Is it better to fill up with regular gas or with discounted (and subsidized) ethanol blended fuel? In Iowa, for instance, it is ten cents cheaper to fill up with ethanol blend than to buy regular. It looks pretty tempting when filling up to spend less per gallon, but does the discount make it worthwhile?
The National Highway Traffic Safety Administration data show that ethanol has 75,670 british thermal units (BTUs) per gallon instead of 115,400 for gasoline. What this means is that with ethanol, one has to burn more fuel to generate the same amount of energy – 1.53 gallons to be exact. So ethanol has 35% (34.43% to be more exact) less energy per gallon than does regular gasoline. One would expect, then, that filling up with E85, which has a combined 81,629.5 BTUs, would achieve 29% fewer miles per gallon than straight gas. This works about about right. In a recent test by Consumer Reports on a Tahoe, the fuel economy dropped 27% when running on E85 compared with gasoline (from 14 mpg overall to 10 mpg (rounded to the nearest mpg). So using BTUs for the calculations seems reasonable.
So now let’s look at it from the perspective of a person filling up in a state with subsidized ethanol blend available widely. The ten cent discount comes with 90% gasoline/10% ethanol blend. Given this blend, we can expect 3.5% fewer miles per gallon. So in order to justify the price, one would expect the discount on blended fuel from regular gasoline to be more than 3.5% (otherwise we’d pay more on an energy-equivalent basis to use ethanol). That doesn't happen to be the case today.
With gas at about $3.60 and blend at $3.50, that’s only a 2.8% discount in price. (The higher gas prices go the smaller that ten cent price discount will be on a percentage basis.) If we assume the 3.5% less mileage is a good number, the breakeven price (where we should be indifferent between the two) is $2.86 for regular, $2.76 for blend. We’re definitely above that. For E85, prices should be 29% cheaper, or $2.56, for a fuel purchaser to be indifferent between the two alternatives. The last I saw, it was about $2.90.
Just some fuel for thought.
Full disclosure: I’m filling up with regular. I’ll take a look again when (if) prices fall to $2.86 or the price discount widens.
Credit Problems in Perspective
With all of today’s seemingly dire newspaper headlines, sometimes it is difficult to keep things in perspective. Consider, for instance, the current “credit crunch,” including mortgage-related write-downs and credit losses and their effect on financial institutions globally. Through April 1, over 45 of the world’s biggest banks and securities brokerage firms have announced a total of over $230 billion in asset write-downs and credit losses, according to Bloomberg.
This is certainly a very large number, but let's view it in context. It is just 0.4% of the $57.7 trillion U.S. household net worth and less than 2% of our annual gross domestic product. In addition, only $26 billion of this is actual realized losses. In other words, over $200 billion has been due to valuation changes in the securities, whose underlying assumptions may or may not accurately reflect the eventual economic reality that will transpire. If losses actually turn out to be less than is implied by these valuations, we could see “write-ups” and/or higher returns on equity in future periods (owing to the smaller capital base caused by asset-writedowns) . But, of course, losses could also be larger than expected...
This is certainly a very large number, but let's view it in context. It is just 0.4% of the $57.7 trillion U.S. household net worth and less than 2% of our annual gross domestic product. In addition, only $26 billion of this is actual realized losses. In other words, over $200 billion has been due to valuation changes in the securities, whose underlying assumptions may or may not accurately reflect the eventual economic reality that will transpire. If losses actually turn out to be less than is implied by these valuations, we could see “write-ups” and/or higher returns on equity in future periods (owing to the smaller capital base caused by asset-writedowns) . But, of course, losses could also be larger than expected...
2008: A Disjointed Market
As I did last year, I wanted to set forth my views on the markets as we head into a new year. Again, I offer the caveat that predictions, in general, are worthless. The future is necessarily unpredictable. This doesn’t stop people from predicting that, for instance, the S&P 500 will end the year at 1,650 or that oil will top $150. I take a more measured approach, preferring to indicate ranges of possibilities rather than precise estimates. Note that I don’t trade based solely on these macro viewpoints, as I prefer to concentrate on individual names.
Let’s first consider what I said last year: I said I liked two of the Dow’s worst 2006 performers, a statement which is still true (though there are much better bargains out there than these). In fact, I like them even more than last year (since they're cheaper), as Home Depot (HD)was the Dow’s second-largest decliner [after Citigroup (C)]. Wal-Mart (WMT) stayed about where it was at the end of 2006, but business value grew more than its stock price. I said domestic markets may do better than developed international markets. This was partially right: the MSCI EAFE was up 11.2% on the year in dollar terms, but only 3.5% in local currency terms. The S&P 500’s 5.5% gain bested the EAFE’s apples-to-apples return. But the dollar continued to decline (and help international investor returns) while I expected it to rise.
I still believe the dollar is due to rise. On a purchasing power parity basis against major currencies, the dollar is probably 10-30% undervalued. Of course, over long periods currency fluctuations even out, but the dollar has added to returns substantially over the past five years, and I don’t think that trend should be extrapolated too far into the future. Add that to the popular sentiment against the dollar – virtually all of it negative. Add also that a to-remain-nameless supermodel announced publicly that she no longer wants to be paid in dollars. When the least knowledgeable person or group appears, through the lens of popular sentiment, to be making a brilliant decision, it may be time to take a fresh look at the alternate scenario. I now believe it prudent to hedge back to the dollar, if possible. Several very good mutual funds, recently reopened, hedge their currency exposure.
Where is the stock market today? The spread between the forward earnings yield on stocks and the yield on 10-year Treasuries is about 1.6% at today’s levels. As I’ve mentioned in a previous post, this spread has averaged 0.4% but has varied between –4% and +7% over that time period as well. At this point, I would rather have my money in stocks than in Treasuries.
The worst performing sectors in 2007, Financials (down 20.8%) and Consumer Discretionary (down 14.3%), look to be the leaders over the next few years. Financial stocks look the cheapest and thus the most likely to rise from current levels. In addition, many of these stocks trade below book or at historically low premiums to book. Several consumer discretionary stocks, this year’s second-worst performing sector in the S&P 500, also look to be better performers in the year-ahead. Homebuilders may have a little farther to fall, but the risk-reward tradeoff is very favorable from here. I looked at one homebuilder recently that is generating a 25% free cash flow yield. Several REITs have been caught in the "financials" mess and now trade below book value while paying hefty dividends. I look to the beaten-down areas for future standout performers. I am choosing to stay away from some of the Nasdaq's best performers such as Amazon (AMZN), Apple (AAPL), and Research in Motion (RIMM), which were up 139%, and 137% and 165%, respectively, in 2007. These stocks seem too popular to be cheap.
Utilities are probably priced too expensively for their fundamentals. Consider that the utilities sector has risen 121% in the past five years and is the second best performing sector in the S&P 500 over that period, after Energy, which is up 230% over that same timeframe. Consumer Discretionary, Health Care, and Financials, by contrast, are the worst performing, up 42%, 33%, and 32%, respectively, over the past five years. Continuing to bet on Energy, Utilities, and Materials seems to me to be more a bet on hope than on fundamentals. I could be wrong, but it is not within my circle of competence to project from where such high future returns will come.
The market, for the first time in a couple years, is quite disjointed. In 2004, 2005, 2006, the worst performing and top-performing sector were all positive and the spread between best and worst was between 34% and 16%. We had a pretty homogenous, steady march upward. In 2007 that changed, as the spread between the best performing (Energy) and worst performing (Financials) was 53%, with Energy up 32% and Financials down 21%. In such disjointed markets, it is likely that the best performing are expensive, the worst performing are cheap, or both (think technology in 1998-2000). In this case, I’d much rather dive into very cheap financials than ride energy and materials stocks on the hope that commodity prices continue to rise.
I, nor anyone else, can know for sure if a recession is coming. To be honest, I wouldn’t be surprised if one is already here, a feeling I get after reading third quarter earnings reports and listening to company conference calls. Jobs data, as a lagging indicator, has not yet declined to reflect this, and unemployment is still at a level many consider “full.” Two sectors – financials and consumer discretionary – probably already reflect recessionary conditions and thus stocks in these sectors should be hurt less by an actual downturn. The sectors that will really be hurt by a recession are precisely 2007’s winners – energy, materials, utilities and industrials. While utility companies will be okay, their stocks look to be pricing in uninterrupted, strong global growth.
In 2006, oil prices were essentially flat. This year they rose almost 30%. I think in 2008 we’ll average the year at a lower price that where we began. This is especially true if the worldwide economy really slows down. I don’t have any special insight into the marginal cost of production of a barrel of oil, but some very credible sources lead me to believe it’s now over $50 but under $70 per barrel (which is quite a bit higher than I thought last year). So somewhere in that range doesn’t seem like a bad place to consider as a fair price for oil. Regardless of the oil price fluctuations, I would like to see some of these oil companies trading at a 6 times earnings like we saw in mid-2006 again in 2008. But we’ll have to see if I get my wish.
