Monday, June 30, 2008

The Gods at Goldman Taketh Away, But Are They Right -- This Time?

Goldman Sachs research analysts are widely attributed, at least in part, to have been responsible for last weeks collapse in stock prices. As analysts are seemingly wont to do, they went into a crowded room and yelled sell and everybody did. They weren't alone in dissing stocks. As a result of the Fed's recent turnabout from worrying about recession and cutting rates to worrying more about inflation and potentially raising rates in the near term. Indeed, this shift came so swiftly that it was hard to catch in most hometown newspapers. We literally went from recession watch to inflation watch in a matter of days, as a result of upward revisions to GDP and clear signs that a recession is nowhere to be seen. The stronger-than-expected economic data would normally be seen as a good thing by the stock market, but in these days of skyrocketing oil and food prices, it was taken as giving the Fed enough breathing room to begin fighting inflation by hiking rates. Goldman analysts came out last week with sell signals on Citigroup and General Motors and downgraded the Brokerage and Industrial stocks. On Wednesday and Thursday, they lowered the proverbial boom on all these sectors in a curiously timed call on stocks groups that, for the most part, had already been hammered. Their only downgrade regarding a strong performing group was in the Industrial sector. Here they really couldn't find a lot wrong, but the rise in steel prices may put a drag on the group's earnings. Goldman has cachet, as they say. They have become the axe, the most powerful analysts on the street, and if they are saying sell or buy, the automatons of Wall Street follow, even if several other Wall Street analysts are calling things in the opposite direction, and even if Goldman's earlier predictions on almost all of these stocks were dead wrong. Goldman's axe comes from lots of success, but three stand out in particular: 1. They have been the most powerful investment banker for a decade or longer; 2. They have taken far fewer losses on subprime debt than their Wall Street brethren; indeed, they made billions by going short the subprime index; 3. Their oil analyst nearly a year ago called for oil to hit $100 per barrel, at a time when prices were not much more than half that price. Success breeds success, and success calls for more calls. Goldman in recent weeks has obliged those who have been anticipating their every word. First, their oil analyst suggested that oil prices could reach $200 per barrel. Immediately prices started lurching toward this new official Goldman target. Late last week they made sell recommendations on Citigroup and General Motors. Again their minions threw Citi and the General from the train. They don't like the Industrials because steel prices are going up, and , well, you know, these industrial bend a lot of steel. Finally, they think the big brokerages are in for more rough times ahead, reducing the group from buy to neutral. By my count on the days that they made these "bold" calls the markets were down a total of nearly 450 points, nearly 4%. But there is something wrong with this picture. Goldman is big and powerful and they know they can move just about any stock they want to pick on in these skittish markets. But to pick on a group of stocks that have already been mauled seemed like piling on to me. Something that smacks of mudslinging; after all, most of the companies they downgraded were in their own industy, if not direct competitors. It would be like in yesterday's Euro Cup soccer finals if one of the Spanish soccer players ran over and kicked Germany's Michael Balak after he was lying on the ground bleeding from catching a Spanish defender's head in his eye. Spain kicked the ball out of bounds like the true sportmen they are. Balak was sewn up on the sidelines in relative safety and returned to the match dazed but mobile. One just has the sneaking feeling that Goldman is not doing big investment banking work for Citi or any of the other brokers that they downgraded. I have not checked General Motors, but I would be surprised if Goldman was their lead investment banker, either. It is very curious to me that on October 1, 2007, even in the face of the subprime crisis, Goldman had good things to say about Citi and Merrill Lynch. Indeed, my recollection is that both had buy ratings for the year ahead. At the time Citigroup was trading at around $42, and Goldman had a year-ahead target price of $57. When Goldman cut their rating on Citigroup to a sell last week, Citi was selling near 18. In October of 2007, Merrill Lynch was trading at around $70, with a year-ahead target price of $94. When Goldman cut Merrill's rating last week to neutral, it was trading at $35. In September of 2007, with GM trading near $30 -- again after the subprime crisis was widely known -- Goldman had a buy rating and year-ahead price target of $37 for GM. Last week with the stock was selling for about $14, Goldman cut it to sell. The market gobbled up these bold calls by Goldman last week and kicked all of these stocks in the teeth. In my judgment, it is no act of courage to put out sell signals on beaten down stocks. The problem I have with Goldman's calls is that they were dead wrong six-nine months ago when they rated all of these stocks buys. Why should we be so pessimistic now when they are putting out sell signals or downgrading stocks that in most cases are nearly 50% far lower than they were when Goldman rated them buys? If history is any judge, we may be near the bottom in all of them.

