Tuesday, July 22, 2008

Peak Oil: The Golden Geese Are Squawking

Americans have an addiction to cheap oil and it was engendered and nurtured by OPEC. This addiction could have gone on for many more years, except that OPEC, emboldened by the prospects of the global economic expansion and with the cover of the war in Iraq, got greedy and allowed oil prices to skyrocket way beyond oil's demand-supply equilibrium price. Since much of the oil consumed in the developing world is government subsidized, the end users in those countries do not pay a market driven price, but an artificially low price. Thus, the fastest growing parts of the world felt no pain from OPEC's price hikes. This has led to huge increases in energy demand in China and India and helped drive worldwide oil prices higher than almost anyone could have imagined just a few years ago. Having said this, we think OPEC forgot all about monopoly pricing theory, and in the process, unleashed a backlash among American consumers, who bristled with each new all-time high price for a gallon of gasoline. The laws of supply and demand and price elasticity have not been suspended for the oil market. Period. Every student who takes a course in economics knows that monopolies or near monopolies like OPEC must always be careful to price their goods on the demand curve; in this case,meaning pricing oil where consumers will pay the going price and keep consuming more. It’s no different than a drug cartel. Price the drug right, hook the users and keep them hooked on cheap drugs, then let price gradually rise to meet the gradually rising demand. Then do it all over again, being ever careful not to raise prices so much that the hikes reach the users’ consciousness and provoke a “push back” that results in their cutting back consumption. The reason is simple. The drug-pusher knows if you raise prices so much that it moves to the front of the users’ minds, his clientele may decide to go into rehab and get off the drugs. OPEC May Have Misjudged Us The shocking rise in oil prices has, however, led to an unexpected outcome in the United States, which is still the most important oil market in the world. As gasoline prices moved past $4.00 per gallon, Americans began to cut back their oil consumption, something that many believed would never happen. In early July, US oil consumption is down 3% year-over-year, on top of 2% and 1% cut backs in June and May, respectively. Three data points make a trend, and Saudi Arabia and the rest of OPEC know the routine. They must stop the upward spiral of oil prices at all costs and soon; indeed, they must get oil prices down so most Americans think the whole thing was just an aberration. Again, as we have said in previous blogs, the reason is simple: conservation, substitution, and innovation. Conservation, Substitution, and Innovation Americans may have been addicted to cheap oil for a long time; however, if oil is not going to be cheap anymore, then American consumers are going to make some changes. They are going to conserve, even if it is only at the margin. They are going to use alternate forms of energy and transportation to make their daily rounds; and they are going to encourage and buy new technologies that will allow them to live the kind of lives to which they have grown accustomed. Sales of high mileage automobiles are skyrocketing, while the sales of trucks and gas-guzzling SUVs have all but stopped. The use of mass transit is growing rapidly. High-efficiency heating and air conditioning equipment is flying off the warehouse floors. GE says it is having difficulty keeping its high efficiency “energy smart” light bulbs on the shelves. Because it is now cheaper to ship merchandise across the country on trains than on trucks, railroad stock prices are at 100-year highs, while trucking profits are poor. Shopping center associations tell us retail sales remain close to last year’s levels, but the numbers of visits shoppers are making to the malls are down. Wind farms have popped up in 20 states, including our own Indiana. Capital is being invested in more fuel-efficient automobiles, homes, and offices. Rapid Transit is sprouting up in many cities, Phoenix being the most recent. If you ask a Portlander from Oregon what they are most proud of about their city, you are likely to hear about the bike friendly byways, the beauty of the Willamette River, or the majesty of Mt. Hood, but soon you will hear about Max, the city’s rapid transit system. It’s clean, it goes where you want to go, and it’s cheap. Why should we be surprised with these manifestations of conservation, substitution, and innovation? We have grown addicted to cheap oil, but that does not mean that it has addled our brains completely. Once before when OPEC put the squeeze on us, we cut back and overall consumption went sideways for many years.

In 1978 the US consumed 19 billion barrels of oil per day, at the time of the Iran-Iraq War. As prices rose rapidly and calls for conservation became more common, US consumption fell to about 15 billion barrels per day by 1983. It was not until 1994 that our total consumption and imports reached the 1978 levels.

According to “The Economist” a virtual explosion of alternative energy plans is underway throughout this country and the world. Wind power, solar power, clean-burning coal, liquid coal, nuclear power, geothermal, tides, grain based, hydroelectric, electric cars, hybrid cars – you name it somebody with very deep pockets is investing heavily in it and putting the brain power behind it to make it commercially viable.

