start-up-tomism

It strikes me today that optimism in the professional investment community remains at a relatively low level. Why? Out-of-control government spending. The $1.4 trillion federal deficit. $13 trillion in national debt. Eurozone economic concerns and the implications for the future of the euro currency. Not to mention the Federal Reserve’s actions which could spur inflation. The potential for an abrupt rise in interest rates. Rising commodity prices. The rise of China and India as competitors to the U.S. An equity market still meaningfully below its 2007 highs.

Many of the above are valid concerns and indeed are areas that need work. The equity markets today are implying decade ahead returns around 5%, certainly not a place to take unmitigated risk. Interest rates are low (but rising), benefiting borrowers/spenders at the expense of savers. The volume of the above factors is loud and the focus on them disproportionately high among investors and the public at large. They can lead us to forget a couple of things.

First, most of them we can’t control. We simply can’t, other than through elected officials, reduce government spending. We can, however, get ourselves into better financial shape through our own actions and position ourselves for worse economic times through higher savings, for instance.

Furthermore, these things tend to work on one way or another. Let’s take it to the extreme and say that government debt continues to rise and short-term interest rates go to 10.0%. With the government rolling over roughly a third of its total debt each year we’re looking at another $300 billion in interest expenses each year just on short-term debt. Say we print money and devalue the dollar in world markets to pay for this extra debt. Interest rates rise across the country, prices rise for consumers and unemployment rises dramatically. We couldn’t have stopped it, but we could have assets invested and liquid assets available to ameliorate the personal impact. Okay, enough of that since it detracts from what I’m really trying to say.

That is, in the fog of our short-term focus on the above issues and the maddening tendencies of the media to bloviate about them 24/7, we forget the ingenuity of the U.S. spirit and what’s going on in the entrepreneurial community today.

At this point, startups are being created like wildfire and funding is rabid. Several prominent venture capitalists have declared that there could be a bubble forming in early-stage technology companies, especially so-called Web 2.0 companies. I’ve heard many write and speak about the prices at which early funding rounds are taking place. Apparently, they’re not grounded in reality at this point and to some it “feels” like 1998-1999 again. (However, there are certain fundamental differences that differentiates this period from then. I may touch on this at a later date, but it mostly relates to valid business models and actual earnings.)

Anecdotally, it’s becoming more prevalent to see local articles about new companies being started dealing with the tech space. I’m encouraged by these signs. Let me point out that first and foremost I am a value investor. I try and figure out the stream of cash flows (both positive and negative) that can be expected over the life of an investment and discount it at an appropriate interest rate. Startups don’t have the luxury of much visibility on this front and so I haven’t (not yet, at least) invested in them. Also, I understand macro and micro-economics that makes me reticent about trying to pick winners.

Surely, there is no way that all startups receiving attention and/or funding today can reach the level of the most popular examples – such as Groupon, Twitter and Facebook. It doesn’t work like that. Many, if not most, won’t survive another year. As Warren Buffett has said, first come the innovators, then the imitators, then the idiots. Probably a lot of the incremental funding is coming from those in the third category and when the level of sophistication falls, so does the quality of the overall pool.

My broader point can get lost in the micro discussion, so I’ll finish here. Just because the effects of competition will ensure that most of these businesses fail (90% as goes the statistic?), the activity speaks to an entrepreneurial spirit that is alive and well in this country. And it’s a spirit that will endure in spite of the broad economic, fiscal, and monetary concerns that receive disproportionate attention in media coverage.

no sabbatical excuse

I wish I could say I was on sabbatical this past year but that hasn't been the case. I simply haven't put enough effort into getting a few thoughts down "on screen" on a regular basis. I intend to remedy that.

I intend to write a bit more frequently after a hiatus that comes down mostly to reticence in sharing new investment ideas, as was the prior focus. With growing compliance concerns in the investment industry and given the inherent competitiveness of the market I cannot often write about original ideas I’m pursuing. Though I will certainly comment on specific companies I will not necessarily do so often, especially those I own for myself or clients. Nor will I present performance information of any type, as has always been my penchant. In fact, I intend to sometimes put down ideas that are only tangentially - or not at all - related to investing, but interesting nonetheless.