What I am worried about is inflation and a lot of others are too (gold was up substantially in 2007, as were TIPS). Nevertheless, I think is healthy to worry about it because it is an ever-present threat to wealth. From what I’ve read, inflation (as measured by the CPI) if calculated the old way, would be substantially higher than at present (8-10% versus just 2-4%). This is not hard to believe. I see higher prices or similar prices but smaller packages (stealth inflation) almost everywhere I shop. Food price inflation is rampant in fast-growing countries like China and in the U.S.. I’m sure the artificial (read: subsidies necessary to survive) market for ethanol is playing a role here. I must note that deflation continues in certain areas, such as consumer electronics. Why worry about inflation? Higher (especially higher than expected) inflation means higher interest rates which leads to higher bond yields (lower prices) and may hurt stock market values. Companies with pricing power will be the best positioned. Also, real estate values tend to rise with inflation though it pays to be selective here.
Well, I’m sure I could write several more paragraphs on what I’m currently thinking but I’ll cut it off here. These are some overarching views on the year ahead. As usual, it is bound to be interesting. If your investments get cheaper and nothing fundamental has changed, buy more! Be greedy when others are fearful and fearful when others are greedy. Happy investing in 2008.
Disclosure: Long shares of C, HD, WMT.
Let’s first consider what I said last year: I said I liked two of the Dow’s worst 2006 performers, a statement which is still true (though there are much better bargains out there than these). In fact, I like them even more than last year (since they're cheaper), as Home Depot (HD)was the Dow’s second-largest decliner [after Citigroup (C)]. Wal-Mart (WMT) stayed about where it was at the end of 2006, but business value grew more than its stock price. I said domestic markets may do better than developed international markets. This was partially right: the MSCI EAFE was up 11.2% on the year in dollar terms, but only 3.5% in local currency terms. The S&P 500’s 5.5% gain bested the EAFE’s apples-to-apples return. But the dollar continued to decline (and help international investor returns) while I expected it to rise.
I still believe the dollar is due to rise. On a purchasing power parity basis against major currencies, the dollar is probably 10-30% undervalued. Of course, over long periods currency fluctuations even out, but the dollar has added to returns substantially over the past five years, and I don’t think that trend should be extrapolated too far into the future. Add that to the popular sentiment against the dollar – virtually all of it negative. Add also that a to-remain-nameless supermodel announced publicly that she no longer wants to be paid in dollars. When the least knowledgeable person or group appears, through the lens of popular sentiment, to be making a brilliant decision, it may be time to take a fresh look at the alternate scenario. I now believe it prudent to hedge back to the dollar, if possible. Several very good mutual funds, recently reopened, hedge their currency exposure.
Where is the stock market today? The spread between the forward earnings yield on stocks and the yield on 10-year Treasuries is about 1.6% at today’s levels. As I’ve mentioned in a previous post, this spread has averaged 0.4% but has varied between –4% and +7% over that time period as well. At this point, I would rather have my money in stocks than in Treasuries.
The worst performing sectors in 2007, Financials (down 20.8%) and Consumer Discretionary (down 14.3%), look to be the leaders over the next few years. Financial stocks look the cheapest and thus the most likely to rise from current levels. In addition, many of these stocks trade below book or at historically low premiums to book. Several consumer discretionary stocks, this year’s second-worst performing sector in the S&P 500, also look to be better performers in the year-ahead. Homebuilders may have a little farther to fall, but the risk-reward tradeoff is very favorable from here. I looked at one homebuilder recently that is generating a 25% free cash flow yield. Several REITs have been caught in the "financials" mess and now trade below book value while paying hefty dividends. I look to the beaten-down areas for future standout performers. I am choosing to stay away from some of the Nasdaq's best performers such as Amazon (AMZN), Apple (AAPL), and Research in Motion (RIMM), which were up 139%, and 137% and 165%, respectively, in 2007. These stocks seem too popular to be cheap.
Utilities are probably priced too expensively for their fundamentals. Consider that the utilities sector has risen 121% in the past five years and is the second best performing sector in the S&P 500 over that period, after Energy, which is up 230% over that same timeframe. Consumer Discretionary, Health Care, and Financials, by contrast, are the worst performing, up 42%, 33%, and 32%, respectively, over the past five years. Continuing to bet on Energy, Utilities, and Materials seems to me to be more a bet on hope than on fundamentals. I could be wrong, but it is not within my circle of competence to project from where such high future returns will come.
The market, for the first time in a couple years, is quite disjointed. In 2004, 2005, 2006, the worst performing and top-performing sector were all positive and the spread between best and worst was between 34% and 16%. We had a pretty homogenous, steady march upward. In 2007 that changed, as the spread between the best performing (Energy) and worst performing (Financials) was 53%, with Energy up 32% and Financials down 21%. In such disjointed markets, it is likely that the best performing are expensive, the worst performing are cheap, or both (think technology in 1998-2000). In this case, I’d much rather dive into very cheap financials than ride energy and materials stocks on the hope that commodity prices continue to rise.
I, nor anyone else, can know for sure if a recession is coming. To be honest, I wouldn’t be surprised if one is already here, a feeling I get after reading third quarter earnings reports and listening to company conference calls. Jobs data, as a lagging indicator, has not yet declined to reflect this, and unemployment is still at a level many consider “full.” Two sectors – financials and consumer discretionary – probably already reflect recessionary conditions and thus stocks in these sectors should be hurt less by an actual downturn. The sectors that will really be hurt by a recession are precisely 2007’s winners – energy, materials, utilities and industrials. While utility companies will be okay, their stocks look to be pricing in uninterrupted, strong global growth.
In 2006, oil prices were essentially flat. This year they rose almost 30%. I think in 2008 we’ll average the year at a lower price that where we began. This is especially true if the worldwide economy really slows down. I don’t have any special insight into the marginal cost of production of a barrel of oil, but some very credible sources lead me to believe it’s now over $50 but under $70 per barrel (which is quite a bit higher than I thought last year). So somewhere in that range doesn’t seem like a bad place to consider as a fair price for oil. Regardless of the oil price fluctuations, I would like to see some of these oil companies trading at a 6 times earnings like we saw in mid-2006 again in 2008. But we’ll have to see if I get my wish.
What I am worried about is inflation and a lot of others are too (gold was up substantially in 2007, as were TIPS). Nevertheless, I think is healthy to worry about it because it is an ever-present threat to wealth. From what I’ve read, inflation (as measured by the CPI) if calculated the old way, would be substantially higher than at present (8-10% versus just 2-4%). This is not hard to believe. I see higher prices or similar prices but smaller packages (stealth inflation) almost everywhere I shop. Food price inflation is rampant in fast-growing countries like China and in the U.S.. I’m sure the artificial (read: subsidies necessary to survive) market for ethanol is playing a role here. I must note that deflation continues in certain areas, such as consumer electronics. Why worry about inflation? Higher (especially higher than expected) inflation means higher interest rates which leads to higher bond yields (lower prices) and may hurt stock market values. Companies with pricing power will be the best positioned. Also, real estate values tend to rise with inflation though it pays to be selective here.
Well, I’m sure I could write several more paragraphs on what I’m currently thinking but I’ll cut it off here. These are some overarching views on the year ahead. As usual, it is bound to be interesting. If your investments get cheaper and nothing fundamental has changed, buy more! Be greedy when others are fearful and fearful when others are greedy. Happy investing in 2008.
Disclosure: Long shares of C, HD, WMT.
Sears Hunts for Restoration
Last night, Sears Holdings (SHLD) disclosed a nearly 14% ownership stake in Restoration Hardware (RSTO). Restoration, a specialty retailer of hardware, bathware, furniture, lighting, textiles, accessories and gifts, has a few retail locations but focuses the mostly on its direct-to-consumer catalog/Internet business. RSTO shares were up significantly in after-hours trading following the disclosure. Sears acquired the shares at an average cost of $5.69, including commissions. RSTO shares closed at $6.33 yesterday prior to the announcement.
This is interesting news because Eddie Lampert, Sears’ Chairman and the person designated to invest Sears’ excess cash, has been relatively quiet lately. Sears Holding stock appears to be down in large part due to lack of activity; the disclosure last night may give the market some impetus to drive shares higher. In the 13D filing, Sears disclosed that it had engaged in discussions for a transaction at an initial price ($4/share when shares were at $2.87) that was much lower than RSTO’s current price. Chairman Lampert, the President of Land’s End, and a Sears director together visited with Restoration’s management regarding a merger, only to learn that RSTO’s management was considering a management-led buyout. Though initial talks went nowhere, Sears is currently seeking a confidentiality agreement and to engage in a due diligence process regarding a strategic alliance or merger.
