Valuations Favor Stocks

Stocks: The second quarter of 2010 was not good, with Mr. Market struggling between optimism, and finally caving in to pessimism. A slide of over 11% for the quarter ensued. Thus far in July we have recouped about 6%. We continue to selectively make purchases in areas that appear undervalued and underappreciated for their earnings stability, necessity, and stable of products. As an example of our risk-adjusted approach to equities, we have favored new purchases in oil and oil drillers, health care companies, mining/materials, and telecomm. While the broader stock market trades at 15x earnings, we are finding exceptional companies trading between 5-10x earnings, which provides a greater “margin of safety” in investing. We focus on bottom-up company analysis within a greater context of top-down global macro analysis, global demand, and currency issues. In fact, valuations of the strongest, best-managed, highly capitalized multinational businesses are priced at a deep discount (about 35%) to where they have traded on a normalized 10 year basis.

As a consequence of low interest rates, investors are very interested in purchasing higher yielding securities. This has led some to some investors buying longer 10-30 year bond maturities as they reach for yield, which frankly we view as a mistake. Though we have not yet seen investors flock to higher dividend paying securities in the stock market, it would not surprise us to see this movement gain momentum going forward. Corporate balance sheets have improved dramatically, and it is now possible find stable stocks with healthy dividends whose yield exceeds the 10/20/30 year bond.

Bonds: Investors continue to throw money at the bond markets with little consideration to the risk inherent in choosing an asset class that is grossly overpriced. The yield on the 10 year Treasury bond implies investors are paying a price-to-earnings ratio of 34x for these interest payments. Over the past three years, $572 billion has flowed into bond mutual funds. Over the same period, nothing has flowed into stock mutual funds. Corporate cash levels are at the highest percentage of total assets ever, and total cash sitting in money market funds stands at $9.4 trillion, also the highest level in history. The message is that we are on the right track in terms of how we value cash flows, particularly the entities that produce those cash flows. We would rather own a high quality corporation, trading at 5-10x earnings, paying a 4-5% dividend (that can grow relative to inflation) than an asset class (10 year Treasury) trading 2x stock market valuations that on a risk-adjusted and inflation-adjusted basis are likely to lose money over the next decade. Are we facing a future “lost decade” in the bond market?

Value Investing
This is worth repeating from Bill Miller, legendary investor:

“If your expectation is that we will outperform the market every year, you can expect to be disappointed. We would love nothing better than to beat the market every day, every month, every quarter and every year…Unfortunately, when we purchase companies we believe are mispriced, it is often difficult to determine when the market will agree with us and close the discount to intrinsic value…
Our goal is to construct portfolios that have the potential to outperform the market over an investment time horizon of three to five years without assuming any undue risk. If we achieve that goal, we believe we will be doing our job, whether we beat the market each and every year or not.”

At ACCIMI we agree strongly with Bill Miller’s view. Often it takes time for the market to capture the intrinsic value of securities. While there are those who “believe” in the EMH (Efficient Market Hypothesis), we note that it is extremely important to realize that an “efficient” market doesn’t mean the market is “always rational”; in fact the inverse is quite true. “Efficiency” means that the market will efficiently produce a price, matching a buyer with a seller. “Efficient” pricing led to extremely high valuations in 1999/2000, and extremely low prices in March 2009—but was it rational?

Our media, and the certain parts of the financial services industry, continue to focus on the shorter term-- economic announcements hit the wire and investors are led to believe that all of this information is important and that it will have a direct impact on a company’s performance. Nothing could be further from the truth. In fact, sometimes we can capitalize on investors’ shortsightedness by taking advantage of lower prices over a short period of time. Over a five year period, the price of a stock will largely track the fundamentals of the company, and its actual earnings rather than its quarterly economic reports.