Friday, June 27, 2008

Randy's Comment to a Client

This is a response to a client by Randy Alsman. Randy is our newest portfolio manager. Randy joined us from a major pharmaceutical company where he held numerous positions from finance to senior executive for managed care, where he dealt with the government and the insurance companies. You don't need to ask, why he's so happy to be back in his hometown. I consider Randy and expert in corporate strategy. He's a brilliant guy and has taken responsibility for our investment strategy in health care, insurance, and technology. His joining our firm will be good for all of us. Jim, here's my view of the current state of the market and economy: Oil traders continue to push oil prices higher because of fears that there are no new visible oil discoveries coming on board large enough to meet the increases in demand from the burgeoning economic expansions in China and India. In the face of these rising oil prices, US consumers are cutting back their use of gasoline for the first time in 20 years; however, both China and India still provide cheap oil to their citizens and thus, demand continues to grow at a high rate in these countries. Stock traders, seeing the runaway oil prices combined with their growing belief that more bad loan write-offs are coming in second quarter earnings releases beginning next week, have sent stock prices in the opposite direction of oil prices, with stocks falling to new 2008 lows. All of this flies in the face of the US economy which continues to confound the pessimists with a steady stream of better-than-expected reports, the most recent showing GDP growth in the first quarter of 1%. Indeed, many economists, who were formerly calling for a recession in 2008 have now come over to our view that the economy will just muddle along for the rest of the year. The media and many political candidates seem to be going in the opposite direction of the economists. From their perspectives, a "Hooverville" will be coming to a city near you soon. In fact, Arthur Lafley, chairman of Procter and Gamble, lashed out at the presidential candidates yesterday for crying, "woe is me" on the economy, which Mr. Lafley said was making people feel the economy is it much worse than it really is. The oil spike is lifting inflation fears and the credit crunch is increasing recession fears. We're a long way from stagflation (double digit inflation and unemployment at 6.5 - 7.0%), but it still feels like stagflation to a lot of people. The fixes for recession or inflation are pretty straightforward. However, facing both at the same time is much trickier. That uncertainty is causing traders to be more cautious, which translates into lower stock prices. Forced to put a stake in the ground, I'd guess near term trading will continue to be very volatile. If I am right and second quarter earnings come in much better than expected, the markets will be just as volatile on the upside as they have been on the down. Right now, we're pretty close to where we were at the January and March lows, which were just a few points shy of the mythical 20% down bear-market definition. Absent any big new news, we will most likely bounce up and down between here and 1,000 points higher for a while. Our investment strategy for 2008 is based on that scenario. Risking sounding like a broken record, we're buying and holding quality companies that have successfully weathered similar bad times, and worse, and that are increasing their dividends. So far, the average company in our portfolio has increased its dividend more than 11% over the last 12 months. We see that partly as a sign that they are expecting to come out the other side of this down market in decent shape. That’s all for now, I’ll have more to say when the earnings start rolling in. Randy Alsman, Vice President Portfolio Manager

Friday, June 20, 2008

Dow Jones Dividend Watch: Good Readings

All of us have been fixated on the subprime crisis in banking and it many twists and turns, but the financials as a sector represent only 15%-20% of all stocks and banks are an even smaller percentage of that total.

Our dividend strategy states that long-term dividend growth is the key to price growth. Our work on the Dow Jones Industrials shows us that if you include changes in interest rates and earnings growth with dividend growth, the correlation with price reaches nearly 90%.

With bank dividends much in the news, and seemingly headed in the wrong direction, that must mean that our dividend strategy should be signalling that bad times are ahead.? Nothing could be further from the truth. Indeed, the table below shows that dividend growth is very much alive and well and signalling that dividend troubles in financial land are not spilling over into the other industry sectors, and by extension other parts of the economy.

