Archive for June, 2012

Agriculture Stocks Heat Up

Wednesday, June 27th, 2012





The Ag industry is gaining favor and the stocks of companies in that industry are beginning to perform well in the face of European troubles.

The Ag industry has some catalysts that drive prices that are not materially impacted by the banks in Spain and their mortgages on the plain. The hot US Midwest Summer and near drought conditions in much of the farm belt, as well as ongoing drought in China’s farmlands, plus a growing emerging market middle class that is demanding a better diet that is leading to smaller and smaller grain reserves has investors interested in these companies.

On June 6th, we added shares of Potash to our “Best Ideas” client portfolios. Since then, you can see what the stock has done:

Potasch Corp

You can see we were a few days early in this particular investment as it trailed down for a couple days, but we are up 11.81% on it so far and are quite pleased that our initial analysis has played out as anticipated.

Our reason for adding Potasch Corp to client accounts as a 2% position in the Best Ideas equity exposure was based upon:

> our discounted cash flow analysis gives a value for the company of $92.37, or 114% potential price appreciation (this is not a 12 month target, but more of a valuation based upon the companies operations and their ability to generate free cash flow)

> analyst consensus target price (usually a 12-month target) of $53.84, or 25% potential price appreciation

> 5-year average Earnings Per Share Growth of 39.95%

> Trailing twelve month EPS Growth of 40.94%

> 47% Gross Margins

> 36.55% Return on Equity

> 26.7% Return on Invested Capital

> PEG Ratio of 0.92% (less than 2 is good, less than 1 is optimal)

> P/E Ratio of 13 compared to 17 for its industry

> Debt to Equity Ratio in line with its industry competitors

The tough thing for investors to grasp is that stock price is not exactly correlated with performance numbers like those above. Stock price is influenced significantly by investor sentiment which is impacted by things that have no specific correlation to farmers buying chemicals for their crops.

For me, as long as I see a strong discounted cash flow value for a company, profitability, growth and financial strength ratios like those above – plus added catalysts that can transcend the news of the day – I am quite happy to invest in a company like Potasch.

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Operation Twist Again

Wednesday, June 20th, 2012

S&P 500 Since June 1st

In a blog post on June 1st that you can find here: Click Here for June 1st Blog Post I made mention that we were putting the cash to work we had raised when the market was higher because it was my belief that the weakness in the US economy would cause the Federal Reserve to do some form of monetary stimulus, most likely Quantitative Easing (QE3), and that would raise stock prices.

In the graph above, you can see that the market has strengthened considerably since June 1st (the purple vertical line). Today, the Fed came out with an announcement that it did in fact decide to some monetary easing, but of the mildest extent possible. It is going to extend Operation Twist (a mild form of quantitative easing) which will keep the current level of monetary easing going for an extended period of time.

The stock market is down about 1/2% right now as the Fed Chairman is speaking – investors seem to be mildly disappointed that the Fed isn’t doing a more robust stimulus like a full blown quantitative easing program. But it also isn’t selling off in a huge way, which it certainly could have done if expectations were too high.

As I look at it, Operation Twist extends the duration of the Fed’s holdings of Treasury Notes by reinvesting the short-term notes that are maturing into longer term bonds. This should have the impact of lowering longer-term bond yields, and any debt that is indexed to treasury yields (like mortgage rates and some bank business loans) should have low interest rates for the foreseeable future.

The Fed also stated that they were lowering their forecast for GDP growth by 1/2% and that they expect unemployment to increase from current levels. Given these, I think today’s action is just to buy them time – they want to see if their forecast really comes about, and if it does, they will engage in a full blown quantitative easing program.

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When Diversification Hurts

Monday, June 18th, 2012

Global Market Past Three Months

The bar chart above shows you what’s been happening in the global stock markets over the past three months.

Brazil has been absolutely crushed, down -22.49% while the S&P 500 Index is down a much smaller -4.26%.

Looking across the graph, most of the major indices around the world are down 7% – 11% in the past three months.

Let’s take a deeper look at the US market:

US Market Industry Sectors

Looking at the sector performance the past three months, its easy to spy what has performed and what has not. The defensive sectors have all soared higher while the sectors tied to the economy (and which have had strong earnings growth in spite of our slow-growth economy) have languished.

Let’s look at the major asset classes:

Asset Class Comparison

The bar chart above shows you how some major asset classes beyond equities have performed in the past three months.

You can see that any exposure to commodities and commodity stocks have been devastating, and they have more than offset any diversification benefits from the asset classes that performed better than the S&P 500 (high yield bonds, REIT’s, gold, etc.).

