Friday, October 24, 2008

GE: Out Like A Light, Or Just On a Dimmer?

By Randy Alsman, Vice President, Portfolio Manager Questions about General Electric’s future are flying among investors lately. The stock has recently set a series of new 52-week lows. Criticism of CEO Jeff Immelt abounds, including left-handed compliments from legendary former GE CEO Jack Welch. GE Capital, a $65+ billion finance subsidiary, one so far without the same access to the full range of federal support available to banks, generates much concern. Its huge commercial property division is struggling with the decline in that market. The housing slump has hurt GE’s appliance division – now up for sale along with the storied lighting division. Even good news is sometimes seen as bad. Investing “genius” Warren Buffet recently professed his confidence in GE and bought $3 Billion of new preferred GE stock to prove it, but GE had to pay him 10% and the warrants that he got are now underwater. Despite its litany of problems, GE’s credit is still rated AAA. Only five other companies occupy that lofty perch. So, in many ways, GE is seen as embodying America’s economic preeminence in the world. However, there is enough fear in the air and blood in the water right now for the darkest of predictions to seem inevitable. Is General Electric destined to become another General Motors? Or at least, is GE going to deteriorate into one of those once-great companies that loses its way and can no longer put together a string of growing annual revenues and earnings? Maybe so. No one can see the future perfectly. But like a smoke screen, the current bad news hides some very solid, very positive things about GE. Most divisions of the company, except GE Capital, have been growing rapidly, and not just in the U.S. Heavily entrenched in the global conventional and alternative energy infrastructure markets, GE will continue to benefit from the world’s insatiable appetite for energy. GE is a world leader in sophisticated turbines for power generation and aircraft. It supplies locomotives to the energy-efficient rail industry. Aging Baby Boomers in the US and around the world will demand more MRI’s, CAT scans, cardiac imaging tests, and other diagnostic measures - markets that GE dominates around the world with only a few other firms. The entertainment business is viewed by many as recession-resistant, and again GE is a major player. The cash flow from NBC Universal continues to be very strong. The current double-whammy of a credit crisis and economic recession has hampered or damaged each of GE’s businesses. An objective eye will see, however, that none of those problems will last forever. Also, GE still is seen with good reason as a company just packed full of extremely competent workers, managers, and executives. Jeff Immelt does not make every decision that determines the future of GE. He has lots of very talented help. Finally, GE does a better job than possibly any other company of linking one division to another, enveloping large customers in the full range of GE’s product offerings. Things are rough and troubled right now. However, unless you think all hope is lost and we’re reverting to candles, voodoo medicine, horse-drawn wagons, and a barter economy, GE should continue to be an increasingly valuable company for many years to come. With today’s PE of 8.0 and a dividend yield of over 6%, one is buying GE on the cheap and is getting paid to wait out the economic turnaround that will inevitably come. GE is poised to provide handsome returns for investors with the courage and patience to ride out the latest storm. We own GE in a number of our investment styles. Our principals also own the stock. Please do not make investment decisions on the basis of this information. Consult your own investment professional for investing advice. Find out more about Randy Alsman and our other portfolio managers at the following link:

Wednesday, October 22, 2008

Johnson and Johnson Offers More Than A Band-Aid

I still believe that the hedge funds are the main culprits behind the continuing sell off in stocks. Their client defections are running high and their funding sources have disappeared. Without the ability to borrow, they have only one choice -- sell. The sell off is creating some unusually attractive bargains. The chart at the right compares the dividend yield of Johnson and Johnson (JNJ) with the yield on a 10-Year US Treasury bond, going back 20 years. In 1988 the T-bond yielded nearly 9% vs. about a 2% dividend yield for JNJ. JNJ's dividend growth and price growth have had a high correlation for many years, thus, to break even a buyer of JNJ in 1988 would have had to have expected at least 7% annual dividend and price growth to justify buying the stock.
The second Chart shows the actual annual dividend growth of JNJ over the last 20 years. Its dividend growth has averaged nearly 14% per year, well over the break even level required. Even with the recent swoon in the market, JNJ has produced a mid double digit total return over the last 20 years. Looking back at the top chart, we see that a 10-Year T-bond now yields about 3.75% and JNJ's dividend yields just over 3%. This relationship is betting that JNJ's dividend and price will not grow in the foreseeable future. I don't think that is a good bet and neither do the analysts who follow the stock. The consensus average of the analysts is that JNJ's earnings and dividends will grow by just over 8% annually during the next 3-5 years. If JNJ's dividend does grow 8% annually, as the analysts are projecting, and its price continues to grow at about the same rate as it dividend, that would produce almost an 11% total return over the next 3-5 years. Sounds too good to be true, especially when we see the carnage that has befallen Wall Street lately, but I believe many quality companies such as JNJ will continue to produce solid results in spite of the uncertainties that are confounding the markets. We are passing through a financial storm. Yet, we now have the whole world working to repair the effects of the storm. History shows us that when we have gotten the whole working on a problem, it has been solved. I believe this will happen again. I will review other companies in the coming weeks that appear to be oversold. We own JNJ in our clients' accounts. The principals of the firm also own it. Please consult your own adviser on the merits of JNJ.