Restoration appears to offer products complementary to Sears’ own and a partnership (or acquisition) with them could bring important synergies as Sears could drive those products through its retail locations. Lampert is very smart and I’m sure he would like to see more here than a minority ownership. Despite that, he is not someone who overpays for assets. Perhaps we’ll get a little more color on this when Sears Holdings releases its third quarter results on November 29th.
Full disclosure: Long shares of SHLD.
Where Is the Bottom?
"Many will be restored that now are fallen and many shall fall that are now in honor."
Where is the bottom? At this point, it doesn’t seem like there is one with banks and mortgage-related companies. Several very good companies’ stocks are down more than 50% year-to-date, yield in excess of 10%, and in many cases trade below book value. I’ve seen many of them trade down 5-10-15% in one day on no specific news. Fear is pervasive. Investment capital continues to shift to commodity-related companies – energy, materials, industrials – which continue to perform well, from bank and mortgage-related stocks – on concerns about bad loans – which are performing terribly. Yet the degree of stock price selloff in many cases is disproportionate to the actual levels of economic value that may be impaired by escalating loan losses. Eventually, stock prices will reflect the companies' true fundamentals.
While it is nearly certain that many banks and mortgage companies will experience lower levels of profitability over the next few years, that profitability is well below normal. Yet the stock market is valuing many as if declining loan losses will continue indefinitely, all dividends will be discontinued, and book value will erode far beyond its current levels. While these scenarios are inevitable with some specific names that are less prepared for a more difficult credit and economic environment, several will do very well as market sentiment shifts.
It is important to keep a clear head in this environment. Investors seek to earn a total return on their capital over time and historically dividends have been a big piece of that return. At their current quotations, some financial stocks offer (growing) yields of 10% or better. This happens to be the S&P 500’s approximate average annual return over 70+ years. At those yield levels some very good companies trade for in the market today, one need not see any price appreciation from here to earn satisfactory returns over long periods. But when most of the problems seem resolved, the market is not likely to leave yields at these levels for long.
For those looking for a diversified way to play this opportunity, take a look at the Financial Select Sector SPDR (XLF), which continues to (not surprisingly) hit 52-week lows. It yields 2.8% and trades at 1.6 times book value. For those unwilling or unable to handle the short-term volatility, buy a long-term call option on the XLF out to January 2010 at a strike price of $30 (roughly its current price). Buying the calls now cost $5.75 for a net cost basis of less than $36 if shares are worth more in a couple years. Also attractive (and probably more so) is the iShares Regional Banks ETF (IAT).
The quote at the beginning of the post sums the case up nicely, and for those willing to venture into individual names there are opportunities for significant upside potential with little risk of permanent capital loss.
Full disclosure: No positions in the securities mentioned.
Where is the bottom? At this point, it doesn’t seem like there is one with banks and mortgage-related companies. Several very good companies’ stocks are down more than 50% year-to-date, yield in excess of 10%, and in many cases trade below book value. I’ve seen many of them trade down 5-10-15% in one day on no specific news. Fear is pervasive. Investment capital continues to shift to commodity-related companies – energy, materials, industrials – which continue to perform well, from bank and mortgage-related stocks – on concerns about bad loans – which are performing terribly. Yet the degree of stock price selloff in many cases is disproportionate to the actual levels of economic value that may be impaired by escalating loan losses. Eventually, stock prices will reflect the companies' true fundamentals.
While it is nearly certain that many banks and mortgage companies will experience lower levels of profitability over the next few years, that profitability is well below normal. Yet the stock market is valuing many as if declining loan losses will continue indefinitely, all dividends will be discontinued, and book value will erode far beyond its current levels. While these scenarios are inevitable with some specific names that are less prepared for a more difficult credit and economic environment, several will do very well as market sentiment shifts.
It is important to keep a clear head in this environment. Investors seek to earn a total return on their capital over time and historically dividends have been a big piece of that return. At their current quotations, some financial stocks offer (growing) yields of 10% or better. This happens to be the S&P 500’s approximate average annual return over 70+ years. At those yield levels some very good companies trade for in the market today, one need not see any price appreciation from here to earn satisfactory returns over long periods. But when most of the problems seem resolved, the market is not likely to leave yields at these levels for long.
For those looking for a diversified way to play this opportunity, take a look at the Financial Select Sector SPDR (XLF), which continues to (not surprisingly) hit 52-week lows. It yields 2.8% and trades at 1.6 times book value. For those unwilling or unable to handle the short-term volatility, buy a long-term call option on the XLF out to January 2010 at a strike price of $30 (roughly its current price). Buying the calls now cost $5.75 for a net cost basis of less than $36 if shares are worth more in a couple years. Also attractive (and probably more so) is the iShares Regional Banks ETF (IAT).
The quote at the beginning of the post sums the case up nicely, and for those willing to venture into individual names there are opportunities for significant upside potential with little risk of permanent capital loss.
Full disclosure: No positions in the securities mentioned.
"Good" Mortgage News
Countrywide Financial (CFC) reported a huge quarterly loss yesterday, amounting to $2.85 per share. Most of this was a noncash charge to write down asset values – both of performing loans that are simply now worth less in the marketplace today as well as securitization residuals, on which there is not likely to be a recovery of value. CFC also added meanginfully to its loan loss reserves as delinquencies rose during the quarter. With respect to residuals, there is still $900 million on the balance sheet. On the other hand, there are between $900 million and $2.7 billion of mortgage servicing rights not reflected on the balance sheet, according to management. The conservative thing to assume is that both are $900 million and thus offset each other, having no effect on book value.
After today’s write-down and the 32% stock price rally, the stock still trades below its diluted book value of over $20. Now, in the near-term, book value is tough to get the arms around. Is it too high? While you may not be able to liquidate the company for that, as long as CFC has the ability to hold the loans they can wait for more favorable pricing. In this case, the economic value of the loans on its balance sheet could be even higher. While GAAP encourages write-downs of assets deemed permanently impaired, it does now allow “write-ups.” So if asset values are significantly written down due to higher loss assumptions that do not materialize, the balance sheet values will actually understate the economic value. Despite this possibility, I assume things will get worse.
In a more normal environment, Countrywide can earn returns on equity of 15% or greater. In this case, the company should be worth in excess of $30 per share versus its current price of around $17. In my view, that is a big enough discount to offer a solid margin of safety. Management, while surprised by the depth with which the credit market disruptions affected their access to the capital markets, is now stronger. Loan underwriting standards have already improved. During their conference call Friday management offered a slide I would call their "oops" slide showing the past business they would underwrite now versus under their old underwriting guidelines. On $170 billion of business underwritten 2006 and before, only less than $60 billion would have been accepted under the new guidelines. That is an admission of how lax their standards became and explains why loans on 2005 and 2006 vintages are performing as poorly as they are currently. Loan performance from those years certainly would be a lot better now had the company (and most of its competitors) not been as aggressive in pursuing market share while ignoring prudent underwriting principles.
While the company is not out of the woods, it seems they are dealing well with the current market realities. Access to capital has improved and the company is working to virtually eliminate its reliance on the commercial paper market, formerly its largest source of short-term financing. Having migrated its primary financing to the bank, near-term growth will slow as the company either sells loans to GSEs or holds them on its balance sheet. Given its exit from certain lines of business and elimination of 10,000 to 12,000 employees, Countrywide from here will grow from a much smaller base. But the company is poised to take share in a smaller, more rational market and be a meaningfully more profitable company in future periods than it is today.
The credit market turmoil is not over. The housing market is far from recovery, having not yet bottomed. There is still substantial excess housing inventory that must be lapped up. In some areas, prices went up far too much for far too long to not have a longer “payback” period where the excesses are wringed out and prices move more into alignment with income levels. There are more shoes to drop, but this news from Countrywide is reassuring to investors who have watched the stock freefall amid panic selling the last few months. Yet for a value investor, the bigger the discount to underlying business value, the greater is the implied future return on the stock.
Full disclosure: Long CFC shares and call options.
After today’s write-down and the 32% stock price rally, the stock still trades below its diluted book value of over $20. Now, in the near-term, book value is tough to get the arms around. Is it too high? While you may not be able to liquidate the company for that, as long as CFC has the ability to hold the loans they can wait for more favorable pricing. In this case, the economic value of the loans on its balance sheet could be even higher. While GAAP encourages write-downs of assets deemed permanently impaired, it does now allow “write-ups.” So if asset values are significantly written down due to higher loss assumptions that do not materialize, the balance sheet values will actually understate the economic value. Despite this possibility, I assume things will get worse.
In a more normal environment, Countrywide can earn returns on equity of 15% or greater. In this case, the company should be worth in excess of $30 per share versus its current price of around $17. In my view, that is a big enough discount to offer a solid margin of safety. Management, while surprised by the depth with which the credit market disruptions affected their access to the capital markets, is now stronger. Loan underwriting standards have already improved. During their conference call Friday management offered a slide I would call their "oops" slide showing the past business they would underwrite now versus under their old underwriting guidelines. On $170 billion of business underwritten 2006 and before, only less than $60 billion would have been accepted under the new guidelines. That is an admission of how lax their standards became and explains why loans on 2005 and 2006 vintages are performing as poorly as they are currently. Loan performance from those years certainly would be a lot better now had the company (and most of its competitors) not been as aggressive in pursuing market share while ignoring prudent underwriting principles.
