Bailout Perspective

The Bush Administration and Congress are hammering out an agreement on a $700 billion financial bailout. Rep. Barney Frank predicted a deal by Sunday. Here are several articles to provide some perspective.

The Paulson Plan Will Make Money for Taxpayers
By Andy Kessler, Wall Street Journal, 9/25/08

Kessler’s analysis leads him to conclude that the United States Treasury could “net a trillion dollars and maybe as much as $2.2 trillion.”

What’s the Real Cost of the Bailout?
By Brett Arends, Wall Street Journal, 9/26/08

Arends agrees: “…. the Treasury will certainly get some of its money back and will probably get most.” He goes on to say that the Treasury “could make an absolute killing.”

Bailout Cost Unknown – CBO
By Jeanne Sahadi, CNNMoney.com, 9/24/08

Because the government will be acquiring assets having underlying value, Peter Orszag, CBO Director, believes the ultimate cost of the bailout will be much lower than the $700 billion.

What We Learned From Resolution Trust
By William Seidman and David C. Cooke, Wall Street Journal, 9/25/08

Seidman and Cooke ran the FDIC and RTC during the savings and loan crisis. They remind us that managing the assets to be acquired under Treasury’s proposal will be a complex and difficult process.

This isn’t Armageddon
By Geoff Colvin, Fortune, 9/25/08

Colvin sees our system having a “self-correcting impulse” to successfully adapt to dramatic change. Hopefully it will be for the better.

Buffett Buys Into Goldman Amid Wall Street Losses
By Erik Holm, Bloomberg, 9/24/08

While Buffett negotiated an excellent deal for himself, I believe his investment is a strong expression of confidence. As Michael Yoshikami, president and chief investment strategist for YCMNet Advisors, said, “…. this suggests the world is not coming to an end.”

Fast Tracking for Ideas

Through all of the current turmoil Coca-Cola’s business and share price have been doing just fine.

Fast Track results: Coca-Cola (KO) failed 2 of the 8 categories, and is a potential idea that’s worth the time to thoroughly research.

Key points:

1. Coca-Cola generates lots of cash. The company delivered free cash flow of $5.5 billion in 2007, up from $4.6 billion the year before. Although down $203 million in the first six months of this year, free cash flow was still strong at $2.3 billion.
2. Cash is growing on the balance sheet. Cash and marketable securities totaled $6.9 billion at the end of the second quarter, an increase of $2.5 billion from year-end 2007.
3. Coca-Cola is conservatively capitalized with long-term debt as a percentage of total capital of only 11.0%.
4. Earnings per share surprised on the upside for the last four quarters, and Street estimates have been stable. Second quarter earnings came in at $1.01, for an 18.8% gain. Worldwide unit case volume grew 3%, with international up 5% and North America flat despite a difficult economy.
5. Warren Buffett’s Berkshire Hathaway owns 8.6% of Coca-Cola’s outstanding shares.

The Company Stock Risk Profile Fast Track is a research tool for quickly and easily screening stocks for potential ideas. Fast Track is comprised of 10 key categories incorporating fundamentals, valuation and how management and the Street feel about the stock. I like to see a stock fail no more than 3 categories before putting the stock through the complete 50-category Company Stock Risk Profile research process. Most important, whatever screening tool you choose to use, always thoroughly research the stocks that pass your screen before buying.

Mark to Market Contagion

There hasn’t been much discussion about Financial Accounting Standard 157. But I believe it has been a principle underlying contributor to the current financial crisis, and needs to be modified. John Berlau wrote an excellent article on this in last weekend’s Wall Street Journal.

A Different View of Risk

I posted this article on March 12, 2008 . I thought it would be worthwhile repeating.

World economic collapse is imminent. 1929 is just around the corner. My stocks will never stop going down. I can’t take this anymore, and I’m getting out now. This is a new age for the economy and the stock market, and there’s no way stocks are going down. Everyone else has been making a lot of money in the stock market, and I’m not going to be left out. Feel familiar? These are examples of strong emotions that can push you into making bad investment decisions. However, these same emotions can be your allies, and a resource that you can use to take advantage of investment opportunities.