Thursday, October 16, 2008

Dr. Ed's Explanation For Yesterday's Stock Tailspin

By their very nature panic-driven markets defy rational understanding, but yesterday's plunge simply made no sense to me. The weak economic data was blamed for the big drop in stocks by most of the media that I have read, but as I went to bed last night, in my mind the weak retail numbers alone just did not justify a 700 point fall on the Dow. Everyone knows that there is a gawkers affect, and the constant headlines of bank bailouts and failures would certainly keep people away from the malls. It just did not add up to me that the market could not see that the cavalry was on the way. With all of the assistance world governments are giving banks, the new programs for troubled homeowners, and a new stimulus package moving through Congress, it would have seemed that the markets should have reacted far less violently. I believe my suspicions were answered this morning when I read Dr. Ed Yardeni's morning economic report. Dr. Ed, a widely respected economist, reported that investors had pulled $43 billion from hedge funds in September alone. He went on to say that as a result of the demise of Lehman Brothers and the pull back in higher-risk lending by investment banks and commercial banks the world over, that the hedge funds are under siege. In short, their lending sources have all but dried up. Thus, when investors want out, the hedge funds have no choice but to sell stocks no matter what the price. That is what Dr. Ed is convinced drove the Dow's fall yesterday. That makes much more sense to me than the market's reaction to a weak economic number that will be adjusted many times in the coming months before we know for sure how the economy is faring. I have spoken before of the reasonably good long-term correlation between GDP and the Dow. It's not tit for tat, but particularly since 1960, the two have moved together. With yesterday's close around 8,500 on the Dow, the Dow is back to were it was in 2002. At that time, the cumulative real GDP of the US was just under $10 trillion. The most recent reading of GDP is $11.8 trillion, nearly 12% higher. With the Dow at this level, that would mean that the economy has grown by nearly its long-term average over the past six years and stocks have not grown at all. Inflation is the only headwind that could cause the Dow's current reading to accurately reflect the value of its 30 stocks. With oil having fallen to under $80 p/b, it is clear that inflation will be falling in the months ahead. Today's CPI showed zero headline inflation and .1% at the core level. The are many unknowns in all the new governmental plans to bail out the banks and stimulate the economy, but we remain convinced these plans will do their jobs, and that as consumers become more confident of this, they will not continue to stay at home and eat microwave dinners. There will be more spells of hedge fund selling, but their selling has very little to do with the underlying values of the companies that they are selling. Their selling is just bailing out to payoff exiting customers. As the bank stabilization plans come clearer into view, we believe the hedge fund selling will likely diminish, if not turn to buying. I am in Dallas Texas for my oldest son's wedding. He is marrying a wonderful belle of Texas. He asked me just a few weeks ago what I thought the future was for his generation in light of all the problems in the economy. I laughed and told him that I wondered the very same thing when his mother, Joyce, and I got married years ago during the first oil OPEC embargo. I told him the world is far from perfect but that progress is unstoppable. Where free men and women are given the tools, they will always innovate and come up with better ways of doing things. And these better ways of doing things need lots of people to make them happen and move them around the world. Furthermore, I told him, he and his new bride would help cause this new world of innovation to unfold. Justin is getting his PhD in Informatics from Indiana University. He works in areas I cannot describe. How can he or I be pessimistic with this new generation of thinkers and doers on the move?