While the company is not out of the woods, it seems they are dealing well with the current market realities. Access to capital has improved and the company is working to virtually eliminate its reliance on the commercial paper market, formerly its largest source of short-term financing. Having migrated its primary financing to the bank, near-term growth will slow as the company either sells loans to GSEs or holds them on its balance sheet. Given its exit from certain lines of business and elimination of 10,000 to 12,000 employees, Countrywide from here will grow from a much smaller base. But the company is poised to take share in a smaller, more rational market and be a meaningfully more profitable company in future periods than it is today.
The credit market turmoil is not over. The housing market is far from recovery, having not yet bottomed. There is still substantial excess housing inventory that must be lapped up. In some areas, prices went up far too much for far too long to not have a longer “payback” period where the excesses are wringed out and prices move more into alignment with income levels. There are more shoes to drop, but this news from Countrywide is reassuring to investors who have watched the stock freefall amid panic selling the last few months. Yet for a value investor, the bigger the discount to underlying business value, the greater is the implied future return on the stock.
Full disclosure: Long CFC shares and call options.
Wisdom from Forbes' Second Wealthiest American
"...The scorecard on our investment decisions will be provided by business results over [many years] and not by [stock market] prices on any given day. Just as it would be foolish to focus unduly on short-term prospects when acquiring an entire company, we think it equally unsound to become mesmerized by prospective near-term earnings or recent trends in earnings when purchasing small pieces of a company; i.e. marketable common stocks."
- Warren Buffett, March 1978
- Warren Buffett, March 1978
A Win-Win Deal?
Bank of America (BAC) scored itself a sweet deal, announcing yesterday that they’ve acquired $2 billion worth of 7.25% convertible non-voting preferred securities in Countrywide Financial (CFC). The securities are convertible at $18.00 per share, so they’re already in the money by over $4 per share. Assuming the preferreds trade at a price based only on the underlying common stock, at this point they're sitting on a capital gain of nearly $500 million. Both sides are touting it as win-win, though it gives some insight into the terms B of A can garner given its reputation and solid finances.
So why did Countrywide accept terms that appear to offer asymmetrical economic benefits? Put simply, the credit market continues to be tight and it’s difficult to discern how widespread or deep the problem could go. Credit was abundant for a long time as risk premiums declined to historic lows. Now, to paraphrase Warren Buffett, the hangover may be proportional to the binge. Countrywide’s primary funding sources, or “oxygen” as CEO Angelo Mozilo calls them, are commercial paper, the repo market, and medium-term notes. The markets for each of these has more or less seized up. The Fed’s discount window is available to them, but only to the Banking division. But the bank doesn’t have sufficient assets to borrow in amounts that will put much of a dent in the needs of the Home Loan division, where most of the assets are held. Over time, as the banking business becomes the primary funding source for home loans, the discount window would be a much more viable source of funds. But it isn’t at this point.
To make a long story short, Countrywide needs capital to continue funding new loans. The transaction gives Countrywide some additional capital along with the implicit backing of deep-pocketed Bank of America. Countrywide has traded some of its economic value (offering a conversion price that is half what the shares are worth) in exchange for a strong endorsement and (at least implied) reliable access to capital.
How does this affect Countrywide value to common shareholders? It dilutes shareholder value, but because it saves them from selling off assets at fire-sale prices to continue to finance operations, it looks to be more wealth preserving than wealth destroying. Start by assuming B of A waits to convert. In this case Countrywide is on the hook for $145 million in preferred dividends, which is around 5% of the company’s 2006 net income. The 7.25% interest rate is reasonable, but does not enjoy the tax break that interest receives (preferred dividends are paid from net income, not pretax income). But the additional expense is not unduly burdensome.
In calculating per-share value, I assume B of A will convert the shares, which adds an additional 111 million shares to Countrywide’s 562 million outstanding. So the share count goes up by nearly 20% and B of A owns 16-17% of the company. Book value (as of June 30th) now is a little over $20 (down from over $24) after considering the dilution. The widespread credit market problems have destroyed some shareholder value here, which is why a margin of safety in initial purchase price is so important. Though this is only a start, Countrywide is now on more solid footing. The media, which has been a part of the problem these past few weeks should now (hopefully) cast the company in a more positive light going forward, which should reinforce confidence in the company by its investors, depositors, and other stakeholders.
Full disclosure: Long CFC and BAC shares.
So why did Countrywide accept terms that appear to offer asymmetrical economic benefits? Put simply, the credit market continues to be tight and it’s difficult to discern how widespread or deep the problem could go. Credit was abundant for a long time as risk premiums declined to historic lows. Now, to paraphrase Warren Buffett, the hangover may be proportional to the binge. Countrywide’s primary funding sources, or “oxygen” as CEO Angelo Mozilo calls them, are commercial paper, the repo market, and medium-term notes. The markets for each of these has more or less seized up. The Fed’s discount window is available to them, but only to the Banking division. But the bank doesn’t have sufficient assets to borrow in amounts that will put much of a dent in the needs of the Home Loan division, where most of the assets are held. Over time, as the banking business becomes the primary funding source for home loans, the discount window would be a much more viable source of funds. But it isn’t at this point.
To make a long story short, Countrywide needs capital to continue funding new loans. The transaction gives Countrywide some additional capital along with the implicit backing of deep-pocketed Bank of America. Countrywide has traded some of its economic value (offering a conversion price that is half what the shares are worth) in exchange for a strong endorsement and (at least implied) reliable access to capital.
How does this affect Countrywide value to common shareholders? It dilutes shareholder value, but because it saves them from selling off assets at fire-sale prices to continue to finance operations, it looks to be more wealth preserving than wealth destroying. Start by assuming B of A waits to convert. In this case Countrywide is on the hook for $145 million in preferred dividends, which is around 5% of the company’s 2006 net income. The 7.25% interest rate is reasonable, but does not enjoy the tax break that interest receives (preferred dividends are paid from net income, not pretax income). But the additional expense is not unduly burdensome.
In calculating per-share value, I assume B of A will convert the shares, which adds an additional 111 million shares to Countrywide’s 562 million outstanding. So the share count goes up by nearly 20% and B of A owns 16-17% of the company. Book value (as of June 30th) now is a little over $20 (down from over $24) after considering the dilution. The widespread credit market problems have destroyed some shareholder value here, which is why a margin of safety in initial purchase price is so important. Though this is only a start, Countrywide is now on more solid footing. The media, which has been a part of the problem these past few weeks should now (hopefully) cast the company in a more positive light going forward, which should reinforce confidence in the company by its investors, depositors, and other stakeholders.
Full disclosure: Long CFC and BAC shares.
Panic Sellers Want Cash
The recent market selloff, led by financials and consumer discretionary stocks, looks very much like a panic. By mid-day Thursday, the S&P 500 was down 10% - an unofficial "correction" level. The last couple weeks have been one of the best times to invest new money in a very long time.
Over the past few weeks, we've seen indiscriminate selling across the board. For instance, one company I watch very closely was down as much as 50% since the end of June, a result not of its own operational problems but of being lumped into a broad category along with American Home Mortgage (AHM), a just-bankrupted mortgage REIT. Yet its business model and risk profile is very different than the typical “mortgage REIT.” It has now rebounded 50% from its lows and the indiscriminate selling offered a great opportunity to add to positions. This situation is not isolated only to this one stock; I've seen it with many others.
Countrywide Financial (CFC), a company I’ve mentioned here as a reasonable value at higher prices, is down 50% year-to-date on concerns the company doesn't have access to enough liquidity to continue funding its operations. I’ve read all the recent filings and press releases, but what has been reported in the media based on those communications has amounted to “spin.” In the most recent example, the widely reported news that “Countrywide is forced to max out its credit line” was an exaggeration. True, CFC did max out one of its credit lines, but has access to quite a bit of additional short-term liquidity that will allow it to continue making loans. And now, with the Fed cutting the discount rate Friday to 5.75% and the borrowing term now 30 days renewable, CFC now has access through its bank to highly-available, reasonably-priced capital.
As of June 30, CFC was paying its depositors a weighted-average rate of about 5.15% on deposits and is now offering 12-month CDs at 5.65%. Discount window loans won’t cost them much more. Countrywide is continuing to make loans and take market share. They bought five branches from HomeBanc a few days before it entered bankruptcy and are hiring workers from American Home, previously mentioned. Year-over-year through June 30, market share rose to near 19% from under 15% last year, and funding grew despite an overall mortgage market that was down 10%. I cannot summarize the entire investment case here, but I (still) believe CFC shares are an excellent value at current prices, but are not for the faint of heart because the road will be very bumpy until the dust settles.
