“Well, It’s Not Really As Bad As It Sounds…”
Saturday, February 4th, 2012
Mark Twain made the above remark in 1888 after visiting Germany and first hearing Richard Wagner’s music. As with many of Twain’s humorous observations, his assessment of Wagner embodies an idea that has much wider application to many areas and is a useful way to view what took place in the financial markets in 2011.
In 2011 the S&P 500 behaved like a schizophrenic yo-yo, making double digit moves in both directions and ending the year essentially where it started. Much of the market turmoil was linked to the debt crisis in Europe, the downgrade of US Government obligations from Triple A and the lack of constructive actions both in Europe and the US Congress to address the growth of deficits and the lack of growth in the economy. In the middle of the summer it looked as if Euro-zone might implode as the sixteen constituent countries, especially the two wealthiest, Germany and France, could not agree on a way to restructure Greek sovereign debt and avoid a disorderly default with Italy, Portugal and Spain possibly waiting in the wings. At the same time the US Congress could not agree on a constructive agreement to manage our own debt ceiling and growing deficit. These problems and trends are not going to change simply because the calendar has added a digit. Yet now we stand at the end of January 2012 with the sense that implosion in Europe is probably off the table and that some green shoots which had appeared in the US during the past year with respect to job creation and perhaps even residential housing are heading in the right direction. The deficit still grows but if there is little confidence in Congress, there is a consensus that the financing of the deficit is in the more competent hands of Ben Bernanke and the FRB. So after much turmoil or as Angela Merkel might say “Sturm und Drang,” the US equity market recovered in the final quarter to end the past year flat and has begun 2012 with a strong opening month. This is far different outcome than in past traumatic years. Moreover in 2011, Richard Wagner’s The Ring of the Niebelungen enjoyed new and inventive productions playing to sold out houses first at the San Francisco Opera and currently at the Met. So not surprisingly Mark Twain had it right on a few fronts at once.
Despite the equity market ending the year flat, a survey of investment returns reflects the difficulties of navigating through the volatility. Some high profile mutual fund managers such as Steve Leuthold whose Core Fund has consistently beaten the S&P and returned 8% annually over the past 10 years dropped over -5% and fared less well than the aggregate actively managed fund average return in 2011 which was down -3.3% . The place to be in 2011 was the Treasury market, but even Bill Gross at PIMCO, the most influential fixed income manager on the planet, sold his Treasury holdings before their big rally occurred in response to the chaos in the Euro-zone. A year such as 2011 often brings out the index and closed-end fund advocates such as John Bogle the founder of Vanguard, who created the first S&P 500 Index Fund in 1975 and Princeton Economist Burton Malkiel, author of A Random Walk Down Wall Street. Not unexpectedly we usually hear them leading the table pounding against active management. Yet Bogle and the other index asset allocators have been rather quiet and Professor Malkiel has published some Wall Street Journal Opinion Pieces advocating investing specifically in cash flow generating dividend stocks and for long term upside allocating some money to emerging markets. The word “closed end fund,” which was at the heart of the gospel according to Burt in his well known random walk theory does not even appear.
As for the best strategy for investing in 2012, we would combine Professor Malkiel with Shakespeare. Specifically the line repeated several times by Iago in his scene with the wealthy Venetian Rodrigo in the first act of Othello: “Put money in thy purse.” Now of course Iago, one of Shakespeare’s truly maniacal villains is hardly offering investment advice, rather he wants Rodrigo to sell his lands to get more liquid and then Iago will separate Rodrigo from his money. But let us not shoot the messenger. The advice to generate cash flow from your portfolio is an excellent idea. According to a white paper from the Investment Institute in 2010, historically 44% of stock returns over time frames of five or ten years and longer have come from dividends rather than appreciation, and in 2011 the number was higher. Further Shakespearean wisdom on navigating a tumultuous investment environment comes from Rosalind, the heroine of As You Like It. Rosalind spends most the play disguised as a boy in order to evade detection after her father has been deposed. She finds this a problem since some young women fall in love with her, one of these being a shepherdess named Audrey who is spurning the attention of her own diligent suitor. Rosalind’s advice to her is quite simple—the fellow in front of you is as good as it will get: “Sell when you can, you are not for all markets.” This sage investment advice along with a cash flow oriented strategy is something we do our best to implement at JMR Capital through a variety of investment vehicles. Although some of the “it might be 2008 all over again” fears are currently on the back burner, we are not completely out of the woods and it would be a mistake to expect stock returns to derive from significant price gains through multiple expansion. Stocks are cheap according to the historic S&P multiple of sixteen times earnings (they are currently between twelve and thirteen) but they more than likely could stay that way unless the global economy picks up significant steam. As Professor Malkiel points out in his WSJ article of January 5, 2012, good quality stocks are the best house in a bad neighborhood. He notes that if you buy 10 year Treasury bonds now with a 2% yield to maturity, you know exactly what you will earn, and that is hardly a satisfactory return. So there is a good possibility that cash on the sidelines at the end of 2011 could find its way into dividend paying high quality stocks, and our strategy will be to “put money in thy purse” through those kind of investments including high yield bonds, but to the chagrin of the buy-and-hold advocates, it is a good idea to listen to Rosalind be aware that not everything is for all markets and know that adjustments to even the best ideas and strategies will serve us all well in the long run.
JMR CAPITAL OBSERVATIONS, APRIL 2011
Wednesday, May 4th, 2011
ENJOY THE MIXED SIGNALS
In his widely anticipated press conference on April 27th-the first ever by a Fed Chief-Ben Bernanke uttered the word “inflation” thirty-one times. Not far behind was his use of the word “transitory” to describe almost everything, including inflation, unemployment and the slow, bumpy pace of the recovery. In response James Grant, the often acerbic and highly respected publisher of the Interest Rate Observer remarked: “Paper money is transitory.” That certainly holds true for the value of the dollar which last week hit a three year low against major currencies. Most have praised the Fed Chief for his response to the financial meltdown and his ability to “make bullets out of thin air.” Yet as several commentators have pointed out, not everything Mr. Bernanke mentioned in his press conference can be transitory, especially the level of US Government debt. Legendary investment manager, Seth Glickenhaus, still managing over $1 billion at age 97 began his career during the Great Depression and provides some much needed perspective. Mr. Glickenhaus-a self described “optimistic pessimist”– simply noted last week that, “We have far more debt than we can pay back.”
