Friday, December 28, 2007

Strong Banks are Very Cheap

This is the second part of a recent discussion between an old friend and client about the economy, markets, and interest rates.

Friend: So I think we both agree the subprime fiasco, while bad for housing and many banks, may not spill over as far into the overall economy as investors and the media now believe. If that is the case, what do your valuation models now say about stocks in general? I guess I'm particularly interested in the real bargains you might be finding.

GCD: We actually see bargains across almost all industry sectors, as well as, international stocks. But if you want to go where the bargains are, you go straight toward where the damage is the greatest: Financials. We still have to get through mid-January when all the banks and insurance stocks will be going to confession again, but if you stick to the highest quality institutions around the world, we believe their writeoffs will be well contained within their present capital structures, and if not, all they have to do is ask their friends in Asia for a little help. Selective banks are very cheap. Let's look at one in particular.
Wells Fargo is arguably the strongest bank in the US. They have a high double AA financial strength, a strong growth record, and enviable returns on total assets and equity. Finally, their largest shareholder is Warren Buffett, who would probably buy the bank and put in his hip pocket if they would let him. Thus, capital for expansion is not an issue.
The reason Mr. Buffett would buy WFC in a heartbeat is the chart above. It shows the comparison of WFC's dividend yield vs. the yield on a 10-year T-bond over the last 20 years.
The chart speaks a simple reality: 20 years ago there was nearly a 4% difference between the bond yield and WFC's dividend yield. Today it is zero, nada, zip.
20 years ago investors were betting that WFC's dividend growth would be at least 5% over the coming 10 years. If growth would not have been at least that much, the bond would have been a better buy by a wide margin. Indeed, over the last two decades WFC has grown its dividend in the low double digits and its stock has achieved a similar rate of return, beating bonds by a big margin.
Today, with WFC's dividend yield and T-bonds yielding the same, investors appear to betting that WFC will have zero growth over the next few years. That is hogwash. WFC will grow at least as fast as nominal GDP, which we estimate will run in the 5.5% - 6.0% range.
Almost all banks are as cheap as WFC. Some deserve their low prices, but a handful, at a minimum do not. Others that appear oversold to us are Bank of America and US Bancorp.
Banks have certainly made a wrong turn and now find themselves out wandering around in the weeds, but bad times for the average bank means good times for the big, financially strong banks such as WFC, Bank of America, and US Bancorp. With so many banks out in the weeds, these three big banks, along with a short list of foreign banks will gain market share over the coming years at an unprecedented rate.
Next time I'll discuss some other industries that look good to us.
We own all three of the banks discussed here, plus others.

Wednesday, December 19, 2007

A Discussion about the Economy with an Old Friend

Every year near Christmas time, a good friend and client comes visiting with Christmas presents for our staff. After the hub bub of the diet-killer delights he brings, he and I settle into a casual discussion of prospects for the coming year. I listen as much as I speak because I have found him to be a keen observer and a very good student of the markets, particularly human nature.

This will be the first of two or three items that we discussed.

Friend: Everyone seems to be bracing for a recession. I'm having trouble believing that a recession is imminent when most of the economic sectors are doing well with the exception of financial and retail. What do think the odds are of a recession?

GCD: I think they are less that 50/50, and I believe the consensus of our investment committe is that growth will slow, but recession is not the best bet. I have one chart I'd like to show you that I believe is not well understood and most people forget to take into consideration when they project recession.

The chart at the right is of US Net Exports of Goods and Services since 1970. The chart clearly shows that exports have not only been falling relative to imports since 1980, but that their rate of descent has accelerated dramatically since the early 1990s. That trend has been firmly in place until just in recent months when exports have turned higher relative to imports. Indeed, in the most recent quarter, exports represented nearly 20% of total real GDP.

Friend: So you are saying that exports alone may keep us out of recession?

GCD: No, I personally think the economy overall will be stronger than most people think. The housing issue is a tough hurdle to overcome, but I just don't believe that housing in most parts of the country got as overheated as in did in California and Florida, for instance; consequently, I don't think the unwinding of the excess housing stock in the country will linger as long as most people seem to believe. Export growth will almost certainly continue, so any good news in housing will produce more overall growth than Wall Street now predicts.

Friend: Exports are rising because of the fall in the dollar, correct?

GCD: I have said many times that oftentimes the seeds of destruction and the seeds of regeneration are in the same pod. The US's consumer mentality and heavy use of imported petroleum have caused a trade imbalance with almost every country in the world. In essence, we were trading dollars for goods. As those dollars were translated back into the home country's currency, dollars are sold and the home currency bought, ie., a weak dollar.

Friend: But for net exports to have turned higher, the dollar must have fallen sufficiently that our goods and services are now very competitive in the global economy? That still seems hard to believe. Most people think the dollar is destined to fall a far as the eye can see.

GCD: My best explanation for the power of a weaker dollar is the following: In the case of a citizen in Windsor Canada, a year ago a Cadillac at the local dealer and the one across the river in Detroit cost about the same. As a result of the collapse of the US dollar vs the Canadian dollar, the same Cadillac in Detroit is now nearly 20% cheaper than the one in Windsor. Thus, it pays the Canadian to drive across the bridge and "buy American."