The stock market is like riding a wave up and down. Sometimes the wave can be dramatic and last a long time before it crashes or takes you up. While the market seems to extend itself, that is go beyond what seems reasonable, on the upside and downside, it always changes direction. While this may seem obvious, it takes a lot of emotional strength to fully embrace this fact when you’re feeling great and complacent when the market is soaring, and it seems that it will never end, or when you’re feeling fear and panic when the market is dropping rapidly, and it seems it will never stop falling.

Are you on the verge of selling all of your stocks because you cannot take the falling prices anymore causing you to panic? Or, are you about to buy stocks, possibly stocks with a high degree of risk, because you feel that all’s well with the stock market, and there’s no way anything can go wrong? Are these the extreme emotions that are really behind the investment decisions you are about to make? Are you about to sell at the bottom of the market or buy at the top because you are caught up in your emotions?

Get a pencil and paper and draw an elongated S shaped curve. Write Exuberance at the top and Fear and Panic at the bottom. These extreme emotions represent market tops and bottoms. To the right of this graph draw a vertical line and label it Risk. Write the word Highest at the top of the line and the word Lowest at the bottom. I call this the Exuberance / Fear and Panic Graphic.

You must understand risk within the context of your emotions. You are putting your money at the highest risk of losing it when you are the most comfortable and complacent about your holdings, when you are exuberant. Risk is at its lowest level just at the time when you are the most negative about the market’s outlook, when you are feeling fear and panic. Objectively recognizing your emotions, you can then turn your emotions and the graph upside down with Exuberance at the bottom and Fear and Panic at the top. Seeing risk with new clarity, you are able to make better investment decisions to protect your capital and take advantage of opportunity.

What action should you take when you are able to gather the emotional strength to turn the graph upside down? Be afraid of the market at the top of the graph. Turning exuberance into fear, sell your stocks and be entirely in cash. If you find yourself at the bottom of the graph, transform your fears into excitement about finding stocks to buy. Put cash to work towards being fully invested in stocks.

There are various methods of valuing markets, among them price / earnings ratios, dividend yields, earnings yields, sentiment indicators, and technical analysis or charting. These methods look outward. I’m proposing that you also should look inward at yourself with the aid of the Exuberance / Fear and Panic Graphic as another, albeit unconventional, approach.

A successful investor is objective, disciplined, and has a clear understanding of risk. The Exuberance / Fear and Panic Graphic helps you to objectively examine your emotions, attain the discipline not to get caught up in the wrong emotions at the wrong time, and to recognize the real risk inherent in your investment decisions.

Is The Recession Here Yet?

Real GDP increased at an annual rate of 1.9% in the second quarter. The increase went beyond personal consumption expenditures to include exports, non-residential structures, and federal, state and local government spending. Exports were a standout contributor, rising 9.2%, accelerating from 5.1% in the first quarter. Maybe a weak dollar isn’t all bad. Here’s something we don’t hear a lot about. Real final sales of domestic product (GDP less change in private inventories) grew 3.9%, up from 0.9% in the first quarter. Looks like growth to me.

What’s this from the Wall Street Journal? “The U.S. economy was the best performing of the G7, growing 0.5%. Indeed, of the 1.9% year-to-year increase in economic output recorded by OECD members in the second quarter, the U.S. accounted for 0.6 percentage point. The euro zone continued at 0.4 percentage point and Japan at just 0.1 percentage point.” Well that’s a switch from earlier expectations.

And then I came across this from an article in SmartMoney by Donald Luskin dated August 8th: “I’ve just spent two days with friends and family in Disneyland, “The happiest place on Earth.” Based on what I’ve seen, it ought to be called “the most crowded place on Earth.” It was mobbed. Packed beyond capacity.” These families are still taking vacations despite the high cost of gasoline.

The AP reported on August 18th that, “Chile’s Central Banks says the nation’s copper sales surged 8.8 percent in the first seven months of the year over the same year-ago period. The South American nation is the world’s largest copper producer.” State-run Coldelco and BHP Billiton are the country’s largest copper producers. BHP Billiton reported record copper production for the year ended June 30, 2008. The demand for this economically sensitive metal at high prices would seem to support a global economy that’s growing.