Concurrent with more frequent writing comes a couple thoughts:

(1) It can be a waste of time to do extensive editing to text, so expect some grammatical and spelling flaws to emerge from time to time (or just all the time). People generally understand the point without it being encased in perfect prose and spelling, each of which aren’t immutable anyway.

(2) Writing a blog on a frequent basis comes within the context of a busy schedule. Against this backdrop, just getting something type and posted is as remarkable as what is actually written. Still I hope, but can’t promise, that each post is worthwhile and presents at least a new kernel of insight that makes my comments worth reading. I fully realize this a difficult standard, but I will do my best to meet it.

How Long Will Gold Glitter?

I want to spend a little more time on gold here.

Fundamental demand, including Jewelry, Industrial and Dental, is down significantly year over year (8% and 19%, respectively, on a volume basis) while mining supply is up 18% and recycled gold supply is up 31%. Supply is not constrained and the demand from traditional users is very low.

Amidst this fundamental backdrop, investment demand is up 133% and ETF/investment product demand is up 159% year-over-year. At the same time, central bank sales are down 39% year-over-year and the lowest since 1997, meaning a normal source of sales has slowed dramatically. By not selling a normal amount of gold, central banks have become another source of investment demand because of the supply constraints it puts on the gold market.

The data shows that investment (speculation?) seems to be the only source of demand at this point and that its significant growth (and lack of central bank sales) seems to have moved the price higher. One may make money in gold, but only if there is someone later willing to pay a higher price. (This is also known as the greater fool theory.) Gold has a negative yield (it costs money to store), no intrinsic value (it generates no cash flows), and at the current time appears quite speculative despite the claims that it is a good inflation hedge.

Average Returns are Expected with Stocks at Fair Value

The capital markets and the economy are related, but exhibit disparate behavior. The U.S. economy has not been performing well since March, but that hasn’t stopped the stock market from rallying nearly 60% from the lows. The market rally has not been limited to stocks. Indeed, risk aversion has meaningfully subsided across the capital markets; the least creditworthy stocks and bonds have led the charge higher. High yield bonds are up nearly 50% this year, more than double the S&P 500. These risky bonds now yield less than 8%, close to where very low risk (AA) bond yields peaked early this year. Triple-C bonds, which are “currently vulnerable and dependent on economic conditions to meet [their] commitments,” are up 92% for the year. It appears to us that from current capital market valuations, further (durable) price appreciation will require fundamental economic improvement.

We never know where the markets will move next, but we can make reasonable estimates of their intrinsic value. According to our estimates, the S&P 500 trades at 16 times normal earnings and near the high end of its value range. Using cyclically adjusted earnings for the S&P 500, stocks trade at closer to 20 times. (The price-earnings ratio for the market has averaged roughly 15 over very long periods.) Another measure of market valuation which focuses on the replacement value of assets, is over 0.80, just slightly above the long-term average of roughly 0.75. One measure taken alone may not indicate much, but several arrows pointing in the same direction demand more attention. And on many different measures, the domestic stock market in aggregate is no longer cheap but fairly valued.

Ultimately, investors should be rewarded for providing capital to those who use it. But contrary to popular belief, risk and return do not always follow a linear relationship; that is, high risk does not necessarily equate to a high return. Today, the capital markets appear much riskier than just a few months ago (at lower prices) and implied long-term future capital market returns appear to be merely average from today’s levels. What that means for the near-term direction of markets is anyone’s guess.

Gold and Forex, Sitting in a Tree...

There seems to be something dangerous brewing in gold and in foreign exchange markets, at least as it pertains to individuals trading this stuff themselves and betting big. It is now far too easy to “play” in both areas and many of those venturing in now may be setting themselves up to be burned. The foreign exchange market is the world’s biggest casino, where leverage magnifies gains and losses to the point where fortunes can be (and are) won and lost in a matter of seconds. The dollar has been moving lower with remarkable consistency, lulling some to believe in a "can't lose" trend. Danger, Will Robinson.

Gold, on the other hand, strikes me as incredibly bid up, and there are no shortage of brokers there to help (exploit) the individuals scrambling to buy gold. Something tells me when the people facilitating the transactions make more than the investors, there is some froth in this market. While leverage is not inherent to this market as it is with forex, today's "investors" strike me more as the final group in a giant Ponzi scheme. It all comes down to price. Note that investors at the gold's height in the early 80s need a $2,000+ gold price to merely break even on their purchases almost 30 years ago.