As Ben Graham said, “In the short term, the market is a voting machine; in the long-term, it is a weighting machine.” And in the past few weeks people have “voted” by taking their capital out of the market, and especially certain sectors. During just the past week ended Thursday, $585 million was pulled from the Select Sector SPDRs Financial fund (XTF), which was nearly 20% of its assets. Money market funds reported net inflows of $41.484 billion, the largest year-to-date. The week prior to that, money markets had net cash inflows totaling $36.229 billion, the largest inflows since 12/7/05. Investors are selling stocks (and bonds) and going to short-term funds to “wait out” the storm. As a value investor, I am happy to turn over some of my cash for the undervalued assets they’re selling.
The best time to get in is when everyone else is getting out. Analyze well, consider worst-case scenarios and downside risk, and if your reasoning and analysis are good market prices will eventually reflect economic reality, regardless of the irrationality of Mr. Market.
Full disclosure: Long CFC.
Over the past few weeks, we've seen indiscriminate selling across the board. For instance, one company I watch very closely was down as much as 50% since the end of June, a result not of its own operational problems but of being lumped into a broad category along with American Home Mortgage (AHM), a just-bankrupted mortgage REIT. Yet its business model and risk profile is very different than the typical “mortgage REIT.” It has now rebounded 50% from its lows and the indiscriminate selling offered a great opportunity to add to positions. This situation is not isolated only to this one stock; I've seen it with many others.
Countrywide Financial (CFC), a company I’ve mentioned here as a reasonable value at higher prices, is down 50% year-to-date on concerns the company doesn't have access to enough liquidity to continue funding its operations. I’ve read all the recent filings and press releases, but what has been reported in the media based on those communications has amounted to “spin.” In the most recent example, the widely reported news that “Countrywide is forced to max out its credit line” was an exaggeration. True, CFC did max out one of its credit lines, but has access to quite a bit of additional short-term liquidity that will allow it to continue making loans. And now, with the Fed cutting the discount rate Friday to 5.75% and the borrowing term now 30 days renewable, CFC now has access through its bank to highly-available, reasonably-priced capital.
As of June 30, CFC was paying its depositors a weighted-average rate of about 5.15% on deposits and is now offering 12-month CDs at 5.65%. Discount window loans won’t cost them much more. Countrywide is continuing to make loans and take market share. They bought five branches from HomeBanc a few days before it entered bankruptcy and are hiring workers from American Home, previously mentioned. Year-over-year through June 30, market share rose to near 19% from under 15% last year, and funding grew despite an overall mortgage market that was down 10%. I cannot summarize the entire investment case here, but I (still) believe CFC shares are an excellent value at current prices, but are not for the faint of heart because the road will be very bumpy until the dust settles.
As Ben Graham said, “In the short term, the market is a voting machine; in the long-term, it is a weighting machine.” And in the past few weeks people have “voted” by taking their capital out of the market, and especially certain sectors. During just the past week ended Thursday, $585 million was pulled from the Select Sector SPDRs Financial fund (XTF), which was nearly 20% of its assets. Money market funds reported net inflows of $41.484 billion, the largest year-to-date. The week prior to that, money markets had net cash inflows totaling $36.229 billion, the largest inflows since 12/7/05. Investors are selling stocks (and bonds) and going to short-term funds to “wait out” the storm. As a value investor, I am happy to turn over some of my cash for the undervalued assets they’re selling.
The best time to get in is when everyone else is getting out. Analyze well, consider worst-case scenarios and downside risk, and if your reasoning and analysis are good market prices will eventually reflect economic reality, regardless of the irrationality of Mr. Market.
Full disclosure: Long CFC.
Some Broad Market Perspective
In the midst of a stock market that continues its selloff today, I decided to put together a quick analysis looking at the current stock market valuation. So I’ve prepared some commentary regarding the stock market’s current level versus history, the market’s valuation given current long-term interest rates, and the relationship between stocks’ earnings yield (inverse of P/E ratio) and the 10-year yield. As of this writing, the S&P 500 stands at 17.5 times trailing earnings (earnings yield of 5.7%) and (assuming a trend growth rate of 6%) 16.5 times forward earnings.
The first chart is histogram of the quarterly, trailing 12-month (TTM) P/E ratios of the S&P 500 since 1950. It shows the frequency with which the market has traded around a given level relative to earnings. As is shown, the market has traded right around its current P/E ratio 30% of the time since 1950. The chart also shows that when the market trades at twenty or more times trailing earnings, it does not trade there for long. Relative to the past 50+ years, the valuation level does not seem to be excessive.
The next chart shows the trend of the S&P 500’s P/E ratio since 1950, along with its mean value over that time period. The P/E ratio has fluctuated wildly around the average, but it appears the S&P is currently near its average P/E of the past 57 years. This average is, of course, biased upward by the lofty multiples of 1999-2000.
The third chart shows the relationship between the S&P 500 earnings yield and the 10-year Treasury note, along with the average of each value over the period from 1953 through the second quarter of 2007. I am using the constant maturity 10-year Treasury as a proxy for long-term interest rates. I was able to get data from 1953, so this chart runs from that point to the end of 2Q 2007.
I do not focus solely on the rear view mirror when I drive, and it is hazardous to do so when investing. But as Mark Twain said, “History doesn’t repeat itself, but it rhymes.” It helps to have a historical perspective, especially about the broad market. And on a broad market basis, I don’t think stocks are expensive. But I don’t know where they will trade next month or next year. Sure, they can go down (which is what they’re doing now) but over long periods the trend is up. In my view, the lower one can buy the market, the better, because the implied future rate of return rises as the market falls.
A couple caveats about these charts: the P/E ratio – and the earnings yield – is very dependent on the E(arnings). If recessionary conditions come back into the fore, corporate earnings will fall (the earnings yield will drop, absent stock price declines). This analysis is meant to provide some perspective on what the market looks like relative to low-risk alternatives such as long-term bonds (favorable). Also, the time period I chose (largely as a result of the data set that was available) could also have an impact on the averages I’ve calculated. They are merely illustrative and should not be construed as precise calculations. It is better to be approximately right than precisely wrong, as Warren Buffett says.
The first chart is histogram of the quarterly, trailing 12-month (TTM) P/E ratios of the S&P 500 since 1950. It shows the frequency with which the market has traded around a given level relative to earnings. As is shown, the market has traded right around its current P/E ratio 30% of the time since 1950. The chart also shows that when the market trades at twenty or more times trailing earnings, it does not trade there for long. Relative to the past 50+ years, the valuation level does not seem to be excessive.
The next chart shows the trend of the S&P 500’s P/E ratio since 1950, along with its mean value over that time period. The P/E ratio has fluctuated wildly around the average, but it appears the S&P is currently near its average P/E of the past 57 years. This average is, of course, biased upward by the lofty multiples of 1999-2000. The third chart shows the relationship between the S&P 500 earnings yield and the 10-year Treasury note, along with the average of each value over the period from 1953 through the second quarter of 2007. I am using the constant maturity 10-year Treasury as a proxy for long-term interest rates. I was able to get data from 1953, so this chart runs from that point to the end of 2Q 2007.There is a clear relationship, as there should be, between the earnings yield on stocks and long-term interest rates. As the chart shows, the average spread between the earnings yield on stocks and the rate on Treasuries over this 54-year period is just 0.3%. Currently, that spread is 1.0%; stocks yield 5.7% on a trailing basis and the 10-year T-note is trading at 4.7%. What this basically means is that if the S&P 500 experienced zero growth over the next 10 years and paid out all earnings as dividends it would yield 1% more than Treasuries. Looking from this perspective, on a relative basis stocks appear to be less expensive than average. Yet 10-year T-notes have traded as high as 5.3% in the past couple months, which would bring the spread down to only 0.4%, about average. And just because stocks are relatively more attractive does not mean they couldn't get more attractive (read: continue to fall). As the chart reveals, the earnings yield on stocks was substantially higher than long-term rates for the better part of the 1970s. Such a situation would present an incredible buying opportunity.
I do not focus solely on the rear view mirror when I drive, and it is hazardous to do so when investing. But as Mark Twain said, “History doesn’t repeat itself, but it rhymes.” It helps to have a historical perspective, especially about the broad market. And on a broad market basis, I don’t think stocks are expensive. But I don’t know where they will trade next month or next year. Sure, they can go down (which is what they’re doing now) but over long periods the trend is up. In my view, the lower one can buy the market, the better, because the implied future rate of return rises as the market falls.A couple caveats about these charts: the P/E ratio – and the earnings yield – is very dependent on the E(arnings). If recessionary conditions come back into the fore, corporate earnings will fall (the earnings yield will drop, absent stock price declines). This analysis is meant to provide some perspective on what the market looks like relative to low-risk alternatives such as long-term bonds (favorable). Also, the time period I chose (largely as a result of the data set that was available) could also have an impact on the averages I’ve calculated. They are merely illustrative and should not be construed as precise calculations. It is better to be approximately right than precisely wrong, as Warren Buffett says.