Housing starts in July came in at an annual rate of 965,000, 11.0% below June and 29.6% below July 2007. July’s pace was the lowest since March 1991. Consider that a low level of housing start activity is what is needed to work off existing inventory to get to a level where healthy growth can begin. Admittedly only one smaller city, The Tucson Board of Realtors Listing Service reported that the inventory of home listings in July dropped below 8,000 for the first time since March 2008, and new listings are down nearly 20.0%.

If magazine covers are contrary indicators, as some believe, the worst may be over for the financial services industry. Meredith Whitney, a bank analyst at Oppenheimer & Co., is on the cover of the August 18th issue of Fortune. The cover reads, “Bank analyst Meredith Whitney called the credit meltdown a year ago. Her forecast now: more pain on the way.” The author describes her as “the most influential stock analyst in America. And certainly the most bearish.”

Don’t get me wrong. I fully appreciate the serious issues facing the real estate and financial services industries. And the economy may fall into a recession, or it may not. But for now, sentiment appears to be too dour versus reality.

Exxon Mobil: Bull or Bear?

Down nearly 20% from its 52-week high, Exxon Mobil’s (XOM) stock has become quite controversial after reporting 2Q08 results. I like controversy because it may yield investment opportunities. Here are the key issues, both bull and bear, as I see them.

The Bear case:

1. Exxon’s earnings disappointed investors for the second consecutive quarter. While the company turned in record earnings at $2.27 per share in 2Q08, results were markedly below the Street’s consensus estimate of $2.52 per share.
2. Production has been declining. On an oil-equivalent basis, production dropped 8% from 2Q07, and this was on top of a 5.6% year-over-year decline in 1Q08. Even excluding the Venezuela expropriation, the Nigeria labor strike and lower entitlement volumes (higher oil prices result in lower production volumes under production sharing contracts), production still would have been down 3% in 2Q08. Exxon is a no growth company with a depleting asset.
3. The pressures of nationalism in oil producing countries are weighing on the super-majors’ ability to find oil to replace reserves, let alone grow, and successfully manage existing operations in those countries. Venezuela’s expropriations and Russia’s hostile actions against Shell and BP highlight this trend. Will the Russians go after Exxon next? Exxon and all the super-majors are at a competitive disadvantage with state owned oil companies. The violence in Nigeria takes the risks facing these companies up another notch. And the pressure is on to take more taxes from the oil industry in the U.S.
4. High oil prices have been a double-edged sword, as Downstream earnings were crushed in 2Q08. Hurt by weak refining margins, Downstream earnings dropped 54.1%. Chemical earnings fell 32.2%.

The Bull case:

1. Oil is a necessity, and Exxon has plenty of it. The largest reserve base in the industry, proved reserves totaled 22 billion oil-equivalent barrels at the end of last year. Exxon has replaced more than 100% of production for 14 years running. The reserve replacement ratio was 101% in 2007. Long-term, Exxon has 50 billion oil-equivalent barrels, 30 years of production at 2007 levels, yet to develop. That Exxon is a no growth company with a depleting asset may be greatly exaggerated.
2. Exxon has immense financial resources. Cash has been flowing onto the balance sheet with cash and marketable securities growing to $39.7 billion at the end of 2Q08, up $5.2 billion from year-end 2007. Long-term debt was only 5.5% of total capital.
3. Exxon is a huge cash generator. Cash flow from operations was $52.0 billion last year, and a whopping $34.8 billion in the first half of this year, up from $25.6 billion in the same period in 2007. Excluding capital expenditures, free cash flow was $36.6 billion in 2007, and $26.0 billion in the first half of this year, up from $18.7 billion in the same year earlier period.
4. Exxon is a highly profitable company. Return on equity in the latest trailing 12-months was 36.2%, well ahead of the industry’s 27.0%.  Asset utilization or sales / assets (1.9x versus 1.4x for the industry) and return on assets or net income / assets (17.6% versus 12.4% for the industry) are the return on equity components driving Exxon’s performance.
5. The stock has plenty of room for ratings upgrades and institutional buying power. Street opinion is mixed. Eight analysts are recommending purchase out of a total of 16 analysts following the stock. Moreover, Exxon is not a favorite among institutional investors, as they own only 52% of the outstanding shares.
6. Exxon is a cheap stock. The shares are bargained priced at 8.2x this year’s consensus earnings estimate, well below the stock’s 5-year average of 13.3x and the S & P 500’s 15.4x.