Over the past 12 months, approximately the time of the blow up in the subprime crisis, the average dividend growth for the 30 stocks in the Dow Jones Industrials has been 10.4%, as shown in yellow at the bottom of the table. Let's put that in perspective. That is about the same dividend growth as the Dow has experienced over the last 5 years and nearly double that of its 50-year average of 5.7%.

Let's look at the dark side first. At the bottom we see Citigroup with a whopping 41% cut in its dividend over last year. It was the only stock in the Dow to cut it dividend, but there was another small group of companies that would not make it on any dividend stars list: Alcoa, Home Depot, Merck, JP Morgan Chase, and General Motors. They did not increase their dividends during the year.
Looking at the bright side, we see that McDonalds increased its dividend by 50%, while IBM, Intel, United Technologies, and American Express all increased their dividend by over 20%.

Wait a minute, isn't American Express a financial in that very risky business of credit cards? Surely the management of this company has lost its mind. Don't they know that every consumer in America is doomed to bankruptcy? That is what many gurus would have us believe. Surely that increase could not be recent. Perhaps it was in June of last year before things really began to fall apart. Nope, the increase was payable in November. AXP hiked their dividend 20% in the absolute eye of the subprime storm. You did not hear it because the "meat-eaters" (media) weren't looking for any good news to put on the table during that time.

Dividends growth was not a scarcity in the last 12 months for the Dow stocks, and we don't believe it will be over the next 12 months either. There will be a jockeying around for the growth leadership, and indeed, another company may cut its dividend during the coming year (GM is a near sure thing), but on balance the good news will win out over the bad news just like it has for the last 50 years. Only 7 times in the last 50 years have cumulative dividends fallen for the companies in the Dow.

In case you are wondering, our Dow Jones Valuation Model, in this case including dividends, earnings, and interest rates, is now projecting the current "fair value" for the Dow is just over 14,000. That seems like a long way off in light of the current troubles, but all of us know that sooner or later the troubles pass. The difference between today's 12,000 and our models "fair value" of 14,000 seems unattainable, and it is certainly not a guarantee that stocks will be much higher in the months to come. but it is just saying that stocks are very cheap today, when viewed statistically versus the past.

From our model's perspective, the only way that stocks are not cheap is if earnings and dividends fall sharply, and interest rates rise sharply. Small changes in any of the data would still leave us undervalued. Furthermore, weakness in financials alone could not put us in an overvalued position. Financials in the Dow are only about 13% of the value.

I realize this is more good news, and you may not be in the mood for good news, but this is the reality of what is going on in the "whole market", not just the financials.

From the sounds of the doom and gloomers, the darkness is circling all around us. Can the dawn be so far away, particularly when our valuation models are so undervalued.