Nevertheless, the equity markets during the first quarter of 2011 and through April largely shrugged off these concerns with the S&P rising 5.4% for the first quarter and adding another 2.8% in April. What lurked behind the good returns during 2010 continues so far in 2011: political unrest and turmoil in the Middle East and the time bomb of debt in Europe and the US. The confusing tug of war between headline grabbing geo-political events, macro economic concerns and improving corporate balance sheets in the US still shows no sign of abating, and is reflected in the monthly returns: January and February were both positive, showing 2%+ gains, but during March the S&P went below it’s starting point for the year and only after a furious charge in the second half of the month ended flat. US unemployment remains high and home prices remain low, European countries try to implement austerity programs without restructuring sovereign debt; but for the time being the financial markets appear to be forgiving on those two issues. On the currency front, however, the markets have been less forgiving with the dollar substantially weaker as the mounting US debt issuance creates fiscal anxieties. It is always important to remember that much of the money flowing in and out of US equities and bonds comes from outside the US. Since the beginning of the year the dollar has declined more than the S&P has gone up which is not an attractive proposition for foreign investors. Currency hedging is complicated and expensive and it adds an additional layer of risk. Having worked with institutional investors in London in the 1980’s and ’90’s, it is clear that hedged or not, they need to be convinced that the growth prospects of US companies like Apple and Caterpillar will offset the decline in the dollar. This has been the case for the past couple of years, but will it continue? Inflation fears have also entered the picture in China, India and other emerging markets, and perhaps contributed to some of the strong performance this past quarter in commodities, energy, and precious metals. Still the main driver is supply and demand, and at a high profile investment meeting in Los Angeles, some of the largest Private Equity investors say they are still very sanguine about putting money to work in China, emerging markets, mining and energy. Despite all of the caveats the appetite for equities and risk assets moves along apparently unfazed by upheaval around the globe and lack of convincing growth at home. But to quote Arthur Miller’s line in Death of a Salesman, “Attention should be paid,” to market volatility and the weak dollar in the form of appropriate diversification, opportunistic investing and risk management.
LITERARY GLEANINGS
They live off the income of their income. Mary McCarthy, The Group 1963
Mary McCarthy’s satiric novel The Group (1963), far ahead it’s time in many respects, follows eight Vassar friends from their graduation in 1933 (the year McCarthy herself graduated) through their intermingled lives, love affairs and ensuing complications. Out of the eight, six are from families on the Social Register. All desire independence from parental guidance and interference in life style, romance and politics, but do not mind the attachment when it comes to funding their post-graduation experiments in self-absorbed living. Mary McCarthy, who grew up poor after her well-to-do parents died in the 1918 flu epidemic, and made her own way successfully in tough circumstances enjoys calling out the discrepancy. The fictional family cited in the quotation has gained wealth and prominence through success in the steel alloy industry, and their daughter Helena, the class valedictorian is an outspoken liberal who spends the family money freely and much to her parent’s chagrin decides to teach nursery school. “Did we send her to Vassar to teach finger painting?” her exasperated father asks.
There is an old joke in Switzerland about someone who attends a prestigious social gathering where no one will speak to him. One of the newer guests asks why and is told in a hushed whisper, “Of course no one speaks to him. He spends his capital.”
In Thomas Mann’s novel The Magic Mountain (1924) the protagonist Hans Castorp goes to visit his tubercular cousin Joachim at a sanatorium in Davos. Long before Davos became the annual gathering place for global economic ministers, it was best known for expensive ski resorts and sanatoriums-a destination for the very healthy or the extremely ill. Hans Castorp, orphaned at an early age has been raised by a wealthy, very prudent and straight-talking uncle who imparts the following advice to his nephew about the inheritance he will receive:
Hans, my boy–you really don’t have that much—the lion’s share of my money stays in the business. What belongs to you is invested quite nicely and will yield a secure return. But it’s no fun nowadays trying to live off interest unless one has at least five times as much as you have, and if you fancy living a nice life here in the city, like the one to which you’re accustomed, then you’ll have to earn a tidy sum yourself—take note of that my boy.
Sage advice for any era and especially now when the challenge of living off interest income in the current Fed engineered low rate environment has become a source of concern. Thomas Mann’s own life experience in his early years was close to the fictional family cited in Mary McCarthy’s novel who “live off the income on their income.” But during his teens the family shipping business went bust, mostly on account of bad management (recounted in his first novel, Buddenbrooks), so he certainly knew both sides of the coin.
On the front page of the Wall Street Journal of April 4 we find the following headline: Fed’s Low Interest Rates Crack Retirees’ Nest Eggs. The Federal Reserve has kept interest rates low to stimulate the economy but most of those benefits have accrued at the corporate level with many of the Fortune 500 boasting great looking balance sheets. But this is hardly a boon for the fastest growing demographic in the US, people north of 55 years of age, who typically self-identify as savers rather than investors. With short term rates down to zero per cent their CD’s and savings accounts have been producing a net negative return for the past couple of years which not surprisingly is having a noticeable impact on this group’s spending. Most investors see continuing low rates as a positive signal, but last year Charles Schwab wrote an Op Ed for the Wall Street Journal, Enough With the Low Interest Rates (10/02/10) urging the Fed to raise rates so that the legions of retired savers would not suffer. As is often said, “Be careful what you wish for.” According to the more recent article, some of the savers wanted to have it both ways and are now in trouble according to a debt counselor in a retirement village in Florida: “In some cases…retirees took out mortgages and ran up credit card debt on the assumption that their interest income would help cover the payments…Older people tend to hide their troubles as long as they can. People are very prideful.” While recognizing the differences between today’s retirees and the literary examples cited above, all are in the position of needing to do something to change their respective modus operandi and learn to adapt to changing circumstances. In the case of savers needing to replace what had been predictable yields and streams of income, they will need to become investors and expand their horizons in order to generate yield that used to be more readily available.