The American consumer, which is the golden goose of the oil cartel, is squawking and we think it's likely to continue. A limit seems to have been reached by many Americans: rich or poor, they seem to have decided that this mass export of our dollars to the sands of The Middle East has gone on too long with too little to show for it. We are changing our consumption and driving habits; we are challenging each other to use less energy.

We remember 9/11 and where most of those terrorists called home, and we know that in some way we have been dancing too long at the end of somebody else’s string.

The geese have finally begun to realize they are being fleeced. It ought to be interesting to see how OPEC backs out of this one.

Monday, July 21, 2008

To Joyce On Our 35th Wedding Anniversery

Today is one of the proudest achievements of my life. I have been married to Joyce for 35 years. They have all been good years, no matter our state or status because I have had the pleasure and privilege of walking by her side and calling her my wife. In honor of our thirty-five years as man and wife, I wanted to share a poem I wrote for Joyce in 2000. It's called Wyndhill. That is the name she gave our little plot of land when we bought it. Joyce loves gardens, which have how reached a total of five. I realize this poem has nothing to do with stocks and bonds, but it has to do with something better, a life well-lived. If I could grow up to be anybody, I would grow up to be Joyce. Not because she has me for a husband, that is her only weakness. I would grow up to be Joyce because of her love for God, all his creation, and all people great and small. She has taught me a lot about a lot of things, but I thank her most for teaching me about love, and God's love most particularly. Wyndhill So it is on Wyndhill She walks among the dahlias and lilies, and like seasoned symphonists They reach to her and anticipate her every move. The oak leaf hydrangeas, shy in their splendor, whisper to each other Of the Lady’s steps, but hold their breath when she comes near. The black walnuts come to attention and stand in full parade attire and attitude As she moves among their ranks. The troop of dancing peonies calls to the lady to skip her duties and come Play with them in the vanishing sun. The azaleas and rhododendron, decked out in scandalous colors, do long riffs Of jazz to the disdain of the others. So it is on Wyndhill We all wear our Sunday best and show our most flattering sides In hopes that the Lady will come and spend some time with us: That she will touch our bellies and wash our faces; That she will bind up our broken limbs and untangle our hair. All of us have been at seed in our days. All of us have looked out from behind tall weeds that engulfed and encumbered us. All of us have wondered if we would ever sing and dance and laugh again. Certainly, all of us know that we are God’s creation, but just as certainly We know that the lady is a friend of God’s. So it is on Wyndhill. To JED from GCD January 29, 2000

Thank You Mr. Lewis

First, let us say thank you to CEO Kenneth Lewis for the better-than-expect quarterly earnings results Bank of America (BAC) put up today. As he said in his statement, "Outside of real estate-related products, our operating results were quite good virtually across all business segments." That's the kind of news we'd like to hear more of in the quarters to ahead. The news is certainly not all good as credit quality continued to weaken with charge offs more than doubling the levels of a year ago. If there was any ray of good news in the report, it was that loan loss provisions were slightly less than they were in the the company's first quarter. We hope this quarter is the first of many where this is the case. Mr. Lewis further said that these results came under very difficult circumstances (and how!) and show the advantages of the breadth of the company's product offerings, which enabled the company's employees to differential Bank of American from its competitors. The dividend news that we at Donaldson Capital Management have been so anxiously awaiting was also good. BAC is officially maintaining their dividend at current levels. At the current level, the stock now yields over 9%. The company is not out of the woods yet, but the numbers for the second quarter were better than previous quarters and better than expected. If real estate does bottom in the third quarter of 2008 as Mr. Lewis has previously predicted, then a modest dividend hike may be possible in 2009. If that is the case, BAC is one cheap stock. There are, as they say, lots of unknowns here, but that pin prick of light there in the tunnel just got a bit bigger and brighter with these results. Every crisis needs leadership to show us the way out. We continue to believe that Mr. Lewis of Bank America and Mr. Stumpf of Wells Fargo possess the vision and the courage to lead us through the maze of talking heads and knee-jerk gloom and doomers toward a brighter and sounder future of investing in banks. Thanks again, Mr. Lewis. To find out more about Donaldson Capital Management, please click on the following link: www.dcmol.com This blog is for information only. Nothing here should be considered a recommendation to buy or sell. We own Bank of America.