Open Up Your Wallets!
Perhaps to a fault, I enjoy seeing a screen full of red. That is, declining stock prices. And that is exactly what has been happening the past few days. The market is providing the opportunity to average down or initiate new positions in some good companies at attractive prices. I am usually early in buying as a stock goes down, but one cannot often buy right at the bottom. Rather, I buy when the price represents a significant discount from my conservative estimate of instrinsic value. And if the stock price continues to fall, I welcome the opportunity to average down the purchase price. As an investor focused on obtaining value, I believe these are some of the most exciting times to be investing – when fear is overtaking greed in the collective sentiment of stock market participants. Now is the time to be aggressive in taking new positions.
While the overall market is still not cheap, the recent pullback has provided some excellent opportunities to invest cash. Several excellent companies related to housing and consumers are now trading at very attractive valuations relative to their normalized earnings. Companies I’ve mentioned previously, such as American Eagle Outfitters (AEO) and Countrywide Financial (CFC), are now trading at new 52-week lows. Best Buy (BBY) is back near its lows for the year. As for S&P 500 sectors, financials in general have really taken a hit, down 6.4% (so far) this month alone. And looking at a list of stocks that are down significantly year-to-date exposes a myriad of regional banks down 20-30% on average. I think there could be several opportunities in this space.
Full disclosure: Long positions in all companies mentioned.
While the overall market is still not cheap, the recent pullback has provided some excellent opportunities to invest cash. Several excellent companies related to housing and consumers are now trading at very attractive valuations relative to their normalized earnings. Companies I’ve mentioned previously, such as American Eagle Outfitters (AEO) and Countrywide Financial (CFC), are now trading at new 52-week lows. Best Buy (BBY) is back near its lows for the year. As for S&P 500 sectors, financials in general have really taken a hit, down 6.4% (so far) this month alone. And looking at a list of stocks that are down significantly year-to-date exposes a myriad of regional banks down 20-30% on average. I think there could be several opportunities in this space.
Full disclosure: Long positions in all companies mentioned.
A Tough Call
Stable market share positions among the main players in an industry combined with high returns on capital typically are evidence of a long-term competitive advantage. I made a mistake by not weighting this heavily enough in my initial assessment of Motorola (MOT) several months ago. I also did not consider enough the unpredictability of mobile phone industry dynamics. While MOT benefits from scale in distribution, relationships, and the ability to spread fixed costs, including as R&D and advertising, over a larger revenue base than its smaller competitors, the short product cycles and the need to continually innovate products, combined with a smaller, more powerful group of buyers (mobile phone companies that have been consolidating) have made the company’s plight that much more difficult.
In late 2006, I made a buy decision on Motorola (prior to the disclosure that Icahn was involved) based primarily on a few facts: 20% of its market value was in cash, and this cash could be used, among other things, to wipe out its debt and buy back loads of shares. Over the past few years the company had generated copious amounts of free cash flow and that looked reasonably certain to continue. But I soon found that the stock price was down for a good reason. Management had turned to the dark side - managing for market share, not profitability. Profits quickly turned to losses and cash flow evaporated when pricing power faded and unit sales slumped. In March, I sold July call options on the stock. So after being called out a few days ago the investment netted at breakeven (loss on the stock, gain on the option). Over this same period, the S&P 500 was up over 5%, so I consider that the opportunity cost of the investment in Motorola.
The company will probably recover and thrive again. But I came to the conclusion that I am not smart enough to figure out when that will be or how it will occur. If they come out with another product line as revolutionary as the RZR, certainly profits will return in spades. But after that phone comes on the market they’ll need another one to follow it. And now that Apple (AAPL) has entered the mobile phone space, the competition for innovative products is even more fierce. Overall, the visibility of the industry is low to me. So if in a few years I see the stock at double its current price, it won’t faze me because it fell outside my circle of competence. The uncertainty of the commodity cell phone business no longer makes Motorola the no-brainer that I like to see in a stock before I pull the trigger.
Full disclosure: No positions in the companies mentioned.
Subprime Concerns Again!
The concern from the subprime market continues to spill over into the stock prices of companies such as Countrywide Financial (CFC) and others. Countrywide has been the subject of frequent posts and that mainly is because (1) I own the stock so I’m watching it and (2) subprime concerns have caused its price to bob around well under intrinsic value for some time now. And now its share price is back under $35 apiece amidst renewed subprime concerns (less than 10% of its business was subprime).
The latest news regarding subprime is that two Bear Stearns hedge funds that specialized in subprime mortgage-backed bonds have ended up virtually worthless. Much of the reason the funds went down so fast was likely due to the leverage employed, as the index that tracks subprime loans originated in the 2nd half of 2006, the ABX "BBB" 07-1 index, fell to nearly its lowest level ever over the last couple days.
This is a classic illustration of the market being irrational longer than one can remain solvent. Yet these funds were probably using “risk controls” that considered the probability of such an event as so miniscule that they ignored it (based on the dubitable "proof" of historical data or simulations heavily contingent on multiple assumptions). Turns out the risks were higher than the so-called models told them. Looks like they opted to be precisely wrong rather than approximately right.
Over the past few years, anyone could sell a mortgage. Just get in touch with GMAC, provide the documentation they want, and get paid a fee based on each mortgage obtained for them as a broker. GMAC (and many others) in turn would package the loans together and sell them to investors. So the accountability was really lost at each stage while the packaging, or securitization, process mysteriously turned a group of loans into investment grade despite the dubious characteristics of its individual constituents. Downgrades in these bonds over the past few weeks have called into question the quality of the underlying loans and hit these two funds very hard.
I think underwriting standards today are likely to have improved overall (yet, even though its only anecdotal, I still see advertisements touting “no down payment” loans available). But overall, going forward, the lax lending standards have likely subsided and overall loan quality has probably improved (that is, until the next boom period for housing). For originators whose loans are sold through securitization, the bigger players are the ones that will benefit long-term as smaller competitors are shaken out. This includes Countrywide, Wells Fargo (WFC), and other large banks such as Bank of America (BAC) and Washington Mutual (WM).
Full disclosure: Long shares of all companies mentioned.
The latest news regarding subprime is that two Bear Stearns hedge funds that specialized in subprime mortgage-backed bonds have ended up virtually worthless. Much of the reason the funds went down so fast was likely due to the leverage employed, as the index that tracks subprime loans originated in the 2nd half of 2006, the ABX "BBB" 07-1 index, fell to nearly its lowest level ever over the last couple days.
This is a classic illustration of the market being irrational longer than one can remain solvent. Yet these funds were probably using “risk controls” that considered the probability of such an event as so miniscule that they ignored it (based on the dubitable "proof" of historical data or simulations heavily contingent on multiple assumptions). Turns out the risks were higher than the so-called models told them. Looks like they opted to be precisely wrong rather than approximately right.
Over the past few years, anyone could sell a mortgage. Just get in touch with GMAC, provide the documentation they want, and get paid a fee based on each mortgage obtained for them as a broker. GMAC (and many others) in turn would package the loans together and sell them to investors. So the accountability was really lost at each stage while the packaging, or securitization, process mysteriously turned a group of loans into investment grade despite the dubious characteristics of its individual constituents. Downgrades in these bonds over the past few weeks have called into question the quality of the underlying loans and hit these two funds very hard.
I think underwriting standards today are likely to have improved overall (yet, even though its only anecdotal, I still see advertisements touting “no down payment” loans available). But overall, going forward, the lax lending standards have likely subsided and overall loan quality has probably improved (that is, until the next boom period for housing). For originators whose loans are sold through securitization, the bigger players are the ones that will benefit long-term as smaller competitors are shaken out. This includes Countrywide, Wells Fargo (WFC), and other large banks such as Bank of America (BAC) and Washington Mutual (WM).
Full disclosure: Long shares of all companies mentioned.
A Quick Word on Sears Holdings
I want to post a quick commentary regarding Sears Holdings (SHLD), a company I have admired (from the sidelines) for quite a while because of its Chairman and owner of 42% of its stock, Eddie Lampert. The stock was down over 10% yesterday on the heels of a reduced earnings outlook, making the shares more attractive.
Sears is a company that throws off solid free cash flow and continues to buy in shares opportunistically. For any company, what matters should not be size or market share for their own sake but profitability in the markets in which it operates. Lampert is keenly aware of this and is managing for profitability. I would compare this to Warren Buffett not growing premium volume just for the sake of having a larger policy base. There have been 10-year periods for Berkshire where premium volume shrank in every single year, but profitability on those in-force policies remained solid. Lampert is a Buffett disciple, so there is ample reason to believe he looks at Sears in a similar way. I think he’s willing to shrink the total size of the “empire” as long as he, per-share, grows wealthier.