Tuesday, June 17, 2008

A Few Thoughts for Bank of America's Mr. Lewis

Our firm and clients have been riding with you for six to seven years. It has not always been easy since we have had to hold our collective breaths every time rumors started to fly that, yes Bank of America might be extending it product lines or its footprint by making yet another acquisition. Unfortunately, few of the rumors have turned out to be false. We have been with you when you belly-flopped our stock with your Fleet Boston purchase and genuflected our stock with your MBNA purchase. In each case, we held our collective noses because we are big believers in Peter Lynch's notion of "diworsification:" diversification and mergers oftentimes make a company "worse" not better. Through your aggressive program of "diworsification" we now own the bank with the biggest footprint and broadest product line of any bank in the US. But we are none the richer for your diworsification; your stock price is lower than it was six years ago. In our judgment, you are one decision away from joining your good friend Kennedy Thompson, late of Wachovia. That decision, as you know, is if you cut your dividend. If you cut your dividend, we will leave you and we won't be alone. It will prove that all that you have cobbled together over these last few years is a pile of rubbish -- the crown jewels were impostors, the gold was folly. If you can find the money in the middle of the subprime crisis to buy Lasalle National, Countrywide Financial, and put another couple of billion in China, you can keep paying the dividend. If you cut it, you will have proved, as so many analysts have said all along, that you didn't know what you were doing, and we will have to fall on our swords and admit that we followed you. You said recently that the condition of the economy will dictate your dividend decisions. Wrong, with your spending spree you have asked us to believe that the future is bright, why would you need to cut the dividend if the future is bright? I don't like the tone of this piece anymore than you do, but I am giving you fair warning: if you cut the dividend you'll be playing golf everyday with Kennedy Thompson. By all accounts, you are a good man; a man who loves banking, your employees, small business people, and your shareholders (I think the list is pretty long). This is a time to show boldness for your stakeholders interests. Lay down the gauntlet and say that Bank of America will not cut its dividend under your leadership. You cannot brag about your dividend hikes for a decade and wipe them all away in a year. That is pretty much what you said about your investment bankers actions. You decided on their behalf that you had had about a much fun in investment banking as you could stand. You know that is what many investors will decide about you and Bank of America if you wipe out five years of dividend increases. Wall Street is laying odds on you cutting the dividend. Why don't you prove them wrong for once by saying "the dividend is safe on my watch." Of course your investment bankers will say that that kind of statement is a foolish thing to do, but good grief how much bad advice are you going to take from them? They were the ones who told you all the smart things that are now blowing up in your face. The banking system needs someone to stand up and risk his own neck for the benefit of his shareholders. Why do you constantly leave that up to Wells Fargo. Why not just say it: "If the dividend goes, I go." At least you can leave with your dignity when this is all over. Nearly tw0-thirds of our client are at or near retirement. They need for you to stand firm for them. We can stand a few years of no increase, but please, stand firm for your shareholders. We have not given up on you. We believe you are the man to begin the healing process between investors and banks: do it with a dividend imperative, Mr. Lewis.