And finally, the US and its allies were ecstatically praising the bold and successful operation by the Navy Seals that killed Osama Bin Laden just a few months before the 10th anniversary of 9/11. To what extent this disables Al Qaeda remains to be seen, but it will likely significantly eradicate the financial support for the terrorist network which came from Bin Laden. Whatever it’s broader meaning the impact on the US and global financial markets will be negligible-far less, for example than last quarter’s GDP report which showed growth at a disappointing 1.8% and testifies to the bumpy and uncertain pace of the recovery. One hopes that this report-to use Chairman Bernanke’s favorite word, is indeed “transitory.”
The Year in Review
Sunday, February 20th, 2011
THE YEAR IN REVIEW
The Dow Jones Industrial Average is flirting with staying above the 12,000 mark for the first time since June 2008 and the S&P 500 is doing the same with 1300 (the S&P gets less face time in the headlines but is the more significant of the two benchmarks). It is worth noting that the last time the Dow was at 12,000, oil was $130 per barrel, gold was $650 an ounce, the 10 year Treasury bond yielded 4.2%, and the unemployment rate was 5.7%. Real estate prices had retreated from their 2007 highs but were still for the most part irrationally exuberant and anyone breathing could get a loan. All of these metrics are now substantially lower with the exception of gold and unemployment. Daily fare in the financial press, Bloomberg Television and CNBC is the meteoric rise in commodity prices and whether the main culprit is inflation fears coupled with political instability or
demand in rapidly growing emerging markets. It is fair to say that all do play a part. There is, however one factor that is not debatable and that is the demand created by the exponential growth of commodity based exchange traded funds.
Before the creation of the most actively traded commodity ETF, the SPDR Gold Trust (GLD), an individual investor who wanted to own gold had buy coins or bullion through an intermediary who charged a substantial markup or take a shovel and pan out to the mountains. There were the futures markets but there were many complications for individual investors so the Chicago and NYMEX trading pits remained largely the territory of large hedge funds and institutional investors. But then along came the commodity and futures based ETF’s which allowed granny to play with the big dogs and go long or short almost any asset known to man. The democratization of the investment universe is by and large a very good trend. But it is important to proceed carefully and with knowledge of what you actually own in the every expanding ETF world. Brokerage houses and the SEC which require a fair amount of financial disclosure to trade options, including prudent hedging strategies in IRA’s require none at all to trade ETF’s correlated to the most volatile and highly leveraged futures contracts. Still to date the most activity in the ETF commodity asset class has centered on gold. How did this happen? As a recent Bloomberg News article recounts, a sea change occurred when James Burton, the former head of CalPers agreed during a round of golf in the UK to become CEO of the World Gold Council which spearheaded the creation of the gold ETF as a means for “the man in the street who would buy a lot of gold if he could find an easy way.” When Mr. Burton was head of CALPERS, the investment portfolio he oversaw, according to the Bloomberg article, did not own an ounce of gold. When GLD, the ETF he created to buy and hold gold bullion for the “man in the street,” made its debut on the NYSE in 2004, the price of gold was $330 per ounce. It ended 2010 at $1390.
During 2010 the S&P as measured by the widely held SPDR ETF or SPY gained approximately 12.8%. Since we are discussing the ETF explosion, SPY was the progenitor of all the others. Despite the double digit gain there was a disconcerting and volatile ebb and flow to the year. In the first quarter the S&P gained roughly 4.75% only to give back 11.8% in the second quarter. On June 30, the S&P stood at 1030, down 7.6% from the beginning of the year and then produced a whopping gain in the ensuing quarter of 10.6% but struggled in the fall. On November 30 the S&P stood at 1180, which was 5.82% ahead of where it started the year. In one of the more unusual December’s on record the S&P gained another 6.5%. From the June 30 low of 1030, the S&P closed the year at 1257 for a valley to peak gain of 22% in the final six months. Such gyrations more often than make for a challenging investment landscape going forward. When the S&P was losing almost 12% the problems in Greece, Ireland, a weak Euro, concerns about entitlement costs and an uncertain domestic regulatory environment were to blame. Conversely when the S&P was rising by double digits, credit was given to upside earnings surprises in financials and technology, a favorable US election outcome and hoped for regulatory certainty. Past experience should raise plenty of caution flags on that front. When the dollar was weak, that meant better export conditions for the likes of Apple and Caterpillar. But when the dollar strengthened that was confirmation that QE 2, the Federal Reserve planned purchase of $600 billion worth of Treasury bonds, which by definition will be inflationary, was a good way to kick the can down the road. So we end the first decade of the new century with a confusing but robust fourth quarter when everything-stocks, commodities and the dollar all went up.
Looking ahead it is not viable to see all of these trends continuing-certainly with the dollar we can’t have it both ways. Some of the problems of 2008, high unemployment and budget deficits still persist at home and abroad, plus inflation worries loom large in China and other rapidly growing economies. Many of the upside earnings surprises in 2010 were based on weak comparisons from the prior year. That will not be the case going forward, and whether we might actually get some real growth remains to be seen. But in some cases the 2010 act will be quite hard to follow especially for financial companies that will not be doing all of things they used to do and charging less for many of the others. In hindsight, 2010 ended up being a good year to throw a dart at the S&P 500; 2011 is starting off well and has the “January effect” working in its favor. Most market forecasts remain very bullish for 2011 with equity mutual funds seeing the first influx of new cash in a few years as small investors take money out of bond funds. Government and high grade bonds which had a great decade do not look terribly appetizing with interest rates sitting at 25 year lows and the Fed committed to priming the pump. But these factors argue for being careful where you throw the darts and for sticking with a cash flow generating, total return oriented portfolio management discipline as the preferred way to navigate a difficult environment.
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Stocks: The Best House in a Lousy Neighborhood
Bill Gross Likes Stocks screamed the cover story on the August 2010 issue of Bloomberg Magazine. Despite the earth shattering import of this news, it did not really cause much of an uproar. Mr. Gross has managed the largest fixed income mutual fund on the planet for over two decades and has won the fixed income manager of the year award so many times it should be renamed the Bill Gross Award. His bond and interest rate commentary can move markets and he predictably appears on the financial stations as the expert on the latest move by the Federal Reserve. Despite his shocking viewpoint about the equity market, he is seldom if ever asked about his take on the S&P or stock sectors he prefers. Not too surprisingly his preference is for carefully selected dividend paying stocks with good growth potential and the investment funds that hold them -and he will find no disagreement here.