If you owned only an S&P 500 index fund during the past three months, you would have done much better than any fully diversified portfolio. If you owned the index fund and a bond fund, you would have been about break-even for the past three months.

It’s never fun when we are going through a time where the asset classes that the Prudent Investor Rule requires be included for diversification purposes hurt your portfolio performance. However, there will always be short periods of time where that happens. Over the long-term, though, things are different. Take a look:

Long Term Asset Class Returns

Over the past 13.5 years, you can see that the S&P 500 has been a significant underperformer compared to the other diversifying asset classes. The lesson here – and I say this to remind myself as much as everyone reading this blog – is to not get overly discouraged by these infrequent time periods where the only thing that works in the short-term is a beta investment in the S&P 500.

Over the long-term, the Prudent Investor Rule plays out as intended – the diversifying asset classes provide additional incremental return while lowering overall portfolio risk.

One of the problems we have today is that with an always-on internet and investment television available at the click of a remote, it seems that everyone’s investment horizon has gone from 7 to 10 years (a must if you want to own anything other than short-term fixed income) to 7 to 10 days.

Many people are making investment decisions based upon short-term phenomena instead of sticking with a long-term strategy. They hear some TV personality say to buy some company because its possible the US economy will grow 1.5% per year instead of a previously forecast 2%. A 1/2% change in GDP growth in a slow growing economy will not materially impact the fortunes of any particular company – but selling a company with strong earnings growth in favor of a utility company with little earnings growth after a market pullback is already well underway makes no sense.

For me, it is always better to raise cash when you believe the market has moved up to the top of what you think is its current range, then reinvest that cash in solid companies with strong earnings growth or macro catalysts that will push their stock prices ahead of the S&P 500 over that 7 to 10 year horizon.

A good example of the above is Caterpillar. It is growing its earnings at 41% year-over-year. It is trading at a P/E of 10.97 while its industry competitors are trading at a P/E of 12.83. Its Return on Equity is at 38.33% compared to is industry competitors at 13.75%. It yields 2.39% compared to the broader market average yield of 2.29% and it has a payout ration of 22% giving it lots of room to continue to increase its payout, which has been growing just under 10% per year.

From a valuation standpoint, the current price for CAT is $86.83.
> the Analyst Consensus Target Price is $127.68 implying a 47% return
> the Industry P/E X Forward EPS is $124.71 implying a 43% return
> the Discounted Earnings Yield value is $121.54 implying a 40% return
> the Discounted Cash Flow value is $148.95 implying a 71% return
> the Cash + Capitalized Earnings value is $125.18 implying a 44% return

The earnings growth of a company like CAT, even though it is tied to the economic cycle, justifies to me owning it over a defensive company with less potential return. Yes, it is more volatile, but if you keep your investment horizon in mind and not focus solely on the short-term – and you add to your position if the price goes down (as long as the fundamentals of there to propel the earnings growth forward) – then ultimately you will be rewarded.

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Social Security

Thursday, June 7th, 2012

Medicare and Social Security Deficits

Earlier this week, I presented a program on economics, regulation, and taxes for the Active Senior Republican group. After the presentation, I was talking to one of the attendees about Social Security, and it got me thinking that there is a lot of misunderstanding about how Social Security works.

The general idea floating around the populace is that if the government would simply remove the income cap upon which the tax rate is applied, that would solve all the problems and be the most fair solution.

I think it is clear that Social Security taxes will have to go up, but simply raising the cap is not the best way, most fair way, nor mathematically feasible way to accomplish that. Here’s why:

> Income under $110,100 is taxed at 6.2% for each of the employer and employee (it is 12.4% when combined) and benefits are capped up to that level of income.

> For workers whose income (and spending) is above the $110,100, they need to save more (and a greater percentage) of their income to fund their post-retirement lifestyle.

> Contrary to what some folks think, they are not receiving Social Security benefits without contributing to the system (for their income above $110,100) – their benefits are simply capped.

> The Social Security tax is an extremely progressive tax in spite of the fact that it is a flat 12.4% rate. The reason for this is that the benefits which are are credited to you decrease substantially as your income approaches $110,100.

> The first $9,204 of your annual earnings are credited for 90% benefit, the amount of your annual earnings between $9,204 and $64,728 is credited for 32% benefits, and the amount of your annual earnings between $64,728 and $110,100 is credited for 15% benefits.

The result is very apparent in the benefit payments that retirees receive: studies show that lower income workers receive benefits of about 55% of their annual earnings while higher income workers receive about 28% of their annual earnings.

