Wednesday, July 09, 2008

Eight Years of Agony

Hard to believe that eight years after the highs of the markets in 2000, we are again below those levels on all three indices. True, the DOW remains near its 2000 peak of 11722, while the S&P500 is about 20% below that level and the NASDAQ, well, the less said the better. Eight years on the index remains at less than half of the 5000 level it achieved in March of 2000.

How can this be? Earnings, which are supposed to drive valuations, have increased meaningfully since that time. Moreover, many companies have much stronger balance sheets than they did before. I would point to four factors - financials, changes in index components, fear about the economy and inflation.

Over the past 10 years or so, financial stocks have represented about 20% of the S&P500s capitalization. As industrial firms and manufacturing, the old staples of the index, declined in market value banks and financial firms came to dominate the index. Financial stocks have been crushed. It is therefore no surprise that the indices have also been punished.

The financial crisis continues to rage with an evolving sense that the whole system is rotten.
What first seemed an isolated problem in a few narrow classes of assets - CDOs and other structured finance products - have metasised throughout the sector. The reality is that while the owners of structured finance might have appeared to be narrow, hedge funds, pension funds wealthy investors - all of them seeking income yield unlike most individual investors - structured products were sold backed by all manner of securities, which drove the prices of those assets above reasonable levels (Greenspan's "conundrum") and encouraged massive leveraging, which, sadly, was rewarded not by the lower prices that increased risk should have produced, but by higher prices as people piled in to ride the wave of asset price appreciation. More on this in a moment.

The second factor is the way the indices have changed. This is most evident in the NASDAQ and is a major reason why the price levels there have not rebounded with profitability. Stop to consider that when one of the profit measures of an index is performed it considers the profitability of all the components - this is logical. But if many of your components were money losing companies and they go bust, your index sees a profit improvement, even though the remaining companies may not really be more profitable than they were before. Sadly, this is exactly what has happened in the information technology sector. The composite index has seen strong profit growth mostly through an "addition by subtraction [of a negative]". The remaining companies, however, have not demonstrated strong profit growth and their prices therefore linger. Think MSFT, a company that is struggling to change from being a fast growth company into one that basically operates a franchise with modest growth potential.

The third factor is of course fear about the economy. If overall economic activity declines, future profitability will likely be lower. Marginal companies, in particular will find the going difficult. And many traditional policy supports such as lower taxes and easier money seem more foolish than helpful given the massive red ink of the US Federal Government and the surge in global prices. Thus, the economy seems set for a cycle of lower growth - possibly below the rate of productivity growth - which leads to unemployment (or fear thereof) and therefore lower consumption and lower economic activity and so on - the classic downward spiral. The only upside in this is that lower spending likely means lower prices for consumers, since output capacity that exceeds demand may lead to lower prices to clear the market (though it may also lead to reductions in capacity and massive write-offs: think Ford and GM). The other upside is that employed people may have the chance to save and repair household balance sheets, if falling asset prices don't overwhelm saving efforts.

Falling asset prices are of course, the biggest concern of policy makers. Sadly, these same people never worry about asset prices increasing too much. People throughout the world have been able to rely on higher asset prices and the high internal rates of return on savings to consume. As I write this, I realize how illogical it is - high rates of return should encourage investment and low rates consumption, but the reverse has happened. There must be a Ph.D. in this somewhere.

The fourth factor is inflation. This is showing up in specific commodities and affecting consumers spending patterns. There is significant substitution toward fuel, heating oil, natural gas and electric expenditure. That money has to come from somewhere and it appears that it is coming from other consumer purchases, particularly in durable goods where outlays can often be deferred for years. Of course, higher inflation also discourages savings and the higher costs of living, unless offset with higher wages, may also be accomodated by lower savinsg, so as to keep consumption consistent.

Inflation, apart from its "real" economic effects, also has another affect on asset prices. Hint: it is not good. High inflation leads to demand for high earnings yields and that means low P/Es for stocks. Note: stocks are usually sold as an inflation hedge, since companies can raise prices and therefore increase earnings. But the problem is, when inflation increases, the value of a dollar of future earnings decreases and it is a struggle to keep earnings growing fast enough to offset the higher discount rate demanded by investors.

To keep it simple - remember that the value of a growing perpetuity is

Dividend/(Discount rate - Growth Rate)

this is the famed "Gordon Growth Model". In theory if the discount rate and the growth rate increase the same amount the value of the perpituity remains the same. However, when inflation is rising, r tends to increase faster than g, so the value of the perpetuity declines.

Recent history offers a compelling example - in 1964 the Dow stood at 766. After 18 years and strong absolute earnings growth - in 1982, the Dow stood at 781. This was because P/Es had collapsed due to inflation. It didn't hurt that earnings took a beating during the nasty 1982 recession.

So - eight years into this cycle, could we be stuck at this level for another decade? Well, let's not forget that the index cycled up and down around this level, hitting 500 and 1000 many times in between. But doesn't this feel like a similar situation to where we are today?

So what to do. Well, one option is to purchase true inflation-fighting investments. Stocks don't do that well against inflation because CapEx expense increases at least as fast as earnings. Returns on Book can plummet. But investments like real estate (I know, real estate? am I crazy!) and commodities are proven inflation fighters. My problem with commodities is that they don't offer current income, so it is pure speculation on price movements. I have to claim ignorance here.

That leaves stocks and bonds. Bonds, unfortunately, get killed in high inflation cycles. Long Treasuries were trading at 15 - 15! - in 1981. Short maturities don't offer yield high enough to prevent the decay of price power. For me, that leaves equities.

But - this is the key - what kind. We must look for current yield, as yield appears to be the only return available to us. We must therefore look for companies with solid yields and a high probability of an increase in dividends goign forward.

These are boring companies, mostly, but their prices will exhibit less volatility and their yields provide a good floor against sudden price drops. Price decreases, actually, are opportunities to dollar cost average your dividends into the stock. A good example is CL.

Also look for stocks that trade a low ratios to book value. Book value is often a good indicator of intrinsic value. Because assets are held on the balance sheet at the lower of cost or market, companies that trade near book are likely to have large phantom equity that you as the shareholder can obtain. Rather than purchase an income stream whose value is questioned by the market, you get real assets that are available now. Good examples here are BSET and HELE.

On the more speculative side, I believe that there are some values in the financial sector, but it will be difficult to determine which banks are relatively safe. The insane leverage of the investment banks makes them all suspect, but the money center banks (excepting Citi, which is a basket case) have been pummelled. Personally, I still believe that BAC is the strongest of the large banks. It continues to make money even after the writedowns (though it has not earned its dividend and may need to reduce it). In a world where finding creditworthy borrowers is the problem, banks will have to offer services and other values to attract those borrowers.

BAC is uniquely positioned to offer the help of a local branch and a local agent who can help people shopping for a mortgage, real estate investors and other small and medium sized business owners looking for financing. Investment banks will be pummeled because large businesses will not have the financing needs they had before. Why float new issues when you don't need new capacity? Easier to finance low CapEx from cashflow. Competition for deals will be amazing and fees will likely be reduced. Commerical banking will be the most profitable part of the industry and here the BoA footprint is a real advantage.

That is how I see it going forward and now you know what I am looking for: firms with solid balance sheets that trade near book value (and will be less immune to multiple contraction) that pay dividends that are reliable and likely to be increased.

1 comment:

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