Wednesday, July 16, 2008

Wells Fargo Is Still Very Cheap

Wells Fargo's (WFC) news of better than expected earnings and a 10% dividend hike sent the stock up nearly 33%. It also powered the overall stock market up nearly 2.5%. This is a perfect illustration of what we have been saying about the banks. Prior to today almost all banks were being treated like they would dry up and blow away, and that is simply not the truth. Banking is the oil that allows local and international trade to occur. No banking and we are back to Mayberry, Green Acres, or Ozzie and Harriett. Those were the good old days, but those days are gone. Banks are going to make it out of this crisis, and it will be the strong banks like WFC that will lead it. I am hearing that in many cities where there are wounded banks like National City, Fifth Third, Key, and First Horizon, that smaller local banks and stronger national banks are taking customer at will. This is completely anecdotal, but I'm hearing it from my sources all over the country. JP Morgan is hiring top talent in California. Most other regional banks there are firing. It is a simple case of the strong getting stronger and the weak getting weaker. Banks that avoided the subprime debacle and have solid capital and loan loss ratios are flat out ruling the roost, and my experience tells me that the gains they are making against the wounded banks will not be won back easily by the wounded crowd. There are hundreds of banks that will report earnings over the next 10 days. The markets will bob and weave with each important release, but the Wells Fargo news shows what a solid bank with a reputation for terrific risk management and a culture of expanding their usefulness to an ever increasing clientele with an ever widening list of products can do. Not all banks are Wells Fargo, but then neither are all banks National City, either. There will be some surprisingly good numbers coming from the banks, and as I have been saying most banks have written off an enormous amount of pain. Is it possible that we are nearing an end of the write offs? If we are, we are near a rally in banks that will make today's pop look like a sparkler. Our models say that WFC is still undervalued by 20%-30%. With the short that has built up in the bank stocks, the winners, like WFC, can go higher than you can imagine, as the shorts are forced to cover. The next key release is for Bank of America next week. Strap yourself in. We own WFC and BAC. Consult your own advisor on any stock mentioned here. Do not use this blog for investment advice. We are very long-term investors, not traders. Our average holding time for a stock is near 5 years. We don't buy anything that we plan to hold for less that 18 months to 2 years. This is not the ways of Wall Street, but this is the ways of dividend investing. It works if you have the patience to judge the value of your investments on something other than their current selling prices.

Monday, July 14, 2008

The Bailout of Fannie and Freddie: The Beginning of the Beginning

Please forgive any punctuation or spelling errors you may find here. I continue to have trouble with the edit function of my blogger account. I will have things back to normal shortly.

Fannie Mae and Freddie Mac appear to be headed toward a rendezvous with something that John Maynard Keynes would advocate -- a bailout. Within days they are likely to be getting a helping and "visible hand" from Uncle Sam in the form of government loan guarantees and capital infusions to strengthen their capital bases. At issue is their net capital -- they don't appear to have enough of it to carry the trillions of dollars of mortgage loans that the two hold between them, especially when housing prices are falling and defaults are rising. As big and as powerful as Fannie and Freddie are, they could not stand as the savior of the housing industry. Only the US government can do that, but Fannie and Freddie will play an important role in the bailout of housing. They will be the conduits and the facilitators of the government's largess in cleaning up the housing debacle. Private and public financial types were in the news over the weekend discussing the Treasury Department's deeper intercession into the housing quagmire. Treasury Secretary Henry Paulson has announced that he will ask Congress to approve a wide-ranging package of loans and equity commitments to the Fannie Mae and Freddie Mac. I have had a growing worry that if the government did not step in to assist Fannie and Freddie that the negative momentum that has ensnared nearly all financial institutions may have propelled both government sponsored enterprises into a technical state of default, whether or not the financial statements would deem it fair or equitable. The banking system largely remains frozen, as banks shore up their own capital ratios with the spreads they can earn from borrowing short-term Fed Funds and investing in longer-term higher yielding debt. Almost all lenders surveys are now indicating a significant tightening of lending standards. Thus, Fannie and Freddie have been left as the home mortgage makers of last resort, and the only windows truly open to all comers. The possible demise of Fannie and Freddie was simply too big a risk for the government to take. They had to act. They had to give up on Adam Smith's invisible hand, for Keynes' visible hand. This intrusion into the fine points of capitalism will be debated ad nauseum, but though I am the staunchest of believers in free markets, I called for this move weeks ago, when I said that before the housing ordeal was over, the United States Government would be investing in mortgages. That was the only way I could see then, or now to stop the cascading real estate snowball from plowing through every bank in the country. Now the government is on the inside. Through an equity role with Fannie and Freddie they will be able to see the real numbers, not play peek a boo with enterprises that are trying to hide their true financial conditions. I want to speak to the different asset classes that Fannie and Freddie have in the market and their relative degree of risk associated with these changes. The list is not exhaustive. It is just the main body of securities that trade everyday. 1. So-called Sovereign Agencies, or Debentures: These are a staple in the investment world and a product that we use broadly. They have been rated AAA for years and continue to be. These Agencies have what is called an implicit backing by the government that just became explicit. This is good news.

2. Collateralized Mortgage Obligations guaranteed by Fannie or Freddie: These, too, just got a lot safer, though they were already had a high degree of safety even before this move because of their high quality collateral.