Social Security was never designed to be a retirement plan – it was designed to be a social safety net where higher paid people assist lower paid people avoid poverty during their final years. You can debate whether this is right or wrong from the left or right, but it is just what President Roosevelt intended.

Where we have run afoul of the solvency of Social Security is that originally in 1945, there were 42 workers paying Social Security taxes for each person receiving benefits. Last Fall, the Labor Department reported that that there are only 1.75 workers paying for for each recipient. The math just does not work out to be able to provide all of the benefits that have been promised based upon the projected revenue stream from an ever-dwindling number of tax payers.

In order to fix the Social Security system’s projected under-funding as detailed on the chart above from the General Accounting Office, you will have to play with more than just the income cap – there simply are not enough people earning above the income cap to completely fund the projected deficit, even if you removed the income cap completely.

What you will see at some point – when someone in DC gets brave enough – is some combination of:

> increasing the income cap

> reducing the benefits credit percentages

> reducing the dollar levels at which the percentages drop

> increasing the age at which people are eligible to receive benefits

> increasing the tax rate higher than 12.4%

> changing the inflation index/methodology upon which Social Security benefit increases are calculated.

It is very likely that current and soon-to-be recipients will be grandfathered to some extent – but for those under 55 or 60, there will likely be some major changes in the way Social Security is taxed and pays benefits.

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I’m A Buyer

Friday, June 1st, 2012

S&P 500 Trading Range

In an earlier post we talked about the dark blue line on the chart above being a support level, and if it broke we would see additional downside.

When the support broke, we used that as an opportunity to rebalance client portfolios – reducing exposure to small/mid-cap and increasing exposure to non-cyclical large caps and large caps with above average dividend yields.

We made our sales and have been slowly buying the replacement holdings. Today, with all of the bad news out of Europe, the news of much lower job growth than anticipated in the US, and China PMI dropping to a 5-month low (PMI is the Purchasing Manufactures Index and represents expansion or contraction in manufacturing activity), the market opened down a percent and a half this morning.

We have stepped up the purchases/reinvestment of the cash generated from the sales the past couple of days based upon my belief that we will see news of additional quantitative easing coming from the Fed at its next meeting (if not before).

The anticipated QE3 (the third round of quantitative easing) will be a narcotic for stock prices. Look at the graph below so you can see how stock prices have reacted historically to this level of monetary stimulus:

Quantitative Easing's Impact

I’ve drawn vertical lines on the graph above to show you the different time frames in which quantitative easing has been used by the Fed to stimulate the economy. The blue vertical lines show when the QE begins and the black vertical lines show you when it ends. The last set of lines shown are technically not QE – it was an effort to sustain the level of liquidity that the original two QE’s generated, so it was name Operation Twist. However, you can see it had a similar impact on stock prices.

There are two main reasons for my belief that we will see another round of quantitative easing: (1) the problems in Europe are inherently deflationary – something that scares the Fed much more than inflation ever will; and (2) the unemployment picture in the US is not getting better.

Fed Chairman Bernanke is a student of deflation and truly believes that the only way to combat it is to flood the economy with newly printed money – hence his nickname “Helicopter Ben” due to his quote about the Fed should drop dollar bills from helicopters if it sees any signs of deflation.

The Fed also has a dual mandate to increase the level employment in the economy – and with the employment number today being well below consensus expectations, they will feel the need to act.

As I write this, the market is starting to flatten out from the initial sell-off.

S&P 500 Today

This chart shows you today’s move in the S&P 500. The initial downdraft of sellers has stalled but buyers (other than me) haven’t really jumped in yet – many are banging their heads against the wall because they missed a chance to sell at higher prices instead of looking at the potential opportunity ahead.

Every sector in the S&P 500 is down today – so it really is a buyers buffet for those that believe stimulus is coming. But, unless you think I am the lone wolf in believing that Qe is coming, check out Gold:

Gold Rally

The big jump in gold today indicates to me that the smart money is also betting on stimulus which will eventually decrease the value of the dollar.

In coming days, I’d look for various Fed Governors to start talking about the positive impact that the economy could see from additional QE. That will get buyers interested and start to move prices higher.

Until then, we will continue to put the cash we have on hand to work in anticipation of Fed stimulus. One thing history has shown, you do not want to be in cash when QE starts.

Will QE fix all of the structural problems in our country? Nope – but it has shown that it can lead to higher stock prices which is critical for investors. Until the structural problems are addressed, we won’t see a new sustained bull market in stocks but more of this up and down we’ve seen during 2011 and 2012.

Hope You Enjoy Some 80\'s heavy Metal