Television and radio are now replete with advertisements for gold buying services and forex trading. Some caution is warranted in these areas; I would expect surprises to be the rule rather than the exception as we move forward. Reversion to the mean can be powerful.

The Federal Reserve and the Crisis

“[There is] no longer any fear on the part of banks or the business community that some sudden and temporary business crisis may develop and precipitate a financial panic such as visited the country in former years…We are no longer the victims of the vagaries of the business cycle. The Federal Reserve System is the antidote for money contraction and credit shortage.”

-- Andrew Mellon, Secretary of the Treasury, April 14, 1928

***** ***** ***** *****

What would the world be like without the Federal Reserve System? Why is it commonly believed that they have superior knowledge and always have everything under control? Do they really know exactly what is going on? At least one member of the Federal Reserve Board, Janet Yellen, President of the San Francisco Fed, has admitted they do not. She has essentially confirmed that their “solutions” have been a series of experiments. They threw some things at the wall to see what would stick, and some did. Now comes the far greater challenge – determining when to remove the unprecedented interventions. Will they remove this excess money in time to avoid adverse effects? Unfortunately, the last quarter century does not give us much hope on that front.

By keeping interest rates artificially low during the so-called Great Moderation, or the period from the early 1990s through mid-2000s that saw strong economic growth with little volatility, the Fed signaled investors that there were more savings in the system than actually existed. Without the Fed intervening in markets, interest rates would have fallen when there was a high amount of savings in the system and risen when savings available to fund investments was low. (Like corn, supply and demand for capital would dictate its price, or rate.) Savings rates since the early 1990s were low and falling, so interest rates would likely have been much higher than they were over the past several years. In effect, the price mechanism for capital was (and is) manipulated by the Fed, which creates false signals for investors and savers. This helped asset markets (stocks, real estate) to bubble and led investments to be funneled into unproductive areas for too long. (Higher interest rates – owing to low savings available to fund investments – would have restrained housing market activity, for example.) In effect, the stimulus provided by cheap money was not withdrawn when it should have been and the mess we’re in is at least partially a result. These false signals continue and it is difficult to imagine the Fed withdrawing excess liquidity anytime other than too late. Unfortunately, the Fed has shown they are more likely to be wrong late than right early.

Is the Future Any Less 'Uncertain' Now?

It may not be the time to exuberant just yet.

The winds of popular sentiment appear to be blowing in one direction with respect to the economy – that is, that the economy is stabilizing and things are looking up. We should see stabilization in the latter half of this year and positive economic growth in the first quarter of next year, we hear. True? Perhaps. I will not make those sorts of predictions because I just do not know (and I know it).

The S&P 500 has rallied about 40% off its early March lows. Emerging market stocks are up close to 70% from their March lows and up 42% for the year, versus an S&P 500 that was up about 5% through yesterday. The CBOE volatility index – VIX – which some call the “fear index” is lower than we saw back in September of last year, prior to the collapse of Lehman and the “economic Pearl Harbor,” as Warren Buffett so eloquently says. Granted, the markets are still about 40% below their highs, indicating another 66% gain needed to get back to even. But they have come up pretty far and fast, and the headwinds to corporate earnings mean stocks’ values have fallen since the highs (and record profit margins) of 2007.

As I laid out at the beginning of the year, our economy is not likely to be the same coming out of this crisis. Consumers are not likely to resume their spendthrift ways going forward. Rather, we’ll probably continue to see higher savings rates and years of deleveraging as consumers align their household cost structures to their income levels. This will probably mean smaller homes and less conspicuous consumption. Accordingly, the source of 70%+ of our economic activity (consumer spending) is likely to be much less robust and become a smaller part of the economy. Capacity utilization will probably be sub-optimal for some time, which means higher structural unemployment and lower wage growth (if not wage rate stagnation). If the government continues its profligate spending without commensurate cuts in entitlements (which it’s actually adding), we will not be able to avoid higher taxes down the road. My personal bias tells me higher taxes are likely because tough decisions on public pensions, Social Security, and Medicare/Medicaid, while probably salable to the public by the popular administration, are not as much fun as tackling health care reform and “green” energy. When the public is willing to suspend disbelief, we get trouble.

