Monday, April 28, 2008

About an Economy

If ever there was a week that was as it relates to the economy, this is it. Economic data for almost every major component of the US economy will be released this week. In addition, the Federal Reserve Open Market Committee is meeting this week and is expected to lower rates by .25%. Here are the reports slated for release this week. Wednesday: Gross Domestic Product -- Even though the media have tolled the recession bell for the last six months, the consensus estimate from economists is for GDP to have grown by .5% for the first quarter. Not a great number, but better than the worst fears of many, and one of the main reasons the stock market has rallied in recent weeks. Wednesday will also see data on inflation, employment costs, crude oil inventories, and most importantly, the Fed's statement on their take of the strength of the economy vs. inflationary pressures. Thursday: There is enough data flowing on Thursday to push stocks up, down, and sideways . . . by noon: Auto and Truck Sales, initial unemployment claims, personal spending, core inflation excluding food and energy, construction spending, and the Institute for Supply Management Index (ISM), an index that measures the strength of manufacturing. Friday: The week will close with two of the most important indicators of economic activity: changes in non-farm payrolls (unemployment rate), and factory orders. By Friday of this week, we ought to have a much better notion of how the economy is handling the subprime crisis and the fallout in real estate. Our best guess is that the data will be a little more positive that most people now expect. We believe the recent rally in stocks has priced in our more constructive view of the economy and inflation. While consumer spending is facing lots of headwinds -- higher oil prices, higher food costs, and more uncertainty about real estate values -- the saving grace of the current economy is the US export market. It is still strong and shows few signs of slowing. Exports may well be what push GDP into positive territory. If that is the case, exports will also be the key to employment. The weak dollar has increased demand for US goods and services from all points of the globe and put a floor under employment. That is good news and we do not foresee a big reversal in the value of the dollar in the coming year, so job losses may continue to be more muted that most would suspect. Hold on to your hat. All the twists and turns of data will likely cause similar twists and turns in security prices.

Saturday, April 19, 2008

Wachovia Still Has More Write-Offs to Take

The board of director of Wachovia - WB may be giving CEO Ken Thompson a vote of confidence, but we are firing him. We became Wachovia shareholders in 2004 when the company bought Southtrust, one of the best banks in the country and one of our largest holdings at the time. We were great admirers of Wallace Malone, the CEO of Southtrust, whom we considered an unrivaled expert at cost control. We knew Mr. Malone had many suitors for his bank, thus, we concluded that if he chose Wachovia, then Wachovia was the bank whose goals and business approach, especially its attention to cost control, were most like Southtrust’s. That has not been the case. Wachovia has made a series of expensive acquisitions, most damaging of which was the big California S&L, Golden West Financial, purchased at the height of the real estate boom in 2006. WB defended its purchase stating that it could make the Golden West platform much more profitable with WB’s expanded product offerings combined with a greater focus and emphasis on cross selling these added products. Unfortunately, we bought WB’s explanation for the purchase and the purchase price of the Golden West. Even Mr. Thompson now admits that the Golden West purchase was ill timed because the ink was hardly dry on the deal before real estate prices started falling and Golden West’s supposedly conservative loan portfolio began to show a spike in delinquencies. Over the last nine months, in listening to management’s explanations of their exposure to subprime risks (always described as modest and manageable), we were shocked at the write-offs and increases in loan loss reserved that WB announced last week. In case you missed it, they took a $4.4 billion write-off and increased their provisions for loan losses by $2.8 billion, up from $177 million in the corresponding quarter a year ago. In addition, they cut their dividend 41%. This last point is especially bitter because CEO Thompson in January said the dividend was safe, and in the company’s annual report, the company’s dividend increases over the years were trumpeted. It is also bitter because it is our stated policy that our portfolios will hold only companies with rising dividends, except in rare instances.
With dividends being so important to us, we have continually studied the possibility of WB cutting their dividend since last July. We concluded only a few weeks ago that the company’s core capital could support a continuation of their current dividend. The primary reason for this was that WB’s Tier 1 capital, a closely watched measure of its core net worth, was near 7.4%, higher than most of the major banks in the US. Additionally, with Mr. Thompson’s declaration just three months ago that the dividend was safe, we were prepared to ride out the storm with the company. With the utterly dismaying news that WB reported at their earnings (loss) conference, we decided that we have had enough and that we will exit the company. A major reason for this is that the thing we were most worried about, a goodwill impairment charge against the Golden West purchase, was not discussed among all the write-offs, and we believe it is inevitable. Here’s the bottom line on the goodwill impairment. Wachovia paid about $24 billion for Golden West. Since they paid more than two times book for the company, they are carrying nearly $14 billion of goodwill on their books. It is now clear that the Golden West purchase is not worth $24 billion, perhaps $16-18 billion at best. That would mean that a goodwill impairment charge of up to $6-8 billion looms over the company. This has been our biggest concern with WB, but we believed they could cover this non-cash write-off by raising new capital. After listening to the July, October, and January earnings conference calls and hearing management repeatedly discuss their limited exposure to the subprime crisis and their confidence in the Golden West risk profile, hearing report their miserable results on the April 2008 quarterly conference call was like listening to a different company. Suddenly, everything that was modest and manageable was huge and like nothing they had ever seen before -- and drastic measures were necessary. We have listened to our last Wachovia analysts’ conference call and voted our last proxies. In the coming months, we will exit the stock completely. Mr. Malone made our clients a lot of money. His chosen successor company has taken a good portion of it back. We blame ourselves for not seeing that the principles of Wallace Malone, did not extend very far into Wachovia's culture.

Tuesday, April 08, 2008

Johnson and Johnson Wants to Go Higher

Drug stocks have become persona non grata for most investors over the last 7 years, as a long list of blockbuster drugs have gone off patents with no replacements. Few pure drug companies are anywhere near their price levels of early 2000.

Johnson and Johnson (JNJ) is one of the few drug-related stocks that has been able to achieve price gains during this time. The reason is simple. In addition to JNJ's pharmaceutical business, it has a broad portfolio of products in such diverse areas as consumer goods, orthopedic implants, and stints. Even in their drug business, they have focused their research in areas where they have little competition, avoiding the "me too" approach that most of the major drug companies have employed.

The Dividend Valuation Chart at the right shows that JNJ has made choppy gains over the past 7 years and is modestly undervalued at its current price. Projecting my estimates for JNJ's dividend growth and interest rates ahead one year, as shown on the black striped bar, the stock may be as much as 20% undervalued.

However, the most important quality that JNJ possesses is that it has broken free of most other major drug-related stocks and it, and perhaps Abbott Labs, are now on a very short list of what might be considered "safe" healthcare stocks. For such a big stock market sector as healthcare to have so few safe stocks, would seem to mean that JNJ is likely to gain weighting in many investment manager's portfolios.

JNJ is a very good story in an industry sector with a lot of bad stories. The relative performance might prove interesting over the next couple of years.