Friday, October 10, 2008

United Technology's Dividend Hike Signals Business Isn't So Bad

In one of the worst weeks in US stock markets history, there was a positive event that occured that suggests that what we saw this week may have been more about fear than about a collapse in underlying business prospects. That important positive event was United Technologies (UTX) dividend hike of just over 20%. A dividend hike in bad times is always a good signal as to how a company's board of directors view the future. UTX's board could have raised the dividend even as little as 7%, and it would have been good news, but raising it 20% causes one to pause a little longer and think about what this big dividend hike might mean. First it is important to note that UTX has raised its dividend an average of nearly 18% per year over the last 5 years. During this time their earnings growth has averaged nearly 15%. In the last twelve months, UTX's earnings have grown 16%. So, the 20% hike was not statistically out of their recent patterns. What is surprising is that the dividend hike is at the high end of their recent range and comes at a time when their stock is under heavy selling pressure. Indeed, UTX's price is down almost 38% in the past twelve months. Was the dividend hike an attention getter to buy back some of the sellers? That's silly. In recent months, dividends have been the last thing on people's minds. UTX would also not seem to be a company that would be slipping through the weakening economy without some bruises. The construction business is important to their Carrier division; the strength of the global economy is important to their Otis Elevator division; and they have tough competition in their Pratt and Whitney and Sikorsky Helicopter divisions. The conclusion I come to is that UTX's business is on balance good. Their geographic diversification of 48% North American sales and 52% global sales is serving them well. Innovations across all their product lines are being well received, and in a world that is increasingly interested in more efficient products, UTX is delivering. This means that UTX's new products are replacing existing installations early because of cost saves. In addition UTX has developed a low-heat geothermal product that is gaining wide acceptance all over the world. I can speak a thousand words or just a few about the week's market's collapse, and one dividend hike pales in comparison to the wealth that was lost this week. However, if the lost wealth this week was about a collapse in business prospects, I believe it would have been reflected in the amount of UTX's dividend hike. Since UTX hiked their dividend at the high end of their recent history and because of their size and influence in our economy, it is a signal to me that business is not falling apart, as the market would have us believe. Indeed UTX's dividend action would suggest that business prospects are still good on a global basis. This was also born out in IBM's spectacular earnings report this weak. The G-7 is meeting this weekend to try to find a way to restore order to the banking system and the markets. With the crushing the markets took this week, investor expectations are not high that a workable approach will result from the talks. I am praying that the market is wrong. I invite you to pray in whatever way is your custom for the men and women who will try to find solutions to the problems of our banking system. Here is mine. Oh Lord, you are the giver of all good things. Your Word says that You bring rains in the proper seasons that provide bounty to the land and food to the cattle and sheep of a thousand hills. Lord a deep fear-driven drought has come to the the financial markets of the world. We ask Lord that You would bring life giving rain in the form of wisdom and truth to our world leaders. Guide them to good policies that are pleasing to you and that will bear fruit. Grant us the courage and the wisdom to do endure these times of uncertainty. Grant us relief from this hour of uncertainty and replace it with the joy that is yours alone to give and you delight in giving. Amen.

Tuesday, October 07, 2008

How We Turn the Markets

I spoke with one of the savviest financial people I know this morning on my way into work. He asked me for my take on why the markets’ seemed to be in such a tailspin. Before I could get into my explanation, he said, “The markets are acting completely irrational. Business is not falling off the table the way that stock prices are.” I told him that his explanation was my explanation. Fear was driving the selling with rationality having left the building. I explained that the bank rescue plan came as a surprise to Congress and they did not do a good job of selling it to the American people. The plan is certainly a rescue, but in its original form, it was not a bailout of $700 billion because the government would be buying frozen assets at greatly discounted prices and would likely make back their investment from the mortgage payments alone, let alone the fact that a house was attached to every loan. The public got up-in-arms because they were angry at not only Wall Street but also the politicians, and as a result, they inflicted their wrath on the halls of the House of Representatives. The House, sensing that they were in a no win position with the electorate, punted and voted the rescue plan down. The stock markets reacted with a vicious sell off that continues to this day, even though the plan was eventually passed. My friend asked why the sell off has continued now that the bank rescue plan had been passed. I answered that I thought there were three reasons:
  1. We have a real problem of liquidity and bad loans in our economy and the rescue plan will take weeks if not months to get moving, so there is still bad news almost everyday to which the markets must react. The volatility will continue until the bank rescue plan and other measures taken by the government begin to work and unfreeze liquidity.
  2. Bank bailouts have hit Europe, with banks in Holland, Germany, and England being bailed out in one form or another.
  3. The most important issue, however, is that stock traders realize that the bank rescue plan being on the front pages for nearly a week has raised the awareness of the American people to the problems in the banking system and will lead to a pullback in consumer spending. Consumers are angry and frightened, and since they represent roughly two-thirds of US GDP, the economy, which has been muddling along, will likely slow; perhaps even dip into negative territory in the coming quarters.

Consumers were already on alert before the banking crisis was on the front pages. Recently released Federal Reserve data show that for the first time since 1998, consumer debt fell in August by 3.7%.

My friend said he agreed the economy would slow but that the stock market was down over 25%, which was dramatically more than the economy would fall. He said, “How does a market get over these kinds of irrational fears.” I said that I thought the market would get over its fears, the same way it got over its greed.