“First, let’s kill all the lawyers!” Shakespeare, Henry VI,
A New York Times article on the travails of the Greek economy noted that in addition to its sovereign debt problems, the cradle of Western civilization is mired in arcane regulations that stifle business formation with many restrictive laws still on the books from the 19th century. Not surprisingly, despite its credit problems Greece is a great place to be a lawyer and boasts the highest number of lawyers per capita worldwide with one for every 250 people. Not far behind is the USA with one lawyer per 270, and a very large chunk of those can be found in California, where regulatory and fiscal comparisons with Greece, according to some, are not so far fetched. In absolute numbers the US has roughly 50% of the lawyers in the world. Spain, Italy and the UK are also in the top ten of lawyers per capita. Perhaps we are seeing an important benchmark which might bear closer scrutiny: India is not to be found among the top ten in lawyers per capita and does China have any lawyers at all?
As The World Turns: Thoughts On What May Lie Ahead
For 54 years beginning in April 1956 a popular daytime TV soap opera called AS THE WORLD TURNS was a small scale embodiment of a belief in what is termed American Exceptionalism. The show sponsored and produced by Proctor and Gamble, a leading US global brand, began with a spinning globe and some corny organ music then dissolved to the fictional setting, the center of the world–Oakdale, Illinois. This “we are the world” viewpoint was not inconsistent with the view held by most Americans during this period. An example of this type of continuing jingoism is that the baseball World Series still remains a contest between two US professional teams even though many of the players hail from elsewhere, particularly Latin America. Maybe at some point down the road the World Series will be played like the World Cup. But the world has turned and to get a sense of what this may portend, New York Times Op Ed columnist David Brooks points out that the US will need to adjust from assuming that we are still the center of things:
In the 20th century, America was the Big Dog Nation. We had more money, more resources…and we could outcompete our rivals by pouring in more talent, greater investments and more resources. In the 21st century, the US will no longer be the Big Dog. Human capital will be more broadly dispersed…To thrive, America will have to be the crossroads nation where global talent congregates and collaborates.
Many of the best companies in the US such as Google, Apple, Nike and Caterpillar anticipated these changes and have effectively taken advantage of the disbursement of human capital. At this writing the attention of the world is focused on the monumental transition taking place in Egypt. The success of the youthful revolutionaries in Tahir Square was attributed to a Facebook page created by a Cairo born and educated Google marketing executive Wael Ghnonim after he was detained for twelve days by the government. As Fouad Ajami, Director of Middle East Studies at Johns Hopkins observed, “No turbaned ayatollah stepped forth to summon the crowd– a young Google executive energized this protest.” David Brooks’ charge for the US to become a “crossroads nation” appears to be alive and well: two US technology companies enabled a momentous change in a country seeking democratic institutions and demonstrate how human capital is being broadly dispersed. Significant and challenging investment opportunities will no doubt evolve as a result.
SHAKESPEARE THE INVESTOR
Sunday, November 7th, 2010
We are in the midst of confusing, challenging and some might say perilous times. In such periods many people including heads of state often look to the works of Shakespeare for some guidance. So taking that cue we shall seek out some Shakespearean words of wisdom that might help us better navigate a difficult investment environment. Here are some examples.
There are more things in heaven and earth, Horatio, than are dreamt of in your philosophy…Hamlet Act 1, Scene 5
Horatio, Hamlet’s closest friend and fellow student at the University of Wittenberg, has just witnessed the end of Hamlet’s initial conversation with his father’s ghost. Horatio has not actually seen the ghost (he’s not entitled to do so), only Hamlet’s reaction to it. Wittenberg was known at the time as a center of Rational Philosophy and Protestant Humanism. Hamlet and Horatio would have engaged in studies and debate about Aristotle and natural phenomena: a talking ghost demanding his son take revenge on a libidinous uncle was definitely not part of that discussion. Hamlet, however, has just been jarred out of his comfort zone and lets Horatio know that in no uncertain terms.
During the past two years many investors have been jarred out of their comfort zones, or certainly should have been. Belief in the equity culture along with the sanctity of real estate investing has been badly damaged, perhaps permanently. Yet the same philosophical debates about buy and hold strategies for the long run versus active management still go on as either/or propositions. The passive index Modern Portfolio Theory (MPT) proponents still claim that what successful investing is all about is capturing the return of respective asset classes, that the only drag on performance is fees and that risk management strategies and trading disciplines used by active managers provide no lasting benefit. The academic evidence notwithstanding, investors who held the S&P and other broad based domestic market indices for the past decade have indeed successfully captured that asset class but have not made any money doing so: something akin to asking Mrs. Lincoln how she enjoyed the play. Nevertheless, the largest domestic equity fund is still the SPDR S&P 500 Fund, followed by the Vanguard Total Stock Market Index fund. It is interesting that the economists who devised MPT hail from the University of Chicago, where the business school is named for one of the theorists who built a mutual fund empire based on its teachings. The University of Chicago is described by its founders as being modeled on a German University so it might be the closest domestic approximation we have to Hamlet and Horatio’s University of Wittenberg. Hamlet’s experience of being jarred out of his comfort zone by events out of his control and seeing things differently as a result is instructive for investors. Perhaps a comparable case in point is the August 2010 Bloomberg Investment Magazine cover article about Pimco’s Bill Gross, the manager of the largest bond fund in the US and probably the most respected fixed income investor on the planet. The article is entitled “Why Bill Gross Likes Stocks: The Pimco Bond King says it’s time to Buy Equities.” Did the bond guru see a ghost? To some of his followers, Mr. Gross is making as jarring a pronouncement as Hamlet. Not surprisingly, on both CNBC and Bloomberg Television, Mr. Gross still holds court as the resident bond market expert and is rarely, if ever, asked about equities. The Bloomberg article appeared this past summer as nervous institutional investors pushed Treasury yields to lows not seen in 30+ years and the Investment Company Institute reported that for fifteen straight weeks retail investors had yanked their money out of equity funds and placed it in bond funds, presumably a lot of it going into the Pimco Mutual Funds managed by Mr. Gross. But Mr. Gross, like Hamlet is saying that he has been jarred out of his comfort zone, is looking beyond his “philosophy” and we should all pay some attention to this.