3. Preferred Stocks: The devil might be in the details here, but as I read Mr. Paulson's plan, Fannie and Freddie's preferred stocks should get and immediate boost. They just got a lot safer because there is now little likelihood that Fannie and Freddie will fail.

4. The wild card is the common stock: I think that was the reason these two stocks were so weak on Friday. If the government is going to take an equity position, it will be very dilutive to current shareholders if it looks like the private equity deals. Having said this, the stocks might pop a little higher if it looks like the deal will be approved quickly.

To me it was inevitable that the government would have to get into the mortgage business to turn around housing. I am very hopeful that in doing so, they have truly begun the beginning of a turn around in real estate.

Tuesday, July 08, 2008

Is GE's Dividend Safe?

Jeffrey Immelt's job may not be safe, but I believe GE's dividend is as safe as any stock I can think of. GE will be reporting its earning for the second quarter this week and the chorus of Wall Street analysts are singing in complete discord. There is wide disagreement over whether or not GE's mark-to-the-market problems are behind them at GE Credit, and whether or not they will make their earnings estimates. I believe GE will land on the good side of their earnings estimates and the heat will come off their stock for a while. Additionally, I believe GE is too big and too strong to continue on its descent as though it were only a financial stock. This is one of the greatest amalgamations of businesses the world has ever seen; if GE has lost his way, it is because Immelt has lost his way with a company that, as Peter Lynch of Fidelity used to say, "Any fool could run." I don't mean to minimize the complexity of the organization. From jet engines to wind turbines and gas powered electric generating plants; from medical imaging products to NBC, CNBC, and MSNBC, this company is the epitome of American ingenuity and power. It is safe, sure, sound, and secure, yet it has languished below $30 per shares since April, when they announced the shocking write off of loans in their GE Credit division. In the weeks that followed the write-offs, rumors flowed that the write off had already been recovered. If that is the case, GE will provide surprisingly good earnings this quarter, if not, Jeffrey Immelt's days are numbered. The reason is simple, he has the infamous "heir apparent" disease. He followed a legend in Jack Welch. That's tough enough, but Mr. Welch, who is trying to polish his own image, after an ugly divorce battle, seems to be throwing Mr. Immelt from the train. He has panned him on numerous occasions, only to say he was sorry later. It has been my observation that Jack Welch doesn't say things he doesn't mean. Saying he's sorry pales compared to his spearing Immelt on a regular basis. Immelt has a job much like we have at Donaldson Capital Management. He allocates capital. He runs an organization that is too large to manage. He manages the portfolio. The write-off blunder was an act of extreme mismanagement, because it means that his top lieutenants in the GE Credit division were not keeping him posted on the problems. If Immelt were a manager, he would be in the loop; as an asset allocator, he seemingly found out about the problem about the same time as we did, and that is not good enough. He is damaged goods and unless he can pull a rabbit or two out of his hat in the next couple of quarters, he will be history. GE's stock is still lower than it was the day that Immelt took over. GE is one of the proudest and toughest minded companies in the world; the results have not been forthcoming, Wall Street has not embraced Mr. Immelt, and Jeffrey's hairdo is beginning to look very colored and very coiffed. These are all signs that his days are numbered. Having said this, the dividend is safe. GE pays out only about half of their earnings in dividends, and their free cash flows are even bigger than their earnings. Indeed, GE raised their dividend earlier this year by over 10%. The dividend is safe, Immelt's job is not.

Thursday, July 03, 2008

There is Still Plenty of Fizz in Pepsico

There have been growing concerns that many of the Consumer Staples are coming under growing cost pressures. Grain, energy, metals, and transportation costs have all risen sharply, and many Consumer Staples are large consumers of these materials.

We believe Pepsico can minimize these headwinds with an equally formidable list of growth opportunities:

  1. It continues to grow its non-cola franchises faster than its competition,

  2. It continues to expand its presence throughout the world -- it is strong in Brazil, Russia, India, and China, the so-called BRIC nations, where growing middle classes are producing geometric growth in per capita consumption of Pepsi. products;

  3. We believe they have more pricing power than many of their rivals.

The Dividend Valuation chart above indicates that PEP is currently selling at nearly a 10% discount from its fair value and nearly 25% under its projected year- ahead value, as shown by the striped bar at the far right.

We think Pepsico is a good stock for these chaotic times, and its continued good results will ultimately push the stock higher.

Finally, Pepsico has a logo of very patriotic colors: Red, White, and Blue. It seems a fitting stock to discuss on the Fourth of July.

We own the stock but this blog is not to be used for investment decisions. We will also not declare if and when we sell PEP. Please consult your own advisor.