The various feedback loops created by all of these elements should result in lower levels of economic growth. Also, corporate returns on equity are likely to be lower and cost of capital higher, meaning price-earnings multiples on stocks might end up structurally lower. Remember, stocks trended strongly upward from 1982 to (roughly) 2007 because of a secular decline in interest rates. We saw interest rates come down from nearly 20% to nearly 0% today. Earnings multiples went from 8 to 20, a roughly 4% annual return solely from multiple expansion. Unfortunately, interest rates are at zero today and a rising interest rate environment is bad for stocks. Look at the market from the early 1940s through the late 1960s – a steady trending market marked by rising P/E multiples and robust corporate earnings growth. From there, the market went nowhere until the early 1980s, paving the way for another strongly upward-trending market. One can argue all they want, but the starting level of valuations plays a major role in long-term stock returns. Judging from this perspective, we clearly lack such tailwinds from where we stand today.

Governments, businesses and consumers do not become aware of all these realities overnight. They take time. It took years for people to go from saving 8-10% of their income (1950s through early 1990s) to 0% (2006), and to double their household debt as a percentage of income. The same goes for businesses and governments (which are run by consumers), who largely didn’t have a “rainy day” contingency plan going into this crisis. I think this is bound to change as we go forward. The result will be a more resilient economy but one that is less optimized should boundless growth and low volatility return.

The market appears fairly valued from both a bottom up and top down standpoint, assuming long-term normal profit margins. That’s not to say it won’t go higher or lower. But from what I’m seeing from a bottom up standpoint, the tremendous bargains we saw in the first quarter of the year are few and far between. Prices at current levels appear to offer only average long-term future return prospects. Yet those willing to dig can find select opportunities available in multiple asset classes.

The Road to 2010 goes through 2009

Another year has come to a close, and another is beginning. And what a year 2008 was. 2009 will prove to be just as interesting, punctuated by more business failures amid bad economic data (and maybe even some good news). Just how bad it can get is anyone’s guess; how good it can get isn’t really on anyone’s mind at this point.

As an investor today it is more important than ever to have a macro viewpoint. For many years, it simply wasn’t necessary because the range of economic fluctuations was pretty narrow. Stability brought investors comfort and, according to popular thought, it was more or less safe to “buy on dips,” because the market would almost inevitably ratchet higher in ensuing years. Downturns were short-lived as the Fed took an aggressive stance, pumping in liquidity, but increasing the moral hazard a bit more each time. Slowly, risk aversion subsided. Investors began paying more for earnings and demanded less interest spread over Treasuries to compensate for the additional risk. Much of the returns of the past 25 years have been driven by investors’ willingness to pay higher multiples on earnings. Going back farther, though – over 100 years –stocks are up less than 5% annually, which happens to be the rate of earnings growth over that time. The rest of the roughly 9% compounded return has come from dividends, which will be back in vogue. (Some companies whose dividends may otherwise be sustainable may still have to temporarily curtail them in the current downturn, even stalwart companies.)

Fast forward to this year. We seen a broad based decline in the stock market, the first such major decline since the early 1980s. (The decline in 2001-2002 was really concentrated in a few sectors – media, telecom, and technology – and thus did not affect all sectors equally.) The market went into the year disjointed – with financials down considerably but energy, materials and industrials still holding up relatively well. Now, the market is no longer quite as disjointed, though the degree of undervaluation in the market is far from homogenous.

The most concerning issues are twofold: confidence and cost of capital. Yes, there are others, but I want to concentrate on these broad themes. Confidence underpins our whole economic system, especially with respect to its lubricant, credit. And confidence has been lost. To use a crude example, when your best friend sleeps with your significant other, it’s going to take a long time to trust either of them again. And I think that’s the case here. Trust is built up over a long period of time as confidence builds that the future will largely resemble the past. Trust in, for instance, underwriting standards, was built up over a long period of time as default rates remained low and leverage ratios were allowed to ratchet higher. The loans made late in the cycle kept it going for longer than would have normally been sustained because of the “Ponzi finance” nature of the activity. That is, new loans were used to pay interest and principal on the old loans. As long as credit was available and lenders were willing to suspend disbelief, this worked fine. Until it didn’t.