“Put money in thy purse…” Othello, Act 1, Scene 1
This phrase is repeated several times in the play’s opening scene by Iago and directed at the clueless wealthy Venetian Rodrigo. Spiced with some lurid bedroom depictions of Othello and Desdemona, Iago uses the phrase as a patter song as he manipulates Rodrigo’s hopeless love for Desdemona. It is also a way for Iago to enrich himself and advance his pursuit to destroy Othello. Rodrigo has little else to do in the play other than provide Iago with steady source of funds. Although neither man’s motivation has much to do with investment advice, Rodrigo does admit that he is getting no cash flow from his lands and will sell them.
Many investors in land and commercial real estate can easily empathize with Rodrigo. But they should have been aware of the pitfalls. A much larger contingent with a similar problem are the countless numbers of people getting little or no yield on their Treasury Bills and cash deposits in what will likely be a protracted low interest rate environment. In a recent Op-Ed piece in the Wall Street Journal, Charles Schwab admonished the Federal Reserve to raise interest rates and stop penalizing savers and retirees (”Enough With the Low Interest Rates!” October 2, 2010).
Despite his treacherous motivation, there is something to be said for Iago repeatedly reminding us of the importance of cash flow especially in uncertain and volatile market conditions. Ultimately all investments turn out to be yield plays and there is ample accumulated research over good market times and bad that higher yielding stocks and corporate bonds outperform the competition with less volatility. In other words cash flow is king and has been for a very long time. Increasing cash flow through dividends, bond interest and option selling is a prudent and proven means of both enhancing returns and practicing risk management. In the 19th century some of the great actors playing Iago were injured by objects thrown by audience members outraged by his villainy. But let us not shoot the messenger: Iago had it right and is promoting a sound investment strategy.
“But mistress, know yourself, for I must tell you…Sell when you can, you are not for all markets.” As You Like It, Act III, Scene 5
The play’s heroine, Rosalind, has disguised herself as a young boy called Ganymede so that she may move freely after her father, known as Duke senior, has been banished by his younger brother. The disguise is a fine idea except that young women fall in love with “Ganymede” which puts Rosalind in a difficult position since she is pursuing her own love interest and must also maintain her disguise. In Shakespeare’s time women were not permitted to act in the theater so we would have had a young boy actor playing a young woman who disguises herself as a young boy; hence the play on words in the title. One of Rosalind’s ploys to deflect the unwanted attention and advance her own interests is to provide impromptu relationship counseling as in the example cited above. In no uncertain terms the disguised Rosalind tells Phoebe that she should accept the proposal of the good hearted shepherd Silvius whom she has been treating badly. In other words: be realistic-it’s not going to get better than the fellow standing in front of you. Not unexpectedly, Rosalind’s directive takes a while to sink in.
The advice is more than pertinent for a wide range of investors who like Phoebe tend to have inflated opinions of themselves and their abilities, or are determined to remain out of touch with market realities. Back in 1980’s when there was a vibrant and often overheated IPO market, in road show after road show CEO’s would often chime the same refrain: “You know, we really don’t need the money we’re getting from this offering.” Such remarks were aimed to assure investors that the company was a viable entity. But that begged the question of why are you standing in front of us trying to raise capital? Occasionally a CEO would speak honestly and answer, “in all honesty, we’re raising money because we can.” That was a sanguine appraisal since for the past decade the IPO market has been effectively non-existent and only functions for large and already successful companies like Google who raised $1.6 billion at an offering price of $85 per share in 2005 without the aid of an investment banker managing the syndicate. Oracle Computer, by contrast raised $31 million in its IPO in 1986 at a share price of $15—an offering that would be difficult if not impossible to replicate since a $30 million deal is now considered too small and more significantly Oracle in 1986 was nothing like Google in 2005. Both companies today are worth about the same ($30+ billion).
The challenge to remain realistic based on the environment at hand also has application to those of us further down on the food chain with respect to investment management. Baron Nathaniel Mayer Rothschild, arguably the most successful banker and investor of his era once noted the key to his success: “I never buy at the bottom and I always sell too soon.” At any level it has always made very good sense not rely on one’s perceived prognosticating ability for success. Benjamin Graham, the founder of modern value investing who was Warren Buffet’s mentor had a guiding principle that made sense in 1934 in his book Security Analysis and perhaps even more so today: “The essence of portfolio management is the management of risks, not the management of returns.”
MARCH MADNESS, UP IN THE AIR AND GUNS ON THE MANTLE
Monday, April 26th, 2010
Sadly, except for Duke students, alumni and maybe not even 100% of them, the Butler Bulldogs did not produce the storybook ending in the NCAA Men’s Basketball Final when their star player’s last second half-court shot bounced off the rim after coming tantalizingly close to going in. Before the game, billed everywhere as a David versus Goliath event, the New York Times produced a graph which showed the disparity in relative wealth and stature between the two opponents. Based on their respective student enrollments, both schools fall into the midsize private university category. But that is where the similarities end. Duke’s endowment is over $6 billion while Butler’s weighed in at $165 million; the Duke basketball budget is over $13 million while Butler spent slightly over $1 million. One sports commentator noted the Butler figure is less than Duke’s phone bill. That is likely a stretch but maybe Butler’s total budget is on par with Duke’s travel bill since taking multiple trips to Madison Square Garden from Durham, NC versus bus rides from Indianapolis to Muncie does add up. Regarding Butler’s final shot, there was this telling comment by a Duke player: “the shot was up in the air, for what, about 3 hours–everyone was sure it was going in.” So even the victorious participants seemed slightly disappointed not to see the storybook ending.