Re-flation of Assets
The economic debate has centered on deflation versus inflation. Based upon a fiat currency (our currency has been this way since we went off the gold standard), inflation is always preferable to deflation. Deflationary risks are to be avoided if at all possible, and by this measure the Fed seems to be succeeding, though there *are* some deflationary signals that exist. In a reflationary period it is quite possible for all types of assets to go up in value, commodities and stocks could decouple in favor of commodities and commodity-related enterprises between 2011 and 2012. In such an environment, it is important to remember “why we invest”, which is to outpace inflation. If the stock market goes up 30% but oil and other commodities go up 60%, you will have wanted more exposure to those sectors within the market.

In a long-term inflationary environment, we expect that foreign currencies may also be useful vehicles, but not as clearly as precious metals and commodities. The reason is that the U.S. is certainly not the only country demonstrating open-checkbook monetary and fiscal policy here. That means that currency positions largely represent the choice of which currency is "less bad." It's quite likely that hard assets such as precious metals and other commodities will advance relative to a wide range of currencies, which is another way of saying that we would expect inflation to be largely a global phenomenon. Conversely, while some currencies will most probably depreciate less than others against a fixed basket of commodities (i.e. exchange rates between different currencies will fluctuate even in a global inflation), those choices may turn out to be more subtle. And what is the distinction between inflation and debasement of a currency in real purchasing power?

Well, the real difference is that the government gets yelled at for the former, and gets an invisible hall-pass for the latter. So bet on the latter. A doubling of the money supply in the last 18 months, again using the Milton Friedman formula, and monetization of debt, yields a currency that is worth half its value in purchasing power. Here’s where it gets even trickier though: let’s say that much of the rest of the world agrees in principle to also print more and more money, as a coordinated effort. Now what? Is a new global currency standard emerging? Nearly all developed economies are behaving badly in terms of fiscal and monetary discipline. We do expect that there will be relative valuation differences in currencies and policies that will provide a basis for currency positions as we gradually transition from a low-inflation world eager for safe-havens to a post-credit crisis inflationary outcome several years from now. But the most likely beneficiaries (and the securities that we would be inclined to accumulate on significant deflation fears), are likely to be commodities, agriculture, oil, and precious metals. As usual, we'll respond to the data as it emerges, but the foregoing is a reflection of where we would expect the opportunities to emerge.

This Time Is Different, Or Not: History As Prequel
On a historical basis, every major stock market peak of the 20th Century was followed by a crash in the U.S. dollar five years later. People who kept their savings in dollars saw the purchasing power of their savings shrink substantially. Commodity prices had triple-digit rises in the mid-1930s and speculators once again made a fortune. Based upon this precedent, we could foresee a raging bull market in commodities (due to a falling US dollar value, big inflation, or both) somewhere between mid-2011 and the fall of 2012.

History has shown that stock markets move in very broad cycles. Up cycles usually give us sustained earnings growth, P/E multiple expansion, and upward sloping economic indicators. Common characteristics of down cycles usually show low/no earnings growth, P/E contraction, and downward sloping economic data. For down cycles, the cause of the final multi-year leg down is nearly always different. However, a bottom is usually finally in place once the major economic indicators are completely gutted, along with P/E multiples, and trailing long term stock returns. Interestingly in March 2009, the items just listed matched the 1982 lows, and arguably March 2009 was a more extreme bottom. Interestingly, in 1983 once the initial spike of new orders occurred post-recession, there was much talk of a “double dip”, leading stocks to trade in a broad range for six to nine months. Sound familiar?

Positioning Globally for Any Environment
The sectors we like most are commodity-related equities, including oil, coal, mining, agriculture, metals; we also like select healthcare, medical device, and biotech companies as well as a few select technology names that exhibit reasonable valuations (Growth At a Reasonable Price, GARP). The reasoning for our commodities-related/oil/metals bent is many-fold: 1) they are needed , (2) they appear undervalued and are economically sensitive; if they drop due to a weaker environment it shouldn’t be disastrous due to their inherent value, and if the market goes up, they go up too, (3) commodities are priced in US$, so if the dollar goes down, it takes more US$ to buy them, meaning the producers of these commodities will have higher earnings, (4) during inflationary periods they tend to hold up the best, (5) if we experience a currency devaluation for whatever reason (and inflation is but another means of achieving this), see #1-4. So we are adding positions that can withstand gale force winds based on macroeconomics and/or deliver strong earnings.