What do I think? I put Exxon through my own comprehensive Company Stock Risk Profile research process spanning 50 categories of company fundamentals and stock valuation. The stock came out with a Low Risk rating, having failed 16 of the 50 categories (I define Low Risk as failing 0-17 categories).

Exxon is the kind of stock I want anchoring my portfolio, particularly when times are tough. The company produces a product that people need and use every day, and generates lots of cash. I also believe we are fast approaching the era of “peak oil” and that Exxon’s large reserve base will continue to become ever more valuable.

Disclosure: I own Exxon.

Dow Earnings: 2Q08

Twenty-five of the 30 Dow companies have reported second quarter earnings. Here are the results:

1. Reported earnings per share from continuing operations and before one-time items for all 25 companies came in at $10.34, as compared with $22.74 in 2007’s second quarter. The Street’s aggregate consensus estimate was $18.45.
2. Eighteen companies beat Street expectations, 2 were on target, and 5 disappointed. Comparing results with a year ago, 17 companies posted higher earnings, 1 equal, and 7 lower.
3. The weak spots, widely reported in the press, were the financials and General Motors. Excluding American Express, Citigroup, J.P. Morgan and General Motors, earnings were $20.99, up 12.7% from last year’s $18.62, and slightly ahead of the $20.46 the Street expected.

Not to underestimate the serious problems in the financial services and auto industries, on balance, the Dow companies have been turning in decent results so far.

Fast Tracking for Ideas

In the January/February 2006 issue of the Financial Analysts Journal, Jeremy Siegel and Jeremy Schwartz published a study titled Long-Term Returns on the Original S&P 500 Companies. Their conclusion would seem to support a buy and hold strategy: “We found that a portfolio of the original 500 stocks chosen by Standard & Poor’s in 1957 to launch their index outperformed the actual (updated) S&P 500 over the subsequent 46-year period and with lower risk.”

They provided a table of the 20 best performing survivor companies based on returns over the period from March 1957 to December 2003. The list was comprised of 11 consumer products companies, 6 pharmaceutical companies, 1 retailer, and 1 integrated oil company. The company completing the list and that caught my attention was Crane. Here’s a mid-cap industrial company vulnerable to economic cycles whose stock returned 15.1% over the period studied making it the 10th best performer.

Fast Track results: Crane (CR) failed 3 of the 10 categories, and is a potential idea that’s worth the time to thoroughly research.

Key points:

1. “A diversified manufacturer of highly engineered industrial products,” Crane adds a lot of value to the products it sells. The Aerospace and Electronics division can boast that its products can be found on “virtually all commercial and military aircraft.”
2. Crane’s long-term staying power through good and bad times, together with the returns that the stock has awarded shareholders is impressive.
3. Crane has been growing cash on its balance sheet. The company ended this year’s first quarter with cash and equivalents of $294.7 million, up from $133.9 million a year earlier and $283.4 million at the end of 2007.
4. Free cash flow has been growing. The company generated free cash flow of $185.7 million in 2007, up from $154.5 million in 2006. The first quarter came in at $35.0 million, which was $5.1 million above a year ago.
5. Earnings beat Street expectations for the last 4 quarters, and consensus estimates for this year and next have held steady. Management stated their earnings forecast for 2008 in the annual report and re-affirmed it in the first quarter earnings release at $3.45 – $3.60, for a gain of 8% – 13%.
6. Street analysts are giving little support to the stock, leaving plenty of room for ratings upgrades. Eight analysts are covering Crane, and only 2 are recommending purchase.
7. Crane offers good value. The stock’s P/E based on trailing 12-months earnings per share is 11.3, well below the S&P 500’s 18. The PEG ratio at 1 also compares favorably with the S&P 500’s 1.2.

