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.”

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.

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.

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.

The Fed Valuation Model Says….

In 1997, the Federal Reserve offered a valuation measure for the stock market. The model compared the earnings yield for the S&P 500 to the yield on the 10-year U.S. Treasury note. The earnings yield is forward earnings divided by price, which is the reverse of the price / earnings ratio. According to the model, the market is overvalued when the earnings yield is below the Treasury note yield (negative differential), and undervalued when the earnings yield is above the Treasury note yield (positive differential).

In the 1988 – 2007 period, the highest negative differential (based on year-end figures) was 2.61% in 1999. The differential remained negative and the market dropped precipitously, bottoming in 2002 when the differential moved to a positive 2.40%. The subsequent trend was up. The differential reached a high of 2.64% in 2005, and has been positive since 2002.

Standard & Poor’s current estimate for S&P 500 2008 earnings per share is $89.44. Dividing $89.44 by the S&P 500 index of 1396.60 (at the time of this writing) gives an earnings yield of 6.40%. The 10-year Treasury note yield is 3.94%. The positive differential is 2.46%, which is the third highest behind 2005 and 2007’s 2.53%. Based on the Fed model, the market is undervalued.

We can get the S&P 500 earnings implied by the model by setting the earnings yield equal to the 10-year Treasury note yield and then multiplying the S&P 500 index by the 10-year Treasury note yield. Multiplying 1396.60 by 3.94% gives implied earnings of $55.03. This is $34.41 below the current Standard & Poor’s earnings estimate for this year, and is the highest negative differential from actual earnings in the 1988 – 2007 period. Unless Standard & Poor’s is way off the mark, the Fed model is suggesting that investors in the aggregate are far too negative about the outlook for corporate earnings.

Water: Staying on the Sidelines for Now

Unlike oil, gold, and other such commodities, water is the one commodity we must have to live. And I don’t even think about it. I don’t have to. Clean water is delivered to my home and where I work. It’s always available, and it’s cheap. Will it always be this easy?

Living in Arizona, one of the fastest growing and driest states, I thought back to a discussion I heard on NPR about population migration. I remembered this startling prediction: the Southwest will be riddled with ghost towns when water runs out, and those looking back 50 years from now will be mystified as to why people ever wanted to live there. Last year 26% of the Southeast was covered by an “exceptional” drought – the National Weather Service’s worst drought category.

Consider these worldwide facts from the United Nations’ Human Development Report 2006:

1. Less than 1% of the world’s freshwater is easily accessible.
2. 1.2 billion people lack access to freshwater, and 2.6 billion are without adequate sanitation.

More people with higher living standards, pollution, and climate change may be pointing to water shortages down the road. A key example, China has 20% of the world’s population but only 7% of the water. Will China have enough water to support its rapidly growing urban population?

The water industry should be ripe with investment opportunities. I put together a group of 18 stocks, certainly not all-inclusive of ways to participate in the industry, to begin to find out:

York (YORW), Pennichuck (PNNW), Middlesex (MSEX), Connecticut (CTWS), Southwest (SWWC), Artesian (ARTNA), SJW (SJW), American States (AWR), Aqua America (WTR), and California (CWT) are all domestic water utilities.

Mueller Industries (MLI) – tubes and fittings used in water distribution systems.

Watts Water Technologies (WTS) – water safety and flow control products.

Nalco (NLC) – water treatment chemicals and services.

Flowserve (FLS) – flow control equipment.

Gorman-Rupp (GRC) – pumps and fluid control equipment.

Calgon Carbon (CCC) – products to purify water and air.

Veolia Environment (VE) – water treatment services based in France.

Consolidated Water (CWCO) – desalination plants and water distribution systems in the Caribbean.