But an earlier March event, in its own way no less mad than the basketball tourney, the Academy Awards did give us a David prevailing over Goliath triumph when The Hurt Locker soundly trumped both Avatar and Up in the Air– the prognosticators favorites heading into the event. Similar to the Duke/Butler comparison, The Hurt Locker cost $15 million to make which sadly remains its gross even after the Awards. This number probably approximated the catering bill for Avatar which did garner a few Oscars, so the real loser at the Academy Awards was definitely Up in the Air, a movie with the mega-star George Clooney playing a likeable road warrior who spends his time flying around the country terminating management level employees. Quite a timely subject and ten years ago it would be hard to imagine this movie seeing the light of day, but desparate times call for desparate measures and the title of the movie aptly describes where we stand in the investment cycle in both literal and figurative terms. After the stock market’s breathtaking ascent in the second half of 2009, we had a continuation in the first quarter of 2010 with the Standard and Poor 500 increasing 5.3%. Yet the road was bumpy with averages falling over 5% during February on worries about a China slowdown and then a Greece meltdown. Interest rates except in Greece and other similar entities reamined largely in check and the Barclay’s Aggregate Bond Index (formerly known as the Lehman Index) rose 1.7%. Yet despite increasing optimism about corporate profits, recently increased consumer spending, and some interesting merger activity, it is hard to be unabashedly sanguine going forward. While the stock market may soon approach it’s pre-Lehman levels, housing and commercial property prices will likely take a far longer time to retrace theirs. A well placed real estate attorney told me that most of downtown San Francisco is effectively in foreclosure since eye popping loan to value disparities will need to be confronted as many loans are due to be renegotiated in the next few years. Indeed the Wall Street Journal’s HEARD ON THE STREET recently discussed the issue with reference to banks such as Wells Fargo , whose stocks have soared, but who have a high number of such loans on their books: “Even seemingly healthy loans where payments are up to date can end up hurting banks. Key Bank recently sold a repossessed Illinois mall for about 65% of the face value of the $37 million of debt against the property, even though it is nearly fully occupied.” (April 12, 2010).
Still there is enough good news on the corporate front both macro and company specific that has trumped such concerns for the time being. The closely watched ISM (Institute for Supply Management) Index, a monthly survey of over 400 US companies in 20 industries, registered a significant upside surprise in March. This is madness we all welcome since the latest numbers indicate GDP growth of 5-6% going forward. Normally GDP growth leads to domestic job growth although in our current predicament this logical expectation may not be a slam dunk. One of the reasons is that many doubt that the US Dept of Labor unemployment figure, hovering at just under 10%, reflects the reality of the job market since many people have stopped looking or have taken part-time work and do not show up on the monthly reports. The ranks of “consultants” have swelled and as the old joke goes, a consultant is a guy who knows how to make love a hundred different ways but lacks a girlfriend. The real unemployment number is likely closer to 15% and some commentators even worry that the encouraging news from the ISM will bring many of the under-employed back to seeking full time work which could even increase the the 10% number. Yet after the debacle of the financial meltdown and the ensuing recession, seeing likely GDP growth of 5%+ less than a year later is something to be welcomed by all.
Anton Chekov, the Russian physician turned dramatist, once noted that a revolver placed on the mantle in the first act must go off in the third. So what we will be waiting to find out is which of the revolvers on the mantle will be the one to go off and have the most lasting resonance. Will it be the recovery we are now beginning to see spurred by the ISM numbers and merger activity, or will it be a continuing downward spiral in housing, commercial real estate and real employment and the reckoning that results from our government continuing to kick the can down the road. As we wait for the ending of the play with Chekov’s warning in mind we should remember that most plays (including his) have four acts. So there will be more to follow after we hear our revolver and in the meantime we will remain Up in the Air. This is not an argument to run to the sidelines or take an ostrich approach. Rather it is a recognition that in an uncertain investing environment it makes good sense to be cautious, hedged, agnostic and above all, opportunistic.
SPANKING THE FAT CATS
Thursday, December 17th, 2009
SPANKING THE FAT CATS
12/15/09
Yesterday President Obama held a meeting with the “too big to fail” CEO’s where he admonished the bankers who received TARP funds to start lending their dough “in the national interest.” Both sides of the aisle have weighed in on this issue-the left decrying the TARP recipients paying their profitable trading desks bonuses built on back of taxpayer money while the right saying that the bailout reeked of socialism and that the banks should manage their own affairs for better or worse.
But let us say you are running one of these banks and you look at the landscape. Banks are in the business of buying and selling money, and like anyone else they want to buy low and sell high. Banks are getting (i.e. buying) money at pretty close to zero given the current level of short term rates via the Federal Reserve. So they should do well lending that money to small businesses and real estate buyers -all of whom agree that getting a loan is about as easy as running a marathon with your legs tied together. If you are paying close to zero for your money and can lend to a business or real estate buyer at 5 times that or better, isn’t that a favorable risk/reward-even if some of the loans don’t work out as planned? That is true, but the banks have a greater carrot dangling in front of them and that is the yield curve. The math is far from complicated. Here they can pick up 4.3% buying a 30 year Treasury or make a 30 year mortgage loan to a homeowner at around the same rate with a questionable asset the bank may end owning. Since there is a lot of that stuff in house already, there is not a whole lot of incentive to increase the inventory. They can hire loan officers and appraisers to determine the credit worthiness of the borrower and the asset-something which will generate positive press, or have their fixed income traders click boxes on their Bloomberg screens and make loans to the US Treasury. Yes and these traders may get a year-end bonus for doing their jobs profitably which involves using leverage and derivatives. And if Obama says you guys have to start lending, the bankers can say, “Guess what, Mr. Prez-we’re lending to you.” So as long as the yield curve looks the way it does at present, and the Fed and the Treasury Dept have not indicated otherwise, there is not a great incentive for the banks to lend, except to avoid a deluge of real estate bankruptcies through workouts and debt for equity swaps—that is the elephant in the room.
There is of course, a long history of US President’s spanking fat cat bankers. In the early years of the 20th Century, President Teddy Roosevelt often railed against the “corporate malefactors of great wealth,” although after 1907 Financial Panic he had no problems when the malefactor in chief—JP Morgan used his leverage with his fellow fat cats to rescue the US financial system from imminent collapse. That famous meeting at the Morgan mansion led to the formation of the Federal Reserve. The next Roosevelt made similar statements but kept mum when the bankers were doing what the current Goldman Sachs CEO called “God’s work.” Like President Obama, TR certainly would have said he did not “run for office to be helping out a bunch of fat cat bankers on Wall Street.” But the rest is and will be history.