The Company Stock Risk Profile Fast Track is a research tool for quickly and easily screening stocks for potential ideas. Fast Track is comprised of 10 key categories incorporating fundamentals, valuation and how management and the Street feel about the stock. I like to see a stock fail no more than 3 categories before putting the stock through the complete 50-category Company Stock Risk Profile research process. Most important, whatever screening tool you choose to use, always thoroughly research the stocks that pass your screen before buying.

Why I Own Altria

“PM USA estimates that total cigarette industry volume declined approximately 4% in the first quarter. For the full-year 2008, PM USA estimates a total cigarette industry volume decline of approximately 3%.” Altria Group’s tobacco manufacturing and distribution business, PM USA expects this trend to continue with industry shipment volume declining 2.5% – 3.0% annually over the next few years. So, why would anyone own Altria Group (MO)? I do, and here’s why:

Altria dominates the U.S. tobacco industry with powerful brand names. The company has a commanding 50.9% share of the cigarette retail market. Marlboro boasts a 41.5% share. Acquired last December, John Middleton placed Altria in a leading position in the machine-made large cigar market with a 26.8% share. Middleton’s key Black & Mild brand controls 25.9% of that market.

Altria has a fortress balance sheet with lots of cash and low debt. The company ended this year’s first quarter with $4.8 billion in cash and cash equivalents, and long-term debt as a percentage of total capital of 13.5%.

Altria has always been and still is a cash machine. Right out of the box post spin-off the company delivered free cash flow of $1.9 billion in the first quarter.

Management is implementing a strategy that should support earnings growth in a shrinking market. The strategy calls for: cutting expenses at rates that exceed declines in cigarette volume; growing market share; and extending product lines and leveraging distribution through acquisitions and internally developed products.

Here’s how the company is performing so far:

1. Management plans to slice $1 billion out of the company’s cost structure by 2011. Selling, general and administrative expenses will drop by $600 million. Corporate headquarters functions have been restructured, including the relocation to Richmond, Virginia from New York, and should yield annual savings of $250 million starting next year. Another $156 million will come from the closing of the Cabarrus, North Carolina manufacturing facility and subsequent consolidation with the Richmond, Virginia facility by 2010.
2. Market share grew in the first quarter from a year ago. The company’s share of the cigarette retail market gained 0.5% on the back of Marlboro’s 0.7% increase.
3. John Middleton is in a segment of the industry that’s growing 4% – 5% per year. Middleton posted a first quarter volume gain of 8.2% with Black & Mild increasing its market share by 3 points.
4. New products have not worked out so well. Marlboro Ultra Smooth, a high tech filter cigarette, was recently pulled from the marketplace due to low acceptance. Other failures include a cigarette with a battery-powered holder to heat the tobacco, and a spit free chewing tobacco. I believe that shareholders would be better served if management would abandon this part of their strategy and redeploy these resources on what they know and already are doing best.
5. Altria has started 2008 with a solid earnings performance. Earnings per share (adjusted for one-time items and from continuing operations) came in at $0.37 in the first quarter, up 12.1% from the same year earlier period on a 2.8% gain in net revenues. Management affirmed their forecast for 2008 earnings per share at $1.63 – $1.67, for an increase of 9% – 11% off of a 2007 base of $1.50, and set an objective of growing earnings 8% – 10% over the next few years. Projections by Street analysts are at the high end of these ranges.

Altria has a 28.6% ownership interest in SABMiller, the world’s largest brewer. At the end of the first quarter, Altria’s investment in SABMiller was carried on the books at $4.1 billion and had a recent market value of nearly $10 billion.

The company is returning cash to shareholders. The Board of Directors set the initial quarterly dividend at $0.29 per share, and is targeting a 75% payout ratio. They also approved a $7.5 billion share repurchase program to be completed over 2 years. The company began buying back shares in April.

Altria’s shares are attractively valued with a price / earnings ratio and yield that compare favorably with the S & P 500. The shares’ price / earnings ratio, at 12.9x 2008 earnings per share of $1.63, is below the S & P 500’s 14.5x based on S & P’s earnings estimate of $88.04 for this year. The shares also offer a fat 5.5% yield, well above the S & P 500’s 2.4%.