Mortgages
Recently the 30 year fixed mortgage dipped to about a 60-year low. Take advantage of this now, especially if you currently hold an adjustable rate mortgage.

Fixed Income Commentary
In the context of our general comments on Treasury securities, high grade corporate bonds look relatively attractive. In fact high grade corporate bonds are now trading on a near-equal basis with Treasury securities, meaning that sovereign debt is trading on credit-worthiness and balance sheet strength (instead of on ability to tax). As far as we know, this has never occurred before in history. Well, after all, who would you trust more to pay back a loan right now? Warren Buffett or the U.S. government? We’d choose Buffett.

Treasury securities with longer maturities should be avoided at all costs in this environment. TIPS offer some inflation protection, but are based upon CPI numbers which are controlled by a government currently desperate to avoid automatic increases in budgetary items based upon CPI.

CA Municipal Bonds
The CA political atmosphere is heating up. Our prediction: Whoever wins will usher in a new era of “hope” for CA, and then around April or May of 2011, it will become quite apparent that CA is drowning in debt, and the CA legislature will fail Californians yet again. We are already beginning to lower our exposures to CA municipals, even short term durations. Both AMBAC and MBIA, the primary issuers of muni debt, are in big financial trouble, and by law they cannot issue municipal debt at a higher rating than their own firm. At some point the Federal government will need to act as a backstop for municipal debt in all 50 states, 48 of which are drowning in red ink.

Big Question Posed: So are we headed for a double-dip recession? Or not?

We read volumes of research, and frankly the signals are mixed, with some research pointing to an “oversold” condition, and some research pointing to an “overbought” condition. The truth is that nobody knows, and because nobody knows we are erring on the side of finding high quality businesses trading for 5-10x earnings (versus 15-17x for the S&P 500). If we run into a double-dip recession, we have already established a huge “margin of safety” by purchasing companies that are trading a low multiples relative to their asset base, balance sheets, dividends, and prospects. If we go into expansion mode, the market may begin to appreciate these companies via expanding market multiples. So in total we feel that our allocation to stocks looks attractive on a risk-adjusted basis.

However, we view our economy as being at an inflection point based on “which policies” are adopted going forward. Pro-growth, pro-incentive, lower-tax policies would be welcomed by the markets, and we think would propel them to new highs. Concerns over our debt burden would be assuaged by a higher growth economy that could service its debt service (due to the higher growth). This becomes a virtuous cycle, particularly to our creditors, who might then not have concerns about buying our Treasury bonds. An anti-growth, let-the-tax-cuts-expire policy (otherwise known as a tax increase), coupled with some of our impending new laws (higher regulation equals higher costs, healthcare is a new entitlement program) could be the thing that propels us downward. The historians out there like to overlay the Great Depression stock charts over the last several years—and it looks strikingly similar, so “policy” does matter. With all of the recent efforts to not repeat the Great Depression, it would be a shame to replicate it because of what looks like such an easy call on policy matters. There could end up being a bipartisan compromise based on the Administration’s latest efforts to extend unemployment benefits (i.e. Republicans could counter “OK, but we want tax cut extension”), though tax cuts are a primary issue of this November’s elections. If the polls are correct, something like tax cuts or stimulus could transpire by April of 2011-- lots of uncertainty in the interim.

Corporate Bonds more Attractive than U.S. Treasury

To follow up with our recent post on bond yields, here is another story emphasizing the point.

http://www.bloomberg.com/apps/news?pid=20601010&sid=aYUeBnitz7nU

This Bloomberg story shows several instances where high quality corporations have recently issued debt with yields just a few basis points shy of a similar-duration US Treasury. What does this mean?