Monday, June 09, 2008

The Thing Most of Us Fear is in the Rear View Mirror

I read this weekend where many investors are "throwing in the towel" on stocks because they can't stand the ride. That is simply not a wise approach. As Warren Buffett once said, volatility does not equal risk. Volatile stocks feel risky, but that is just traders batting the stocks back and forth like tennis balls. They have a right to do this and, yes it would be "nice" if they would stay out of things, but that is not the way of the world. Volatility is here to stay, therefore, we must continue to refine and improve our valuation models to offer our clients "valuation information" that honestly quantifies the intrinsic value of a company, no matter how many tennis balls are flying about. Alan Greenspan said something in an interview recently that has stuck with me. He said that he had learned over the years that when bad things happen, the markets invariably freeze up with fear, and when good things happen, the markets explode with greed (Not exactly his words but close). He said this overzealous reaction in both directions appears to be innate. That would mean that even the most seasoned veteran traders, if they feel threatened, will cut and run, and this cut and run reaction promulgates further cut and run reactions among other traders, who pass it on to still yet other, ostensibly, rational souls, and so forth. Likewise when the news is good, a load-the-wagons mentality promulgates more loading of the wagon, which means more and more people become loaders of wagons. But knowing this, wouldn't it be smart for us long-term investors to cut and run early and avoid the rush when we see a cut and run mentality forming? Likewise when we sense a load-the-wagons mentality on the rise, shouldn't we load like crazy? If we were blessed with perfect timing, yes, but we are not and our own research and experience suggest that probably 95% of all cut and run news turns back on itself within the next 12 months, as does load-the-wagons news. Indeed, John Neff, of Windsor Mutual Funds fame, said that the best place to look for solid stocks to buy was on the list of stocks hitting new 52 week lows. Mr. Neff's words echo almost every famous investor who has ever lived -- buy low and sell high. Mr. Greenspan's thesis, however, is that buying low is innately difficult if not impossible for most investors, because it means buying that which appears to be heading down the tubes precisely at a time when their most powerful emotion is to cut and run. This is what we believe: Over a three to five year time frame, the value and price of a stock will reach a kind of fair value, or equilibrium. The rest of the time prices and values will weave and wobble around each other without any apparent tight correlation. Although we can find very high correlations between dividends and prices among many companies, our Dividend Valuation Tools are not infallible. They only work if a company is reasonably the same company over the next year or so that it has been over the last 20 years. The model requires very mortal men and women to interpret in 360 degrees what it really says about the true valuation of a company. Having said this, if we diversify our portfolios among 30 odd (uniquely wonderful) companies, we should be able to minimize the risk of any one company coming apart and sinking the whole portfolio. That is indeed what we have seen in the last year. Most of our banks have taken a knock. We had to sell Wachovia because they cut their dividend. We have spent more time in the last year analyzing accounting statements than all of us did in all the years we spent in accounting classes in college. On the other hand, our oil stocks, for obvious reasons, have had a sensational year. We have only slightly fewer oil stocks as a percentage of the portfolio than we have bank stocks. That sure makes sense, doesn't it? We have an oil crisis why not buy up the oil stocks. Well, we started buying almost all our of oil stocks in 2001, when the US was under a siege mentality and none of us were ever going to travel more than 20 miles from home for fear the terrorists would strike our home town. We bought oil when it seemed like the worst investment on earth. We bought oil because our models said: Oil is cheap, buy oil. We bought oil and figured about all we could expect for awhile was the dividend, but we bought oil because our models said oil stocks were very cheap. Oil stocks are not so cheap now. Indeed, oil stocks are dear now. Everyone on the face of the earth knows that oil will never fall in price. It can only go to $150 per p/b on its way to $200 p/b and whatever number you want to pick next. But isn't that the kind of "load-the-wagons" mentality that has lied to you and stolen from you all of your lives? When are we going to wise up and come to the conclusion that life is going on, somehow, someway. Life is going on, high oil prices or not. Economic growth is going to continue in every country in the world where men and women get to keep the majority of what they earn. You want to say it is different this time; it's really bad out there. Sure it is; but the opportunities that will come to those who have faith in the ingenuity, innovation, and work ethic of mankind will reap a bounty you cannot imagine over the next few years. The current subprime crisis will be only a memory just a few short years from now, and in the meantime, many companies, financial and otherwise, will prosper. If the managements of these companies are like many of American and World CEOs they will share their good fortune with their shareholders in the form of dividends. The steady growth of these dividends will propel many stocks higher, and one day, not as far down the road as you might think, the load-the -wagon crew will be buying bank stocks. They'll be saying things like: "Gotta have those global bank stocks. That's the thing that cannot lose. You know the world is shrinking and the language of finance is the most common language in the world." Many of you will find this soliloquy naively optimistic or simply devoid of reason. Others of you will not understand a word I have said here. But there will be a few -- a remnant -- a small collection of you who will say,
  • "You know that guy has been in the business for 33 years. He has seen the oil crisis of 1973-80, the high inflation and grinding unemployment of that time, Watergate, the Carter gas lines, the Reagan Revolution, the Iraq invasion of Kuwait, the collapse of the Soviet Union, the S&L crisis, Russia's default on it loans, the Tech wreck, the attempt to impeach a President, 9/11, the Enron scandal, Katrina, the Iraq war, the collapse of the dollar, and now oil at $135 per barrel. He says it is not different this time; that all these past crises proved only bumps in the road, and that progress continued after a period of acclimation or healing in every case; and to sell the world economy or the US economy short has been a terrible bet over the last 30 odd years. Furthermore, he says that it will continue to be a terrible bet as long as people are free and own the fruits of their own labor.

I don't know how or when the current crisis will be resolved, but I am confident that it will pass and that blessings will return. I do know that if we are patient, trust in long-term investing and the power of dividends, and not get caught up in the stuff of cut and run or how much we can pile on the wagon, that there will come a day when prices will intersect with values, which our models now say are about 25% lower than the current value of the average stock.

A Caveat: These are my opinions. Do not take them at face value. Go back and read about each of the crises I have mention here. See the headlines. See what the Wall Street Journal or the New York Times said. See if they were correct on anything and where they were wrong. Finally, see if you can determine how the crises was resolved; how things moved on.

I am basing my optimistic view of the future on my experience of a long series of crises in the past that somehow, someway got worked out. If we have entered a time where mankind cannot solve the problems of our own making, then my view is silly. But if the future looks anything like the past, we humans will figure out what went wrong, correct it, and move on.

Look at the list of crises I have listed; try to recall how you felt during as many of these times as you can. I think you will discover that Alan Greenspan was right: you felt very down and did not know how things could ever get better. Now look at them again and see if you can recall how each crises was resolved. Who were the players? Who helped us understand that doom and gloom were not the only attitudes permissible under the circumstances?