Friend: I just saw where the big European consortium, Airbus -- Boeing's biggest competitor -- is saying that as a result of the collapse in the dollar, they will move $2 billion dollars of research on their new planes to a dollar denominated country. That would seem to mean that some, if not all of that work may come to the US.

GCD: I know we are speaking anecdotally, but this is happening all over the world. The fall in the dollar has made us more competitive and companies the world over have to deal with it.

Friend: Then I guess we are saying that the great bugaboo of a falling dollar is not all bad.

GCD: Yes, it eventually brings itself into an equilibrium level and begins to stabilize. That appears to be happening now, and I don't see it turning around anytime soon. I believe those people who are calling for a recession are missing the contribution of imports to the US economy .

Friend: That is what I have been thinking, as well.

Next time: Are US stocks overvalued?

Monday, December 10, 2007

McD's May Be Going Up, Because It's Going Up

Momentum is a wonderful thing, when momentum is in your favor. Only problem is momentum is like the wind -- nobody knows where or for how long it blows.

As the subprime crisis has extracted its toll from the banks and retail stocks, that toll has been invested in the so-called defensive stocks: consumer staples, oils, and utilities.

The chart at the right is our 20-year Dividend Valuation chart of McDonald's. If you wondered where the money went that they took out of your favorite bank stock recently, look no farther because a bunch of it went here. McDs has been moving straight up in 2007. Much of its rise has been warranted because the company has had a string of good earnings reports and a big dividend hike. However, some of the recent run up is probably due to momentum -- meaning its going up because its going up.

Our model is suggesting that the stock has a projected rate of return for the next twelve months of only 5%, give or take 5% (represented by the blue striped bar at right). In our way of thinking that means, judging from the last 20 years, the most probable year-ahead rate of return for MCD is between 0% and 10%. That does not give us much of a margin of safety if the US economy is a little stronger than many observers now believe. A stronger economy could well cause the momentum of MCD to reverse.

The Fed is meeting today, and to the extent that they keep cutting rates, the odds improve that economic growth may surprise on the upside in the year ahead. If that is the case, financials would be a better buy than staples. Almost all the financials we follow are nearly 25%-35% undervalued, again based on their long-term relationships to dividend growth.

A word of caution. We are only buying highly rated financials whose dividend is secure. I have no idea where Countrywide Financial or Washington Mutual will be a year from now. Additionally, while many consumer staples stocks are overvalued, many are not. I'll have more to say on some of the undervalued staples in future blogs. We will also have more to say on what financials we like.

Thursday, December 06, 2007

Could Oil Prices be Topping?

Oil prices recently flirted with $100 per bl and the consensus of most analysts is that it is only a matter of time before that level is taken out, and we move ahead to ever higher prices. The argument is that with the developing economies of China, India, and Russia growing rapidly and representing nearly half of the world's population, it is inevitable that the price of oil can only rise as far as the eye can see.

When I hear the term "as far as the eye can see," I recall how often it turns out that the eye can't see very far. Indeed, it is almost a certainty that the equilibrium price for oil is far less that the current selling price. Anytime the as-far-as-the-eye-can-see crowd is at work, you can bet that they have laid up lots of bets on oil and, thus, there is a speculative premium in the current price.

I said in a September 2006 blog that what always kills real estate is the gap between market prices and rents. When rents begin to lag way behind prices, it means that the supply of housing is greater than the demand, and the cost of carry will soon become a factor for speculators in the decision to hold or sell the property, even if prices appear to be moving higher.

As it relates to oil, I believe that the best measure of "true demand" is the price of gasoline at the pump. Gasoline prices are thought by many to be inelastic. After all, we have our lives to live and; well, we have to drive to live, etc., regardless of price.

I have been thinking for the last couple of years that to assume that gasoline prices are inelastic is probably not justified. The fact that demand for gasoline has not fluctuated much with higher prices in the past may be because total fuel costs for the average household budget has been a relatively small percent, in the range of 4%-5%.

The chart above is a scattergram (you may want to click to enlarge) that shows, as you would suppose, there is a very high correlation between crude oil and gasoline prices -- R2 of .94. Note the three arrows I have drawn on the chart at the far right. These points, which are the last three months, suggest that prices at the pump are much lower than we would expect them to be based on their historical relationship to crude oil. For instance, last week when oil surged to near $100 per bl, gasoline prices at the pump (Midwest) should have been near $3.50 a gallon. Oil prices in my region never got above $3.15. Currently with crude prices near $90 per bl, the chart indicates that prices at the pump should be near $3.20. Bloomberg shows that the prevailing price in the Midwest in currently $2.95 a gallon.

The lag in prices can be the result of only three reasons. 1. Oil refiners and marketers are holding down the price of gasoline, 2. Consumers are balking at paying much above $3.00 a gallon, or 3. A combination of both.

If consumers are balking at higher gasoline prices, crude oil prices would at the least flatten out, if not fall. The reason oil prices may fall more than you might expect is because of the rampant speculation in crude oil futures.

I'll keep you posted on this trend in future blogs. Could it be that some elasticity of demand is appearing? We'll soon see.