If the Sears (and Kmart) business as a whole shrinks, the stores that are still around will be more profitable in their individual markets. What remains of a smaller, more profitable company will have low reinvestment requirements (since it’s just maintaining what it already has). This will lead to even more robust free cash flow (and proceeds from real estate sales) to use for even more opportunistic buybacks. Using this procedure, Lampert can increase per share business value at a steady clip even while aggregate sales and net income decrease.
As an example of his influence on a company, look at what he’s helped orchestrate at AutoZone (AZO), of which he owns 31%. Since 1997, sales and profits at the company have risen 9.2% and 12.7% annually, but 18% and 22%, respectively, on a per-share basis. They’ve done this by focusing on profitability (net profit margin has gone from an average of around 7% to nearly 10% over that time period) and have used increasing free cash flow to buy back heaps of shares. And the stock has followed, up nearly 20% annually over that time.
Full disclosure: No positions
Sears is a company that throws off solid free cash flow and continues to buy in shares opportunistically. For any company, what matters should not be size or market share for their own sake but profitability in the markets in which it operates. Lampert is keenly aware of this and is managing for profitability. I would compare this to Warren Buffett not growing premium volume just for the sake of having a larger policy base. There have been 10-year periods for Berkshire where premium volume shrank in every single year, but profitability on those in-force policies remained solid. Lampert is a Buffett disciple, so there is ample reason to believe he looks at Sears in a similar way. I think he’s willing to shrink the total size of the “empire” as long as he, per-share, grows wealthier.
If the Sears (and Kmart) business as a whole shrinks, the stores that are still around will be more profitable in their individual markets. What remains of a smaller, more profitable company will have low reinvestment requirements (since it’s just maintaining what it already has). This will lead to even more robust free cash flow (and proceeds from real estate sales) to use for even more opportunistic buybacks. Using this procedure, Lampert can increase per share business value at a steady clip even while aggregate sales and net income decrease.
As an example of his influence on a company, look at what he’s helped orchestrate at AutoZone (AZO), of which he owns 31%. Since 1997, sales and profits at the company have risen 9.2% and 12.7% annually, but 18% and 22%, respectively, on a per-share basis. They’ve done this by focusing on profitability (net profit margin has gone from an average of around 7% to nearly 10% over that time period) and have used increasing free cash flow to buy back heaps of shares. And the stock has followed, up nearly 20% annually over that time.
Full disclosure: No positions
A Stock to Go with Those Jeans
A stock that has recently come onto my radar screen is that of American Eagle Outfitters (AEO). I must admit that I do not shop at their stores, but I do walk by them during my infrequent sojourns to the local mall. I find the stores to be clean, well put together, and the fashions to be relevant (as judged by the fact that the teens walking around the mall are wearing what I see in their store). I also know a few teens in the core AEO demographic who provide me with knowledge on what fashion trends are out there (I bought the stock for one of them). The company’s core target is 15-25 years olds, and its new concept store, Martin+OSA, targets 25-40 year olds.
Obviously the most important thing for a teen retailer is to have the knowledge of not just current fashions but what will be fashionable in the near future. Keeping “on-trend” is crucial. AEO management has consistently done this for the past ten years or so, by using focus groups and extensive market research to remain relevant. And its clothes are lower-priced than Abercrombie and Fitch (ANF), one of its main competitors, which bodes well for less heady times for retailers.
AEO shares are just 2% off a 52-week low, and are probably sitting there because of concerns about revised (downward) quarterly guidance. But it is the longer-term that I am concerned with, and there is much to like here. For one, I like the recently announced 23 million share buyback, representing 10%+ of outstanding shares. Its Chairman (and founder) owns about 14% of outstanding shares, so his interests are aligned with minority shareholders. The stock trades with roughly 15% of its market cap in cash and a free cash flow yield of nearly 10% based on its 2006 results. Even with growth slowing (which it inevitably will), the company can throw off lots of cash.
At first glance, it looks like the company has no long-term debt on the balance sheet, but it holds about $975 million (present value) worth of operating leases off-balance sheet. That makes its true debt-to-total capital ratio about 40%. So you’re really getting a 12% return on total capital (20%+ return on equity) at a P/E of 13.5. If the company can continue to grow at 5-10% over the next few years, this works out to a fairly cheap price, even if the growth is lumpy. And if its new Martin+OSA stores take off, the shares could look very cheap in retrospect 5 years from now. At current prices, the market seems to be offering a good price for the core business and what more or less amounts to a call option on the Martin+OSA brand for free. And if Abercrombie continues to fall (down over 4% today), its shares could start to look attractive.
Full disclosure: As mentioned, long AEO.
Best Buybacks
Best Buy (BBY) today announced a 30% boost to its quarterly dividend and a $5.5 billion buyback program (replacing its previous $1.5B program), $3.0 billion of which will be done immediately. This should reduce share count by over 13% at today’s prices, giving shareowners who hold on a bigger piece of the pie. Given the company’s cash-generating ability (a roughly 5% free cash flow yield after capital expenditures needed to maintain and expand the business are subtracted) and the currently undervalued state of its shares, I think this is a great use for the company’s cash and view this as a shareholder-friendly move as long as buybacks occur at sensible prices.
More good news was announced: management now targets 1,800 stores in the U.S. and Canada (up from 1,400), which represents a near doubling of its store base domestically. Assuming returns on invested capital can be maintained even with such a sizeable store base, Best Buy – the company and its stock – continues to look attractive at current levels (though I certainly wouldn't mind if they went lower in the short term).
Full disclosure: Long BBY shares.
More good news was announced: management now targets 1,800 stores in the U.S. and Canada (up from 1,400), which represents a near doubling of its store base domestically. Assuming returns on invested capital can be maintained even with such a sizeable store base, Best Buy – the company and its stock – continues to look attractive at current levels (though I certainly wouldn't mind if they went lower in the short term).
Full disclosure: Long BBY shares.
Best Buy in the Crosshairs
I love a good growth company. Good growth businesses are even better when paired with long-tenured managers who own a significant amount of shares while presiding over a great track record of growing earnings and free cash flow and earning high returns on incremental capital. Furthermore, the situation is even better when the current stock quotation undervalues the business. These factors all may be characteristic of Best Buy (BBY) at its current price.
Best Buy announced quarterly earnings today that were 18% lower than the comparable period last year and shares are down nearly 6% on the day. Much of the decline in profits was due to a shift in revenue mix to lower-margin products such as flat-panel TVs, notebook computers, and gaming hardware. So is the selloff in the shares warranted? Are lower margins forever in Best Buy’s future? Those selling off shares today seem to think so.
The main concern swirling around Best Buy seems to be that of a sharp downturn in consumer spending. Though likely to slow a bit, betting against the consumer has not historically been a good gamble. In addition, Best Buy continues to take market share from competitors such as Circuit City (CC), which will help mitigate the pressure on its business in the event of a slowdown in consumer spending. But concerns about consumer spending represent short-term thinking. Investors in common stocks should typically think in longer time horizons. Are the company's competitive advantages intact? Can Best Buy grow while continuing to earn good returns on total capital? Over the longer-term, it seems highly probable that Best Buy can continue to grow and prosper both domestically and internationally. For instance, Best Buy holds a potentially valuable option in its Chinese operation, where it now has just one store.
There is a longer-term risk to profitability: Wal-Mart (WMT). I believe Wal-Mart will continue to be a fierce competitor but probably only on the lower end. Its main advantage is obviously price. Yet Best Buy offers more qualitative advantages: clean stores, great selection, a cool environment, and great service, and often consumers go there first if it’s electronics they crave. The wider selection and more knowledgeable staff (rather than someone who also works in fabrics or grocery) give Best Buy an edge over Wal-Mart in its core customer base for years to come.
As for profitability, for the past ten years returns on total capital have been around 20% on average (due to a modest debt load, returns on average equity have averaged a couple of percentage points higher). The lowest-return years of the past ten were 2001 and 2002 (recessionary conditions) and returns in those years were still quite satisfactory at 17.1% and 17.8%, respectively. Sales have risen 13.7% annually while store base has grown only 12% over this same period. Management stated in today’s press release that new store openings continue to produce 20% returns. These are great numbers and are evidence of a competitive advantage.
The stock currently trades at 15 times forward earnings based on the low end of management’s updated guidance for 2007. This compares with the stock’s average P/E in the 18-20 times range over the past 15+ years. Debt represents about 9% of capital. Management has been buying back shares and increasing the dividend payment steadily since initiating payments in 2003. Chairman Richard Schulze still owns 15% of the company. Even while steadily expanding its store base (the company has ample room to grow) and investing in existing stores, the stock’s free cash flow yield is roughly 5% at today’s price levels. And the company has $2.8B in cash and short-term investments (13% of market value) on the balance sheet. Back out the cash ($5.70/share) from today’s price and the stock trades at 13.5 times forward earnings. Hardly expensive for a business generating such high returns on capital if the returns are sustainable.