It means that investors would much rather put their faith in a high quality company's ability to pay its debts than in the U.S. government (with its endless money-creation and ability to tax).

Rumor has it that the USA is about to lose its AAA credit rating, and get bumped to AA. It's about time, and the "market" for US bonds (i.e. China, India, Japan) is sending a wakeup call to our leaders in the USA to right the ship and become sensible in our financial dealings. If we don't, it is very likely that US bond yields will continue to rise in anticipation of a bond market that requires a higher rate of return for the risk.

Solution to Pension Promises

Here's a link to a great piece from Barron's over the weekend, which addresses the debt albatross hanging around society's neck.

http://online.barrons.com/article/SB126843815871861303.html?mod=BOL_hpp_popview#articleTabs_panel_article%3D1

What to do? What to do?

Why don't we apply the same solution set that can be found at www.cato.org referencing their many-year-old "6.2% Solution" for Social Security. Namely, we need to create a "bridge" from one generation to the next in order to keep the promises we made from two generations ago. Why? Because that "social contract" is completely unsustainable and is literally creating insolvency issues at a local, State, and Federal level.

What would happen? Freeze all pensions today, ideally "earmarking" the frozen portion to each individual. This means that society will honor its social contract in terms of the net-present-value (NPV) of its pension obligations to you (defined benefit plan), but starting tomorrow, like "everyone else", you need to use a 401k-style approach (defined contribution plan). This solution will take 25 years, but it will work. Make it apply to anyone under 50 automatically. If you are 51-55, you can opt "in" or "out". If you opt in, it means you get the NPV of your currently accrued benefits + whatever your 401k-style plan grows to. Anyone over 55 would automatically stay in the current pension system.

How would the bridge work? First off, it is widely known that public sector jobs now either match or exceed private sector jobs in terms of compensation, benefits, etc. This "bridge", besides keeping past social contract promises, also encourages people to buck-up and become entrepreneurs in the American system while simultaneously discouraging people from "getting taken care of by the state". If the perceived benefits from going "public" decline, the benefits of going "private" increase.

Over 25-30 years, the "old" pension system quite literally gets phased out, along with its tremendous debt burden. This additionally creates an additional huge voting bloc that will want investor-friendly rules and regulations, stable money policies, tax incentives and the like. Thus, US politicians will need to answer to this investor class, which simply reinforces the traditions of the American entrepreneurial system, while also backing the USA away from its debt-induced tipping point (toward a welfare state system). A welfare state is simply unsustainable, and not unstoppable (yet).

This whole idea isn't "perfect", but it's a good starting point for a conversation-- a conversation that is long overdue...

Ribbit Mobile is Like TiVo For Business

I usually just discuss some market news item, investment, give policy analysis, or distill some complex issue as it relates to investments. Today, instead, I wanted to advise you with a way to simplify and distill your work life: Ribbit Mobile.

Huh? What? What is Ribbit Mobile?

The best way to describe it is to first tell you why I love it. I get cold-called from different suppliers ALL day (hedge funds, mutual funds, separate account managers, etc.). If I don't recognize a phone number coming in, I let it roll to the Ribbit Mobile phone system, which transcribes the voice message into a readable email and text within a couple of minutes. If I erroneously missed the call, I call right back; but otherwise, the cold call message gets transcribed. Then...I don't have to talk to them, lose my train of thought, waste time with them, try to understand what they're selling...none of it. It goes to voicemail/text message version.

Frankly, sometimes it even helps if I legitimately miss a call, because I can read the gist and call back with a really well-thought-out response, possibly with some research, or answer for somebody. It actually improves my business and my service.

So now that you know WHY I like it, I'll tell you how I think of it: it's like "TiVo for Business". Yes, just as Tivo improves TV-watching productivity, Ribbit Mobile improves my phone-answering productivity. By a ton! You need to check this out:
http://www.ribbit.com/mobile/

If you want to thank me, just call ACC Investment Management, Inc. at 650-344-1600, but don't be surprised if I don't answer.

