Wednesday, November 28, 2007

Beware of Momentum Shifts

There is so much money being bet on the front-running groups in the securities markets in recent months that there is a clear possibility that a sharp reversal in leadership may be in the offing. That is, the sectors that have been winning in recent months such as energy, consumer staples, materials, commodities, utilities, and Treasury Bonds may be running on pure momentum and not solid fundamentals. If this is the case, then as the financials find a floor, the front-runners may find a fall. Our models would suggest so. Energy is not cheap either on a nominal basis or a relative basis. Basic Industries valuations are off the map, consumer staples are fairly valued, utilities need for Treasury Bonds yields to stay at these levels to justify their prices, and Treasury Bonds need continued blood in the financial streets to stay where they are. We have been convinced that the subprime crisis would not wipe out the banks and that the Fed would do what they need to do to diminish the risks of a recession. It has almost been remarkable to us that subprime fears has spread so wide and so deep. In our judgment, the markets over the last 90 days have been more about smart-guy computer trading and less about anything resembling the present value of the long-term prospects of companies. Mindless momentum chasing is as prevalent on Wall Street as it ever has been, and it is likely to end up in the same place as most mindless endeavors: in trouble. Financials, consumer cyclicals, industrials, technology, and lower quality bonds have all been the whipping boys lately, but we believe the bad news is now fully priced in, and then some. We think there is a good chance that oil prices may have peaked (we will have more to say on this later). We think the subprime mea culpas may be nearing an end among the banks, and we think there is good reason to believe that the dollar's collapse may be at an end. All the worms are turning, and in our judgment, that which has been last shall likely be first in the coming year, and vice versa. Indeed, we are inclined to believe that the financials may lead the performance parade in the year to come, and the energy sector may well breath the hindmost fumes.

Wednesday, November 21, 2007

Thanksgiving Blessings

Each Sunday in our church, at the end of the service, the pastor stands before the congregation and gives us, what I believe is called the priestly blessing. It comes from Numbers 6:25-26 May the Lord bless you and keep you; May he make his face to shine on you, and be gracious to you. May he lift up his countenance on you and give you peace. These words never fail to cause my eyes to mist over. God is with us, and he is for us. There are worries a plenty in this world and in each of our lives. But on Thanksgiving day, I invite you to take the time to count the blessings in your life -- the people around your table, the food you will enjoy; the growth and promise of the younger ones; the strength and sacrifices of the older ones; the new faces at the table; the memories of those who have gone ahead. God's face does shine on us. If it were not so, this old world would have dried up and blown away a long time ago. May you all have a blessed Thanksgiving

Saturday, November 17, 2007

Berkshire Hathaway: Is It Overvalued?

Our valuation model for Berkshire Hathaway is suggesting that Mr. Buffett's pride and joy is modestly overvalued based on data from its recent financial report. This can be seen on the Valuation Chart at the right. The price line (in blue) is modestly above the green value bar for November 2007.
BRK/A is selling near $136,500 ($4,550 for class B) per share and the model indicates that its "normalized" value is just under $125,000 ($4, 170).
Having said this, our model's primary objective is to determine a company's probable price 12 months ahead. Plugging in our best guess for book value growth and interest rates in the year ahead, we get a price of $144,000 (4,800), shown by the green candy cane at the far right. That would put the stock approximately 7% undervalued.
In December of 2006, we arrived at a similar conclusion when we calculated that BRK was slightly overvalued on a near-term basis but undervalued based on a year ahead book value of $77,000. It now appears that BRK will end 2007 with a per share book value approaching $80,000, a remarkable performance in a tough market.
BRK/A is a great company and we have owned it for many years in our Capital Builder accounts. It's terrific performance in 2007 is a combination of its own solid results and a flight to the safety of Buffett's stable of "wonderful companies" and BRK's AAA rating.
Another driver has been Buffet's remarkable ability to find the gold in every crisis. BRK came out of 9/11 stronger than it went in. Buffett built 2007's powerful financial results partly in the aftermath of Hurricane Katrina by betting, though his insurance companies, that such devastation was an aberration and not an annual occurrence.
Since the rise of the subprime problems, he has been buying big pieces of Wells Fargo, Bank of America, and US Bancorp. He is rumored to be involved in taking positions in the municipal bond insurance crowd.
Buffett and Berkshire Hathaway have been on a powerful winning streak, and there are those who say he is due for a spectacular flop. Couple this with our Valuation model signalling that the company is fairly valued, and one might think it wise to take some profits in Berkshire Hathaway.
We are not following that plan. We think the current subprime crisis and Buffett's track record are likely to propel BRK much higher. Markets are not efficient. Greed and fear are powerful forces that do not end when valuations appear over or undervalued. They end when they exhaust themselves. To the extent that the subprime crisis stays in the headlines, BRK is likely to continue to climb. We do have a level in mind that we believe factors in all the possible good news for the next couple of years, but obviously, for the present, we are keeping it to ourselves.