We’re going to get back to system that relies on the character of the borrower rather than purely (unreliable) quantitative measures. I’m not sure how exactly this will work, because financial innovations will remain a fact of life. But I know it will mean banks and other finance companies will retain a larger portion of their securitizations and/or provide stronger guarantees to security holders. Business models will evolve (with the help of what is likely to be heavy-handed regulation). Formerly profitable businesses will cease to be so, and the seeds of future banking problems will be planted.

The economy is a non-equilibrium, evolutionary system where feedback loops play a meaningful role. George Soros calls this “reflexivity.” The cost of capital across the system has risen quite suddenly, not just debt financing, where rates are obviously much higher and capital less available, but equity. What isn’t often considered is that higher stock prices (along with lower interest rates) bring down the cost of capital. And cost of capital has been falling since the early 1980s, which has been a tremendous tailwind for the values of financial assets. Consider the feedback loop here. At a lower cost of capital, there are more potential projects for companies to undertake. For instance, if cost of capital is 6%, projects with a return potential greater than 6% will add economic value. Adding economic value feeds back into higher stock prices, which decreases the cost of capital, and the cycle continues. And undertaking more projects means more capital spending, which feeds back into economic growth in a meaningful way and further lowers the cost of capital. But when cost of capital goes to 10% or 12% for an extended period, old projects will run off and newer ones will be made under more restrictive conditions. That is, projects with return potential higher than 10% or 12% are now needed to add economic value. (Most) companies would not undertake an 8% return project while paying a 10% capital cost since to do so would be value destroying. With the long-run average return on equity at 12-13%, there are far fewer projects when the hurdle rate is 10% than when it is 6%. Less economic value added means lower stock prices, which leads to a higher cost of capital, and the cycle continues. The longer stock prices stay low, the more likely it is we’ll be in a feedback loop that will look very different from the past 25 years.

Furthermore, when cost of capital is higher, the justified P/E ratio on stocks is lower. We’ve lived in a 15-20 P/E market for the past 20 years largely on the basis of lower cost of capital as interest rates have generally been declining and remained low over this period. The cash tax rate and growth rate do not vary much over time. Returns on capital have moved higher, too, but at least partially have been driven by the levering up, through debt, of the country. So as capital costs rise and the feedback mechanism kicks in, justified P/Es, in my view, will be much lower than we’ve been used to.

What does this mean for investors? Active management is going to be very important. Index fund investors are going to be more challenged. This last year should have proven, once again, that the efficient market hypothesis, beta, alpha, the capital asset pricing model, etc., are all garbage. Markets follow power laws, not normal distributions. Markets are open, complex adaptive systems, not closed equilibrium systems. Returns to the stock market are path dependent. They exhibit oscillations and experience periods of punctuated equilibrium that come about largely through endogenous factors that may or may not have exogenous shocks as the initial cause. Small changes can have big impacts (and do). It is not completely different this time, but it will be different for a while and investors must recalibrate their expectations for how stocks behave. We are likely to see a market, akin to the 1970s, that moves in a trading range over time. (Actually, we’ve already seen it – from 2000 forward.) Income from dividends will be more important in this kind of environment. Being willing to buy at high free cash flow yields and sell at lower free cash flow yields and being willing to hold cash at times will be key. If we get back to a market that forgets what has happened over the past year and resumes trading at its 15-18 multiple consistently, I would be very surprised. But I have been wrong in the past and will be wrong again.

Either way, it will be an interesting year, and I will make no explicit predictions regarding the markets. The economy is bound to get worse in the year ahead and geopolitical concerns will become more serious (for instance, a few countries may defect from the Euro currency), but asset prices will turn up well ahead of a recovery in the real economy.

Time to be Aggressive?

The U.S. stock market capitalization is now just 65% of GDP, and stocks are trading around 10 times normal earnings. That is, stocks’ earnings yield is 10%. The current dividend yield is 3.6%, higher than the 3.2% on the ten-year Treasury note. On an absolute basis, the last time we saw these prices on the S&P 500 Index was in April 1997. But to find these valuation levels, one would have to go back to the mid-1980s. Yes, the economy is weakening significantly and will be very difficult for quite some time. And stock prices will probably still go lower, perhaps meaningfully so. But stocks are discounting a very difficult economic scenario already, and investors at current levels should do very, very well from here. As Warren Buffett recently wrote, "If you wait for the robins, spring will be over."