BEWITCHED, BOTHERED AND BEWILDERED
Wednesday, August 5th, 2009
The hit song from the 1940 Rodgers and Hart musical Pal Joey provides a good tag line for the 2009 second quarter’s investment commentary. To provide some more insight, let us first look at some lyrics:
I’m wild again, beguiled again, A simpering, whimpering child again, Bewitched, bothered and bewildered—am I.
In the musical, Vera Simpson, a wealthy, bored and married socialite falls for the charming heel Joey Evans, who seduces her, separates her from her money, then dumps her. Sound familiar! There is not much transference required to see how the song works as a corollary for most people’s investing experience over the past eighteen months. After a year which for many investors resulted in both major losses and a high degree of shell shock, the first half of 2009 has shown some improvement with the S&P 500 being in the black by 3%. But it took a 30% plus rally in the second quarter to achieve this.
Although conditions both in the market and the overall economy have improved somewhat in the past few months, there is still a fair amount to be bewitched, bothered and bewildered about. For the past two decades we the investing public were happily “bewitched” by the equity culture with encouragement and cheer-leading from the likes of legendary fund manager Peter Lynch, (One Up on Wall Street) who told us that we could all find the proverbial 10-bagger if we kept our eyes and ears open, and Wharton Finance Professor Jeremy Siegel (Stocks for the Long Run), who still strongly advocates staying fully invested in stocks and ignoring whatever the market is doing in the short run—i.e., less than 100 years. Those are fine sentiments when investing is less of a blood sport than it has been for the past 18 months. Yet for many, this time it was different: having experienced a severe decline which for many people eradicated their gains of the past decade, there is much trauma, blame and bother to go around. That brings us to the current state of bewilderment— fretting about whether our budding green shoots will blossom or turn to yellow weeds. There are compelling arguments for both. The US economy has moved past Point A (”A” perhaps standing for Armageddon) but how to get to Point B is less clear. The last quarter and July have produced encouraging upside surprises in company earnings reports as well as some economic indicators. But unemployment numbers are discouraging and according to commentators such as Morton Zuckerman and Roger Lowenstein, the statistics do not accurately mirror the worsening reality. Despite the improvement in business inventories, consumers are still not spending and home prices remain in the dumps. How lagging these indicators prove to be is the $64 question.
Remaining agnostic about the stastical barrage may prove to be the best course. This will likely result in seeking out sensible opportunities but using risk management strategies to guard against a reversal. Besides the song from Pal Joey we can also gain some perspective from a popular play that premiered two years later in 1942, Thornton Wilder’s The Skin of Our Teeth, in which the heroine tells us: “Don’t forget that a few years ago we came through the depression by the skin of our teeth! One more tight squeeze like that and where will we be? My nerves can’t stand it.” Maybe it is deja vu all over again, but as in Wilder’s play, the capacity for survival and renewal appears to be trumping our most dire predictions.
INVESTING WITH A CONDOM
Monday, June 1st, 2009
This will be a regular column with additions, comments and hopefully responses pro and con. Sorry I could not think of a better title but it does accurately describe the current investment strategy at JMR Capital.
Since the last half of 2007, the global equity markets have exhibited the kind of volatility which recalls the “Panics” of the early 20th century. This was discussed in a previous posting entitled Your Great Grandfather’s Stock Market. So what is a prudent way to invest in this environment? Many have headed for the mattresses, making risk aversion the new bubble. Others have been like deer frozen in the headlights with fingers and toes crossed. Neither approach will bear much fruit going forward and while a passive investment style suits a market whose general trend is clearly up (cf. Jeremy Segal Stocks for the Long Run) there is now a strong case for hands-on active management complete with hedging and downside protection.
To illustrate and lead by example, here are some real examples of investment strategies used in accounts managed at JMR Capital Management.
CASH FLOW IS KING
In the last quarter of 2008 we initiated some positions in exchange traded funds with high cash yields which could be added to by writing (i.e. selling) covered call options.
HYG. IShares IBox High Yield ETF. This security replicates a well known high yield bond index which contains the most liquid and tradable US dollar denominated high yield corporate bonds. The top ten holdings comprise 22% of $2.7 billion of total assets.
10/30/08 BUY 500 SHARES @ 71.84 $35920
Since November we have received 7 monthly dividends totaling $2390.5 or $4.78 per share. In addition we added to the cash flow by selling the following call options:
10/30/08 Sold 5 March 09 $76 calls @ 1.60 $800
Since the price of the stock was below the strike price (76) on the option expiration date, we sold another call.
4/14/09 Sold 5 June 09 $72 calls @ 1.85 $925
Our total from selling the call options is $1725, which when added to the dividends received since November brings the grand cash flow total to $4115.50 or $8.23 per share. This gives us a return of 11.5% so far. To protect the downside we also have a stop loss order at $70.
KMP. Kinder Morgan Energy Partners. The company owns and manages energy transportation through approximately 8300 miles of pipelines for oil, natural gas and CO2. It has paid and increased its quarterly dividend every year since 1992.
10/14/08 Buy 400 shares @ 50.978 $20,048
12/30/08 Buy 400 shares @ 45.216 $18095
Our total investment for this particular account is $38143 or $47.68 per share
Dividends receveid through the end of April have totaled $2088. To this we have added to the cash flow by selling the following call option.
1/23/09 Sell June 09 52.20 $1180
Our total cash flow is now $3268 or $4.08 per share. If the June call is exercised at 52.50 our total return from dividends, call premium and appreciation will be $7123 or 18.6%. We have placed a stop loss order at 45 to protect our return.
More examples to follow—please stay tuned and let us know what you think.