At today’s price level (roughly $45/share), taking a small position is likely to yield good long-term returns. Yet the stock doesn’t look cheap enough yet to load up. Unless something has fundamentally impaired the business, if the stock price continues to fall, I may be inclined to provide some liquidity to panic sellers.
Full disclosure: Long shares of Wal-Mart at time of writing.
Best Buy announced quarterly earnings today that were 18% lower than the comparable period last year and shares are down nearly 6% on the day. Much of the decline in profits was due to a shift in revenue mix to lower-margin products such as flat-panel TVs, notebook computers, and gaming hardware. So is the selloff in the shares warranted? Are lower margins forever in Best Buy’s future? Those selling off shares today seem to think so.
The main concern swirling around Best Buy seems to be that of a sharp downturn in consumer spending. Though likely to slow a bit, betting against the consumer has not historically been a good gamble. In addition, Best Buy continues to take market share from competitors such as Circuit City (CC), which will help mitigate the pressure on its business in the event of a slowdown in consumer spending. But concerns about consumer spending represent short-term thinking. Investors in common stocks should typically think in longer time horizons. Are the company's competitive advantages intact? Can Best Buy grow while continuing to earn good returns on total capital? Over the longer-term, it seems highly probable that Best Buy can continue to grow and prosper both domestically and internationally. For instance, Best Buy holds a potentially valuable option in its Chinese operation, where it now has just one store.
There is a longer-term risk to profitability: Wal-Mart (WMT). I believe Wal-Mart will continue to be a fierce competitor but probably only on the lower end. Its main advantage is obviously price. Yet Best Buy offers more qualitative advantages: clean stores, great selection, a cool environment, and great service, and often consumers go there first if it’s electronics they crave. The wider selection and more knowledgeable staff (rather than someone who also works in fabrics or grocery) give Best Buy an edge over Wal-Mart in its core customer base for years to come.
As for profitability, for the past ten years returns on total capital have been around 20% on average (due to a modest debt load, returns on average equity have averaged a couple of percentage points higher). The lowest-return years of the past ten were 2001 and 2002 (recessionary conditions) and returns in those years were still quite satisfactory at 17.1% and 17.8%, respectively. Sales have risen 13.7% annually while store base has grown only 12% over this same period. Management stated in today’s press release that new store openings continue to produce 20% returns. These are great numbers and are evidence of a competitive advantage.
The stock currently trades at 15 times forward earnings based on the low end of management’s updated guidance for 2007. This compares with the stock’s average P/E in the 18-20 times range over the past 15+ years. Debt represents about 9% of capital. Management has been buying back shares and increasing the dividend payment steadily since initiating payments in 2003. Chairman Richard Schulze still owns 15% of the company. Even while steadily expanding its store base (the company has ample room to grow) and investing in existing stores, the stock’s free cash flow yield is roughly 5% at today’s price levels. And the company has $2.8B in cash and short-term investments (13% of market value) on the balance sheet. Back out the cash ($5.70/share) from today’s price and the stock trades at 13.5 times forward earnings. Hardly expensive for a business generating such high returns on capital if the returns are sustainable.
At today’s price level (roughly $45/share), taking a small position is likely to yield good long-term returns. Yet the stock doesn’t look cheap enough yet to load up. Unless something has fundamentally impaired the business, if the stock price continues to fall, I may be inclined to provide some liquidity to panic sellers.
Full disclosure: Long shares of Wal-Mart at time of writing.
Some More WB Wisdom
To paraphrase Warren Buffett:
"Be willing to look foolish as long as you don't feel you have acted foolishly."
"Be willing to look foolish as long as you don't feel you have acted foolishly."
Rumors Swirl Around Countrywide Again
Countrywide Financial (CFC) shares are up over 7% in today’s trading on no apparent news. Is this just speculation or another case of trading ahead of an impending deal announcement? Stories of the latter have been in the financial press in recent days regarding suspicious trading activity surrounding the take-private deal for TXU (TXU) and Rupert Murdoch’s recent buyout offer for Dow Jones (DJ). In fact, a complaint has been filed against a couple that allegedly bought Dow Jones shares just two weeks ahead of the offer announcement.
So is Countrywide a viable takeover target? I’ve argued shares looked cheap in the mid-30s but with the stock advancing nearly 20% since then, the margin of safety in purchase price does not appear to be as great. Yet in the hands of the right buyer Countrywide would be worth quite a bit more than its recent quotation of $41 and change. And if it doesn't get purchased, the company should continue to grow shareholder value - gaining market share in both origination and in servicing (both businesses with scale advantages), as the mortgage market “rationalizes.”
Countrywide is no stranger to buyout speculation. Shares ran up in a similar manner at the end of January on takeover rumors that never materialized. We’ll just have to wait and see if there is any substance to the move this time.
Full disclosure: Long CFC shares.
So is Countrywide a viable takeover target? I’ve argued shares looked cheap in the mid-30s but with the stock advancing nearly 20% since then, the margin of safety in purchase price does not appear to be as great. Yet in the hands of the right buyer Countrywide would be worth quite a bit more than its recent quotation of $41 and change. And if it doesn't get purchased, the company should continue to grow shareholder value - gaining market share in both origination and in servicing (both businesses with scale advantages), as the mortgage market “rationalizes.”
Countrywide is no stranger to buyout speculation. Shares ran up in a similar manner at the end of January on takeover rumors that never materialized. We’ll just have to wait and see if there is any substance to the move this time.
Full disclosure: Long CFC shares.
MSFT-YHOO?
Microsoft (MSFT) to buy Yahoo (YHOO)? I must confess that can’t see an acquisition happening, but I suppose it’s possible. The market seems to believe something will happen, given Yahoo shares are up over 15% today. With Google (GOOG) owning over half the market, and growing at more than double the rate of Yahoo’s and Microsoft’s respective online advertising efforts this past quarter, I believe each needs to take action to become more competitive in this arena.
Larger players (in terms of market share) benefit from the network effects inherent in this space, as Google has shown. The combined MSFT-YHOO entity would control 32% of the worldwide search market, compared with roughly 54% for Google, based on March numbers. So it gets them a little closer to Google’s market share, but still a distant second.
The ability to spread the operational infrastructure across a larger base of users is a powerful force; the broader the network, the more valuable that network becomes. As goes Metcalfe's Law, the value of a network is proportional to the square of the users in that system (i.e. n-squared). Google is the most popular search destination, but also boasts a huge network of third-party sites on which to place ads. Yahoo has the most popular online "portal," but has not been as successful at monetizing its position as has Google. There's not much to say about Microsoft.
That said, the result of combining Microsoft and Yahoo’s online advertising capabilities will be a more robust platform for advertisers, but likely won’t change much for users of their sites. I think an integration of some sort makes strategic sense for both parties. But what makes more sense to me here is a joint venture, not a merger. With a merger, the two companies would have a difficult time integrating the two cultures. Certainly that is one of the strengths of Google – a culture that encourages innovation in this space. Trying to put together two disparate cultures into one company would likely be to the effort's detriment.
This is a situation that certainly bears watching: (formerly?) sworn enemies taking the “lesser of two evils” path to gain some ground on Google. Even if today's speculation comes to fruition, I don't think Google needs to be shaking in its boots just yet.
Full disclosure: Long MSFT.
Larger players (in terms of market share) benefit from the network effects inherent in this space, as Google has shown. The combined MSFT-YHOO entity would control 32% of the worldwide search market, compared with roughly 54% for Google, based on March numbers. So it gets them a little closer to Google’s market share, but still a distant second.
The ability to spread the operational infrastructure across a larger base of users is a powerful force; the broader the network, the more valuable that network becomes. As goes Metcalfe's Law, the value of a network is proportional to the square of the users in that system (i.e. n-squared). Google is the most popular search destination, but also boasts a huge network of third-party sites on which to place ads. Yahoo has the most popular online "portal," but has not been as successful at monetizing its position as has Google. There's not much to say about Microsoft.
That said, the result of combining Microsoft and Yahoo’s online advertising capabilities will be a more robust platform for advertisers, but likely won’t change much for users of their sites. I think an integration of some sort makes strategic sense for both parties. But what makes more sense to me here is a joint venture, not a merger. With a merger, the two companies would have a difficult time integrating the two cultures. Certainly that is one of the strengths of Google – a culture that encourages innovation in this space. Trying to put together two disparate cultures into one company would likely be to the effort's detriment.
This is a situation that certainly bears watching: (formerly?) sworn enemies taking the “lesser of two evils” path to gain some ground on Google. Even if today's speculation comes to fruition, I don't think Google needs to be shaking in its boots just yet.
Full disclosure: Long MSFT.
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