The State of the Stock Market

On the New York Stock Exchange:

New 52-week highs: 13

New 52-week lows: 1,813

Of the 52-week highs, 12 of them are Inverse funds. Take from this what you will.

Indiscriminate Selling Continues to Bring Expected Returns Higher

The world sure seems bleak right now. At least that's what the media is intent on conveying, as it produces an almost endless stream of bad news – home prices falling, food and gas prices rising out of control, stocks (and 401k balances) down significantly amid an uncertain and fragile economic situation. What is lost in the noise, however, is that our economy is in good fundamental shape. Because most people still have jobs, they largely continue to pay their mortgages despite fears of widespread defaults. True, some areas have been hit especially hard by problems in the housing market. But this is not the entire country! The average consumer is pretty well leveraged, and may realize that ratcheting back spending is a good idea, even though it may be painful to do so. Consumers ratcheting back their spending will affect the unemployment rate as the most discretionary items are cut from household budgets (especially as more people start to budget). Yet the situation we're seeing now is not really anything new.

While the widespread problems in the housing market are a relatively new phenomenon, it is just a different version of problems we have experienced in the past. This time it is the real estate market, last time it was Internet stocks, in the early 1980s with was runaway inflation. All brought stock prices down to levels that would, years later, look like a bargain. It is my contention that this time is no different. Like a B movie, the specifics may have changed, but the basic story is about the same.

What we won’t hear much about is the incredible opportunities available to investors right now. Home prices are lower, yes. But for those with available purchasing power, very good income-producing real estate is available at lower and lower prices. Cap rates (the assumed rate of return on property based on net operating income) are rising across the country as many of the former sources of financing with loose lending terms have shut down. Stock prices are now more than 20% below their highs of last year. Many of the world’s finest companies are selling at low multiples to long-term free cash flows. The time to invest new money is now. Asset prices may continue to get cheaper in the short-to-intermediate term, but those who have the courage of their convictions and invest now might just look like geniuses five years hence.

Amid all the uncertainty, what can we expect the stock market to look like in 10 years? I ran a few numbers, assuming different scenarios (none of which might illustrate what will actually happen, mind you) but using the same basic underlying idea. I’m assuming that earnings in the future continue to grow at about 6%, or the long-term trend rate. I then made separate lines of assumptions – that ending price-to-earnings ratios are 15, 20, and 25 ten years from now. Given these assumptions, what can we expect for returns from current market levels? The table below illustrates.

If P/Es stay about where they are, or 20 times earnings, we might expect annual returns of around 10% annually including dividends. If P/Es decline to 15, this number drops to 7.5%. At 25, we can expect annual returns of 13%, but when stocks have hit a P/E of 25 they have usually not stayed there for long. In addition to the above, I made another assumption not listed on the chart; that is an ending P/E of 10. In this scenario, stocks should return only a cumulative 10.9% over ten years, or 1% compounded annually, for a total return of 3.3% annually from current market levels. The only way I see us getting to a P/E of 10 is in a highly inflationary environment like the early 80s and/or one where the economy is stagnant. Which scenario ends up being close to the actual result is anyone's guess.

Lower valuations generate higher future returns despite the short term pain. The table below illustrates what these same numbers would have looked like from the highs of October 2007, when the S&P closed at 1,565.

The difference is striking. Falling stocks prices have added about a cumulative 34% (3% annually) to the possible ten year returns from stocks. That is, a person investing now stands to earn an incremental 3% annually versus another person investing at the October highs - regardless of what the market does over the next ten years!



Over the long-term, stocks track earnings. The above chart show the last twenty years (1998-2008) of actual earnings, normal, or trend, earnings, and stock prices. The normal earnings line is the trend line, because it assumes earnings grow 6% annually without any volatility. The actual S&P earnings per share has tracked this line over time, and although it has diverged meaningfully at points, it has always seemed to tend back to it after diverging. Stock prices also track this trend, excluding the irrationally exuberant period of the late 1990s. Betting on stocks is a bet on future earnings. So if you believe that over the longer-term our economy will perform about as it has in the past, stock appear to offer reasonable returns from these levels. But these levels also appear to offer excellent opportunities to buy individual stocks that will perform significantly better than the overall market in the years to come.

Ethanol Blend or Regular?

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...

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.

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.

"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.

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

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.

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.