mess, which will result in a recession for the whole economy.

The best argument against that line of thinking is the aforementioned strength of the banks, but beyond that is recent US economic data. US Gross Domestic Product was just reported to have grown 3.4% (annualized) in the second quarter and the US unemployment rate has remained steady at only 4.5% of the workforce. Remember these data occurred simultaneous with the bad news in real estate and mortgage lending. Finally, if a recession were imminent, the Federal Reserve would have an obligation to start cutting rates.
As I mentioned in my last blog, I listened to the quarterly earnings reports of three of the biggest banks in the country. None of the three reported big jumps in loan charge offs, or greatly increased their loan loss reserves. And, to remind you, two of the three increased their dividends more than we were predicting.

Gyrating markets are not much fun for most people, and they always raise the question: “What are these stock worth, anyway?” If all you are only looking at prices, you might decide that stocks aren’t worth very much, but when you look at companies from the perspective of the cash dividend they are paying and the dividend's rate of growth over the long-term, another picture becomes clear. Many companies are veritable cash flow machines and will be worth more in 10 years than you can imagine.

Cash dividends are real money and determining the value of companies that have long histories of raising their dividends is much easier than it is for companies who must be valued on earnings alone.

As I have said in these blogs before (see my series on The Rising Dividend Story on the side bar)[from the beginning], it was during the severe market correction of October 1987 that our Rising Dividend investment style was born. I knew those dark days would pass because I was convinced the selloff was not fundamentally driven, but I did not know what to buy, and so I sat on the sidelines and let one of the best buying opportunities in the history of the capital markets go by. Now 20 years later, we have a few pretty good valuation tools, and they are signaling that some truly wonderful companies are being put on sale (some of which we already own). I don’t think we need to be in a big hurry, but there are a few that I have been trying to buy for a long time. I’ll be discussing some of those companies in the days and weeks ahead.
Table and data from and FDIC