Investing In A World With No Smart Money
Tuesday, May 12th, 2009
Is the playing field now more level? For thirty years, or at least since this writer has been in the investment business, there was always a lot of chatter about the smart money. Smart money has been around a very long time-even in the pre-internet, blog and twitter days. The smart money did not buy tulip bulbs in the 18th century, bought the right railroad securities in the 19th, somehow did not get wiped out in the 1930’s, recovered mid-century and invested in the new technologies in the 80’s and 90’s. The smart money turned up in some unexpected places. In the hit movie YOUV’E GOT MAIL (1998), the plot hinges on the inventive use of a technology which at one time made a lot of money for AOL. The heroine Meg Ryan, after losing her battle with a large chain run by Tom Hanks, her mystery email suitor, is forced to close the neighborhood book shop started by her mother. She is worried about her longtime book keeper, played by Jean Stapleton no longer having a job, but in a memorable line, Ms. Stapleton reveals that she is eager to retire and live off her investments: “I bought Intel at 6!” she happily announces.. On the movie’s release date, December 18, 1998, Intel closed at 120. Peter Lynch, no doubt cheered loudly. In BEATING THE STREET, Mr. Lynch said that all of us, just like the book keeper in the movie, could be the smart money (since the book keeper scored a twenty-bagger in Lynch terminology–she had something to chortle about). But what a difference a decade makes: so far in 2009 the high for Intel is $15.75. After the dot-com bust in 2001, the smart money moved into alternative investments and private equity. A Barron’s article in June 2003, “Moolah, Moolah,” sang the praises of the Yale Endowment gaining stellar returns via its overweighting in alternative investments:
Is Yale really not that interested in the stock market? Apparently so.
A look the university’s most recent data on asset -allocation shows just how
differently the smart money [emphasis mine] looks at prospects in the market.
Julian Robertson at Tiger Management (the yen-carry trade), George Soros at the Quantum Fund (macro currency plays) and David Swenson at Yale (see above) all seemed to posses the holy grail in the form of unusual allocations combined with exotic trading strategies. Unfortunately as we now know, they spawned far too many imitators chasing the same strategies. Through all of this Sturm und Drang, legendary Graham and Dodd value investors, Warren Buffett and Wilbur Ross made immense fortunes sticking to their knitting.
But during 2008, the smart money vanished and has yet to reappear. The mighty are still falling all over the place. Jim Simons, the highest paid hedge fund manager in the world is taking a major hit as his highly secretive fund for institutional investors, Renaissance Capital, is reportedly underperforming the S&P by 19% in 2009. In the meantime, hedge funds are under attack from all sides: Congress, State Attorney Generals, President Obama, the investing public and even some hedge fund insiders. The former CFO of one of the largest hedge funds which had not experienced a losing year prior to 2008 told me: “We are supposed to do three things: invest in strategies which are not correlated to the stock market, preserve capital and provide some liquidity. We are 0 for 3.” Ten-bagger-plus venture capital and new technology returns will have to wait for a return of a vibrant IPO market, which could be populated by companies developing green technologies, electric cars and the fruits of stem cell research. But as former investment banker Frank Quattrone has pointed out, the Wall Street banking and research system that enabled the likes of Apple Computer and Cisco Systems has effectively ceased to exist. Nevertheless, Mr. Quattrone who had the resources and staying power to reverse a guilty verdict following a draconian Dept of Justice prosecution has set up shop again as an investment banker focused on mergers and acquisitions. He is also a major donor to the Innocence Project. Peter Lynch is quietly hiding out as a consultant to his former employer, Fidelity Investments. Warren Buffett proudly announced in an October 2008 New York Times Op-Ed article that “I’ve been buying American stocks. This is in my personal account in which I previously owned nothing but United States government bonds. My non-Berkshire net worth will soon be 100 percent in United States equities.”
Between October 2008 and March 2009 the S&P 500 dropped 30%, and while admitting that his call was pre-mature, Mr. Buffett can be seen fairly regularly doing lengthy interviews for CNBC, a division of NBC, whose parent company is GE, one of Berkshire Hathaway’s largest holdings. In 2008 Mr. Buffett lent the company $3 billion via a preferred stock investment with a 10% yield plus warrants. Through all of this including his rather downbeat Berkshire annual meeting, Mr. Buffett is as cuddly and charming as ever, driving a succession of female CNBC reporters around Omaha in his Cadillac, waving to his longtime neighbors, stopping at the Berkshire owned DQ for a burger and telling us that he wishes he was 25 so he could be around for the most powerful recovery of all time. But is he or anyone else still the smart money??
Your Great Grandfather’s Stockmarket
Wednesday, March 18th, 2009
Since the summer of 2007, the stock market has exhibited an unusual amount of volatility. Two percent swings in the broad market indices such as the Dow Industrial Average and the S&P 500 have become commonplace as are double digit swings in individual high profile names in the banking and technology sectors. In 2007, for example the Dow Jones Industrial Average moved two percent or more on 15% of the trading days, most of those coming in the final quarter of the year. In the final quarter of 2008, 2% moves occurred a whopping 61% of the time and in the most recent quarter ending March 31, 2009 there were 2% or greater swings on one third of the trading days. Perhaps we are heading back in the right direction. Less would certainly be more on this front.
This kind of volatility in the financial markets has characterized periods of extreme economic unrest such as the Great Depression of the 1930’s and the Panics of 1907 and 1870’s. Those debacles supposedly resulted in some financial market reforms that were designed to mitigate such extremes. The NYSE,AMEX and NASDAQ all tell us that their specialists and dealers are charged with maintaining a “fair and orderly market.” In prior periods of extreme volatility such as 1907 and 1930, there was no such expectation. There was no Federal Reserve regulation, margin requirements did not exist, corners on stocks and underlying commodities were frequent, and large moves were the rule, not the exception. We, however, are supposed to be in a brave new world with state of the art trading systems on the exchanges which maintain a “fair and orderly market,” automatic circuit breakers which close the NYSE in the event of a 10% swing and wise men such as Richard Grasso and Bernard Madoff who have served as the respective heads of the NYSE and NASDAQ boards.
We hear many cries for more regulation, more transparency in derivatives such as credit default swaps and House Financial Services Chair Barney Frank saying that the uptick rule for short sales should be reinstated. These are excellent ideas and perhaps such measures will help. But our markets reflect the ultimate global democratization of capital and as New York Times columnist Tom Friedman has said a world made flat through technology. Our world is jittery, on edge and in a manic depressive state. Our markets will reflect that with or without additional regulation.