Three years ago everyone thought that home prices would go up forever and everyone got in line to buy a house. The banks, particularly in the hot real estate areas, bought into the forever-rising real estate story along with their customers and they started cutting corners on assuring the creditworthiness of their home buyers. So greed took over. Prices went up everyday. Buyers started offering more for houses than the sellers were asking -- and on and on. What killed greed is that in the end you run out of foolish buyers. The higher you go, the more value-oriented people, shall we say “rational” people, drop out, so at the end it is just the greedy doing business with the greedy. Then some of the value-minded people realize that prices have gotten too high and they start selling. Pretty soon, prices start leveling off and then start down because value-minded people keep putting more real estate on the market. As prices begin to fall, the people who were still buying at the end are quickly underwater. In stocks it’s the same way. Right now some people are selling because they believe that earnings and dividends will be significantly hit by a slowing economy, which would make their stocks worth less in the short run. But the great majority of selling is being done by people who aren’t thinking about earnings or dividends at all; they are selling because the market is going down and they are afraid. Fear has seized the day and it will run its course the same way that greed did: until value-minded people step up.

So far it has not made much sense for value-minded people to get in a hurry to start buying. The markets have been getting rocked everyday, but value-minded people realize that there will come a day very soon when the sellers will run out of steam. At that point, the value-oriented buyers will begin buying and the markets will at first calm down and then begin to move higher.

Here’s a very simple reason why: the sell-off in stocks has created great values. The Dow Jones Industrials now yield over 3%. That is a higher yield than a 5 year Treasury bond. That means that investors who buy the Dow today will at least match the income from Treasury bonds and get all the growth in dividends and prices over the next 5 years for free. It is that kind of value that brings the value-minded people off the sidelines.

Another thing that would help a lot would be if the Fed and other world central banks did a coordinated rate cut.

Friday, October 03, 2008

The Shortlist: Wells Fargo On The Move

Two weeks ago I offered a shortlist of five individuals or corporations whose wealth and power made them ideally suited to play roles in turning around the US banking system. On my list were Wells Fargo, JP Morgan, Warren Buffett, WalMart, and General Electric. I identified each participant because, in my judgment, their presence would be a vote of confidence to an increasingly fragile banking system that was having trouble raising capital. I have now updated this list three times as first Warren Buffett stepped up and took a big position in Goldman Sachs. JP Morgan joined in by buying the assets of troubled West Coast thrift, Washington Mutual. Today in the biggest news of all, Wells Fargo has offered to buy Wachovia in a deal that will not require FDIC involvement. Of all the deals announced so far, the Wells Fargo - Wachovia deal is the most important because it is the biggest and is directly involved at the heart of the mortgage crisis. Wachovia, which was formerly one of the most respected banking institutions in the world, fell from grace after its ill-timed purchase of Golden West Financial, a California based thrift. Golden West was one of the leading sellers of an exotic home mortgage called "Pick a Pay", which as its name implies, allowed mortgagees to pay varying amounts on their monthly mortgage payments, even amounts less than enough to cover interest. Pick-a-Pay losses mounted sharply after Wachovia took over Golden West, casting a pall over Wachovia and causing worries that the bank would not survive. What makes the Wells Fargo takeover bid even more interesting is that it tops a deal that the FDIC engineered last week in which Wachovia's banking operations were sold to Citigroup for $2 billion. The Citigroup deal did not include Wachovia's large brokerage and mutual funds operations. Wells Fargo was apparently involved in the bidding for Wachovia all along, but did not have the winning bid in the end. They have clearly rethought their bid and upped the ante considerably. Their bid today is for the entirety of Wachovia, including the brokerage and mutual funds operations, and totals $15 billion. This has created a dicey situation between Citigroup and Wells Fargo and threats of lawsuits are already in the air. It will be very difficult, however, for Citigroup to stay in the battle for Wachovia with such a wide gulf between their bid and that of Wells Fargo's. At the very least, Citigroup is going to have to raise their price and that probably still won't be enough because Wells Fargo's offer takes the FDIC off the hook, while Citigroups keeps them on. Here's the bottom line. This battle for Wachovia could mean we are nearing the bottom of the credit crisis. When two large healthy banks go toe to toe over a bank that only weeks ago was rumored to be close to bankruptcy, it means that big, smart money believes the worst is about over and good values are present. Today the House of Representatives passed the bank rescue plan. The outcome was in doubt until just hours before the vote. The bank rescue plan will free up critical liquidity and allow banking in this country to slowly return to normal over the coming year. It won't happen overnight and there will still be plenty of bad news coming on the economy and banking. Nonetheless, a fight breaking out for Wachovia, the passage of the bank rescue plan, and the courageous actions of JP Morgan and Warren Buffett will undoubtedly improve America's confidence in the US economy and its banking system.