I used Fast Track to get a quick study on the group and find potential buy ideas:

1. These are mostly small cap stocks, and they are not widely followed on the Street. Thirteen stocks have market capitalizations under $ 1 billion. Thirteen stocks are covered by 5 analysts or less, and 9 stocks by 3 analysts or less.
2. Financial leverage is high, with long-term debt to total capital averaging 40.9%, ranging from 0% for Gorman-Rupp to 74.1% for Nalco.
3. Free cash flow was negative at 10 companies in 2007, and 7 companies posted negative free cash flow in each of the last 5 years. These are all utilities.
4. Thirteen stocks had P/E’s below their high / low 5-year average. Only two stocks, Mueller and Watts, also had PEG ratios that were below both their industry and the S&P 500.
5. California Water was the only company where management was a net buyer of stock.
6. The Street is not particularly enamored with this group of stocks. There are 40 purchase recommendations out of a total of 86 ratings, so there’s room for ratings upgrades. Aqua America seems to be the darling of the group with 10 analysts following the stock and 9 recommending purchase.

Here’s my take:

1. I was disappointed to find that Flowserve was the only stock that passed my Fast Track screen, having failed no more than 3 categories. But Flowserve is really a play on oil and gas, which accounts for 41% of their business, as opposed to 6% for water.
2. Only 3 companies, Veolia, Flowserve and Calgon, did not report disappointing earnings in any of the last 4 quarters. But Street analysts have held their earnings estimates steady at 12 companies. Watts pre-announced an earnings disappointment for their March quarter, citing weak construction here, slowing economic activity in Europe, and even problems in China. While this could be unique to Watts, is it a harbinger of more disappointments at other companies?
3. No company in the group delivered consistent earnings growth in the last 5 years. This, and that Watts is a pure play on water makes me question whether the water industry’s growth story has really kicked in yet.

I’ve decided to stay on the sidelines for now.

Is the Recession Here Yet?

Initial claims for unemployment benefits rose to a seasonally adjusted 407,000 for the week ended March 29. Claims over 400,000 are usually considered recession territory. The Labor Department just reported that nonfarm payrolls fell 80,000 in March bringing the unemployment rate to 5.1%. But the unemployment rate is a lagging economic indicator.

What may the market be telling us about the economy? I looked at the year-to-date performance of the Dow Jones Industries Indexes, and I found this:

Delivery Services + 6.70%
Railroads +13.16%
Transportation Services +25.07%
Trucking +14.95%
Home Construction +24.28%
Home Improvement Retailers +8.56%
Hotels +5.07%

The stock market is a discounting mechanism, and the strong performance of these economically sensitive industries may be telling us that a pickup in economic activity is up ahead.

I also thought that it may be informative to look at passenger traffic at McCarran International Airport in Las Vegas. Passenger traffic as compared to a year ago was up 3.4% in February and 0.2% year-to-date.

This also caught my attention. Research in Motion added 2.2 million subscribers and shipped 4.4 million smart phones in the quarter ended March 1.

So, more people are going to Las Vegas to vacation and gamble, and they are buying a lot of BlackBerrys. Is the economy really as bad as the headlines make it seem?

Analysts’ Earnings Estimates

Study: Wall Street Analysts Still Exuberant in Their Earnings Projections
Researchers find that upward bias persists even after 2003 Global Analyst Research Settlement

“Previous studies suggest their stock recommendations do not perform well, and now we show that their long-term earnings per share growth rate forecasts are excessive and upwardly biased.” – from the study by J. Randall Woolridge and Patrick Cusatis, Penn State Smeal College of Business.

My observations:

First, let’s do our own research rather than depend on others to do it for us. We do not have to pay high fees to someone else to manage our money, particularly to brokers peddling flawed Street research.

Maybe we should get out of the forecasting business. Here’s what I would suggest.

1. Use trailing 12-months earnings per share from continuing operations and before extraordinary items in the denominator of the price/earnings ratio. If you feel you have to use an earnings estimate, use the lowest estimate among the analysts offering forecasts for a margin of safety.
2. Instead of using the Street’s consensus 5-year earnings forecast in the denominator of the PEG ratio (price/earnings divided by earnings growth rate), use a company’s internal or sustainable earnings growth rate calculated as follows: earnings retention ratio ((net income – dividends) / net income)) X return on equity.