Thursday, November 15, 2007

Just How Big and How Bad is the Subprime Mortgage Problem?

I have been trying to get my mind around the subprime problems for months. I keep asking myself the same questions everyone is asking: how can it be so bad and so widespread, who's next, and who or what am I missing? Over this past weekend, I decided to take a 30,000 foot look at the situation to see if I could make more sense of the crisis from that perspective than I had been able to wading around in the fast flowing currents of the news of the day. It occurred to me that the macro approach would at least offer a way of putting the subprime crisis into perspective, relative to the US economy. I quickly found that there is as much bad data on the subject as there is good. In truth, no one knows what the ultimate outcome will be; however, I found a way of thinking about the issue that made sense to me, and I have seen others coming to conclusions that are similar to mine.
  1. Subprime is about 13% of the $10 trillion total mortgage market, or about $1.3 trillion.
  2. Currently about 17% of subprime loans are delinquent. For our purposes here, however, let's assume that 50% of subprime loans ultimately default.
  3. That would put the total defaults at $650 billion.
  4. But remember these loans are backed by homes, so let's assume that when the homes are ultimately sold, the debt holders will receive 50 cents on the dollar, or $325 billion.
  5. My study of the situation indicates that the banks and investment banks sold about 50% of the loans to insurance companies, retirement plans, hedge funds, private equity groups, etc., and kept the rest. That would put the amount in banks and investment banks at near $163 billion.
  6. Next, assumed that approximately 70% of the loans stayed in the US and 30% went abroad. That would give us a final exposure to the US banking system of near $115 billion.
That figure would lean toward a worst case scenario. As of today, nearly $55 billion in write offs have been announced. On the surface it would seem that we have a lot of pain left to endure. But remember, even if the worst case comes to pass, it will not happen immediately because, as I said earlier, this exercise assumes 50% of subprime loans default, whereas, only 17% are delinquent today. Finally, if the ultimate losses do total the aforementioned figure, it will represent only .8% of US Gross Domestic Product of nearly $14 trillion, or put another way, less than one year of US bank earnings. I am confidant that if the problem is of the size I describe here there will be no lasting effect on the economy or the vast majority of banks. The only caveat to this line of thinking is it is hard to imagine that things have deteriorated so rapidly and we don't know how other parts of the economy will hold up under the stress of the real estate malaise. In this regard, the recent earnings reports were mostly favorable, but the Christmas selling season is very important to the US economy, so we won't have conclusive data until January. I am receiving many terrific questions from clients about our firm's views on a number of subjects. We will do our best to answer each question here so everyone can be informed. Next time we will look at some Consumer Staples companies we like, and some we don't.

Tuesday, November 06, 2007

Bank of America: Dividend Growth Will Continue and the Price Looks Right

Many readers have asked that I show the Dividend Valuation Model for Bank of America. The company recently announced disappointing earnings and has seen it price fall off with the other big banks.