PIMCO agrees with ACC Investment Management!

The following is from Bill Gross of PIMCO from yesterday. I concur. Gross and I come to the same conclusion through two different analyses. His conclusion is based on the quantitative, showing that sovereign credit spreads are narrowing toward a "unicredit" rating, since governments are printing money, debasing currencies, and their ability to pay will eventually be questioned. My conclusion (June of 2009) is based on qualitiative arguments-- I would rather purchase high grade corporate debt paper relative to sovereign debt, since corporate debt ratios are *finite* and thus more credit-worthy!

Read his piece here, it's quite good.

Investment Outlook
Bill Gross March 2010
Don't Care
http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2010/Investment+Outlook+March+2010+Bill+Gross+Dont+Care.htm

Financial Outlook 2010

January 7, 2010


Program: Financial Outlook 2010

This is from an Investment Panel I participated in at San Mateo Rotary. Enjoy.

Chuck Cattano: Chuck discussed the Dollar Carry-Trade and implications of our "near zero" interest rate policy. Investors can borrow U.S. dollars for .25%, and then invest those dollars globally seeking a higher return. Have you noticed the relationship between gold and the dollar over the last year? When the dollar fell, gold went up; when the dollar rose, gold fell. This is because hedge funds have been borrowing dollars at .25%, shorting the dollar, investing in gold, stocks, and commodities; when the dollar strengthens, they must cover their "short" dollar positions , close out long gold, stock, commodity positions to close the trade.

But there is a problem. What happens when the game ends? When the liquidity party is over, will the exits be too crowded? Our "near zero" interest rate policy has helped reflate assets but it brings with it negative externalities and uncertainties: the specter of inflation, debasement of our currency, uncertainty of creating a new bubble, liquidity concerns. So, what can you do?

Take a sober look at this, consider maintaining bond money in high grade corporate bonds or short term CA municipal bonds. Mid/long term Treasury securities could suffer their own "lost decade"; short term Treasury securities "should" be OK, though can still lose value if sold before maturity (or they could lose value to inflation). Cash will not hold up to inflation, which seems a matter of "when" not "if". To maintain a sufficient hedge against inflation, consider equities in the ag, oil, oil drilling, natural gas, gold, gold and minerals sectors, as well as a healthy dose of large cap stocks that pay nice dividends and are defensive.

Buy the future, but also buy what is needed!

The Dollar Carry-Trade

What is that? The dollar carry-trade is what we get when interest rates are near .25%. This is the path the Fed has chosen to help us re-flate our assets. How? Well, if you are a hedge fund, a government, or some other institutional player, with interest rates near .25%, you can effectively borrow a large quantity of US $ for nearly no cost, and you can probably lever it 10 or 20 to 1 and invest the dollars you borrowed elsewhere. If you borrowed the dollars yesterday, and the dollar goes down a penny or two, your real cost of carry to borrow the dollars was negative. If you invested in gold, commodities, or stocks yesterday, the falling dollar has increased the value of those riskier assets today (in dollar terms).

What this means is that investors are being incented to buy any asset paying (or returning) more than .25%. If inflation is coming, taking out a large mortgage here makes sense, since mortgage rates are so low; buying stocks and commodities makes sense in real dollar terms too.

The Fed is committed for the short term to maintain this extremely easy money policy, which will add stability to markets. But...when the trade reverses, look out. There are a LOT of people on that side of the trade. What could cause a reversal? It appears that the Fed is targeting the unemployment rate in lieu of the value of the dollar. Our US$ is a fiat currency after all, since we can just print more dollars. When unemployment drops below 8%, and we start to show some serious economic recovery (last week's ISM report showed positive manufacturing growth to restock inventories), then the Fed will have the necessary courage to tighten up the money supply.