The Dow on Fast Track

In July 2007, I put the Dow Industrials on Fast Track, and concluded that, “If the Dow were a stock, it failed my 3-category rule, and I would pass.” The Dow is down 7.4% from last July and 5.9% year-to-date at the time of this writing.

Fast Track is a screening tool that focuses on 10 key categories incorporating the balance sheet, cash flow, earnings, valuation, and how management and the Street feel about the stock under consideration. I get interested in doing more extensive research using the entire Company Stock Risk Profile research process if a stock fails no more than 3 categories.

The Dow on Fast Track is a bottoms-up quick study of the Index and its components, and may also uncover a few ideas that may be worth your time for in-depth research. Here’s the Dow on Fast Track today:

1. More cash has been showing up on balance sheets. Cash and cash equivalents and short-term investments totaled $400.8 billion for the Dow companies at the end of this year’s first quarter, as compared with $301.3 billion a year ago. Excluding the 4 financial stocks in the Index, these same numbers were $248.8 billion and $209.5 billion, respectively. Moreover, 26 companies had stable or growing cash and cash equivalents and short-term investments on their balance sheets, up from last year’s Fast Track total of 15.
2. Long-term debt as a percentage of total capital for the Dow companies averaged 33.6% at the end of this year’s first quarter, excluding General Motors, which had negative total capital. Last year, the average was 35.2%, and 32.6% without General Motors. Fast Track favors companies with debt to total capital of 20% or less. Nine companies had percentages below 20%, 1 less than last year’s Fast Track.
3. Despite a tough economic environment, most Dow companies have been posting healthy cash flow. In 2007, free cash flow (cash from operations less capital expenditures) for all 30 companies came in at $86.7 billion, down from $114.1 billion in 2006. However, excluding the financials, free cash flow was $235.7 billion, up from $160.4 billion in 2006. This year’s first quarter is starting out on an equally strong note (without the financials) at $54.5 billion, as compared with $32.1 billion a year earlier. Twenty-five companies had stable or growing free cash flow, 5 more companies than last year’s Fast Track results.
4. But there were more earnings disappointments. Fourteen companies reported earnings that were below Street estimates in at least 1 of the last 4 quarters, 6 more than last year’s Fast Track.
5. Street analysts have been cutting earnings estimates for 11 companies versus only 3 a year ago. Last year’s optimism may be waning.
6. Only 5 stocks passed Fast Track’s 2 valuation measures. Last year, 12 stocks passed.
7. While managements remain overwhelmingly net sellers, they were somewhat more positive about their companies’ stocks. There were 7 companies where insiders were net buyers in the last 6 months. Home Depot stands out with net purchases of 5.7 million shares. Last year’s Fast Track turned up only 1 stock, Coca-Cola, with net purchases.
8. The majority of Street analysts continue to like the Dow stocks. Sixty-seven percent of the analysts following 21 Dow stocks are recommending their purchase. The remaining 9 stocks have the buy support of 41% of those analysts covering them. Fast Track gives higher marks to these 9 stocks, which have more room for ratings upgrades.

The average of all 30 stocks failed 4.3 out of 10 categories, as compared with last year’s 4.5. If the Dow were a stock, I would pass again since it would have failed my 3-category rule.

But the Dow is comprised of individual stocks, and Fast Track uncovered 11 potential ideas that are worth a closer look: 3M (MMM), Altria (MO), American Express (AXP), Boeing (BA), Caterpillar (CAT), Coca-Cola (KO), Hewlett-Packard (HPQ), Johnson & Johnson (JNJ), Microsoft (MSFT), Pfizer (PFE), and Disney (DIS), all having passed my rule of failing no more than 3 categories. Altria, Coca-Cola and Hewlett-Packard each failed 2.

Fast Track is a research tool for quickly and easily screening stocks for ideas. The 11 stocks cited above may or may not be good ideas. So whatever screening tool you choose to use, always thoroughly research the stocks that pass your screen.