Having said this, I believe the bank is dealing with its issues in investment banking and will be one of the first big banks to get its writedowns behind it.
The current dividend yield is 5.5%. BAC has raised it dividend in each of the last 20 years. Dividend growth, during that time, has averaged nearly 13%, and nearly 15% over the last 5 years.

The past is no guarantee of the future, but I believe the company will continue to increase dividends, albeit at a slower pace.

Wall Street analysts are now estimating that BAC's earning over the next 3-5 years will average near 8%. The chart above uses 8% dividend growth in 2008.

The green candy cane at the far right of the chart is the implied value of BAC at this 8% dividend growth rate. That price is $56 per share.

No one knows the magnitude of the subprime loan problems that lurk in bowels of banks today, but we can make some simple observations. Unless the US economy falls off a cliff, the banks have enough capital to withstand a lot more trouble that the subprime problems appear to present. BAC's management has a reputation for being straight talkers. They did not sugar coat their writeoffs, and CEO Lewis said the performance was unacceptable and that changes were coming in the investment banking group.

By the swiftness of the subsequent actions, the plans must have already been underway on the day of the earnings announcement, because three weeks later they have already replaced many of the top managers of investment banking, and announced the elimination of 3,000 jobs.

Including dividends, if BAC reaches $56 per share over the next 12 months, that will represent nearly a 29% total return.

I admit that it doesn't seem possible in light of the news of the day, but, as I said earlier, if Fed does its job and the economy has even modest growth, the subprime fiasco will gradually fade from the headlines, which will allow the banks to move higher.

I own BAC and have for many years. At 5.5% dividend yield, it doesn't take much price appreciation to make a double digit return. That might look pretty good a year from now.

If you are not a client of DCM, please do not act on my discussion here alone. Consult your own financial advisor.

Thursday, November 01, 2007

The Fed Got it Wrong!

My prediction that the Federal Reserve would lower their target rate by 50 basis points was wrong, but in my judgment, they will see the error of their ways and continue to cut rates very soon. I do believe, however, that they missed the opportunity to stay out ahead of the unfolding worries in the subprime market. Today's downgrade of Citigroup by Wall Street analysts is proof of the pudding, so to speak. Citigroup is down nearly 7% on rumors of more write offs and the possibility that they may have to cut their dividend. Citigroup's bad news has spilled over into the general market, pushing the Dow down nearly 1.5%. If you recall in the blog where I predicted the 50 basis point rate cut, my central theme was that the yield spread between Fed Funds and T-Bills was signalling continuing worries about the banks, especially the big investment banks. When the Fed Funds Target Rate is significantly above the rate on T-Bills, it is a clear message that sophisticated buyers are opting for government-backed paper over bank-backed paper. When I first started talking about this phenomenon in early September, the difference was over 1.25%, as high as it had been in nearly 20 years. As a result of the mid-September rate cut, yesterday that difference had fallen to near 1%. Yesterday, after the Fed announced only a 25 basis point cut and indirectly expressed the notion that future cuts may be unnecessary the yields on T-Bills began to fall. For those of you worrying about inflation, a fall in T-bill yields is a very big bet by very big investors that you are wrong. Indeed, a fall in T-bill yields says two things:
  1. The odds are increasing for a recession.
  2. The Fed got it wrong.

I do not believe there is a high probability of a recession, but I do believe that the Fed got it wrong. The good thing is, they can still get it right and well before the next meeting in December. Fed governors give speeches everyday. All they have to do is to take away the implication that the rates cuts are done.

They have now lost the lead in taming the ongoing banking worries, and they will have to do some heavy lifting to regain that position, but if they speak with one voice, they can regain their rightful leadership position by December.

As it now stands, the Fed Funds Target Rate is 4.5%. After yesterday's and today's rallies in T-Bills, they now yield about 3.7%, yield spread of about .8%. That is still high by historical standards and implies the credit and liquidity crunch is far from over.

The Fed is the banker of last resort, and I'm confident that they will ultimately get it right. Having said this, I think they made a mistake in reading the markets that Alan Greenspan would not have made.