Wednesday, February 25, 2009

Lessons from Benjamin Graham, Part #1

In the classic book, Security Analysis, Benjamin Graham presents an in depth thesis on how the "margin of safety" determines the attractiveness of an investment. Graham wrote the book based on a thorough analysis of one of the most severe investing environments of this country, the Great Depression from 1929 – 1939.

Currently our security market is on a downward trend comparable to that historic time. Looking at the historical data regarding the fall of earnings of the industrial companies during the Great Depression, you can see why there was a 90% drop in market cap from peak to trough.

But the analogy to emphasize is that the market is not near the end of the current cycle. In comparison, over 1929 to 1932, the Dow had equivalent to three consecutive 50% drops in value. The value of the Dow fell from par value of 10, 5, 2.5, 1.2. With this in mind 2009 may not drop by as much points wise, but the percentage loss will be equivalent to last year. In any case, the market is still very much on track to match the largest fall ever recorded.

So what to do?

To learn how to handle a potential future depression, it is wise to learn from the last one. When Benjamin Graham wrote Security Analysis, he did so to provide text to support most secure methods of investing based the test cases of the Great Depression. Benjamin Graham wrote…

The economy today involves faster business cycles due to technology, but still contains industries which hold promise to meet Grahams criteria of a stable enterprise. Using Graham’s profit data over the course of the Great Depression, it is observed that regulated utilities held 66% of their pre-Depression earnings. This is a quite impressive feat compared to 99% reduction of industrial company earnings in aggregate, and 100% loss of earnings for railroad companies on aggregate.

What is wisdom to be passed to the wise retail investor? Whereas the broader industrial sectors suffered seriously from decreased consumer consumption and capital spending associated with major downturns, the earnings of regulated utility industry remained relatively insulated. Although not very attractive for an equity investment where growth of profits is required for returns on a stock, this situation underlines the large "margin of safety" risk-reward propositions for fixed income investors of regulated utilities for the next five to ten years. As profits slide with the general economy, equity holdings for all companies will be comprised. But the debt holder of a regulated utility is not as concerned about a fluctuation in profitability as the ability of the issuer to continue to be current on existing claims. Thus, in these humble times, the prudent will buying securities in preparation for years of lean corporate profits, one place Benjamin Graham has told us this can be found is in debt and preferred shares of regulated utilities. (To be continued in Part #2)

Friday, February 20, 2009

How did we get here? Frontline "Inside the Meltdown"

This Frontline news program provides a wonderful set of first hand accounts of the credit meltdown.

Confessions of a short seller (and a question "What were you thinking?")

Originally published as a blog post on Motley Fool CAPS on Oct 21, 2008...

Woo hoo! Mr Paulson, here I am! You banned me for a little while. That hurt. But I weighed my options and decided to stay put. The arrogance of Dick Fuld, the indiscretion of Washington Mutual, and funny people from Iceland nearly made me a gazillionaire. Now I have questions for you and everyone reading this.

Why is it that in winter of 2006 when everyone knew the housing was overleveraged and overpriced that many of you stayed long on financials? But now that the financial stocks are 50% cheaper you are now saying “don’t miss the bottom”. What are you thinking? That is the logic of a lemming. Before you put another dollar in the market, what were you thinking then? What emotion are you listening to now?

Why is it that Bill Nygren made Washington Mutual one of his top five holdings for the next 10 years? Did you “Buy and Hold”? What were you think then? What are you crying about now?

Forget about “in the long run the stock market goes up” stuff because in the long run we are all dead. The fact of the matter is that there was a huge credit bubble supporting growth and it was unsustainable. What is needed is a return to the basic math of investing. Stop thinking about buying low and selling high. Things do not have to go in a specific order. Just think of the more basic concept of receiving more than you invest.

As short seller I long ago realized that markets are like roller coasters driven by fear and greed. They take a slow, deliberate rise toward the peak. But once past the peak, the market drops so fast you will quickly find out what you had for lunch. Moreover, the amount of money made (or lost) in the market is directly propotional to the amount of movement in the stock. The market has never gained 45% in one year, but it definitely has lost it in one year.

The Motley Fool gets you started with Foolish investing based on sound principles. But in IMHO, it is just as intelligent to benefit from the collapse of a house of cards as much as the rise of a dynasty. Is it more dignified to benefit the implosion of Crocs jazzy plastic shoe trend, or the conquest of the Chinese retail market by Wal Mart? Both are successful investing techniques. You can’t have everyone on one side of a trade like you can’t have everyone trying to buy low and sell high.

The best investors I have seen on Motley Fool CAPS or anywhere else focus on a market they know and understand when to buy and sell (and not necessarily in that order). Buffet sold his stake in GEICO once before buying it back later, a synthetic short. Buffett knows insurance, and that is where he plays. So, before you buy another share of Bank of America, please beware I am on the other side of it and realize I will sell you as many as you want because there are so many of you to feed.

Tuesday, February 17, 2009

Don’t suffer the equities markets, buy XFR

The equity and debt markets are topsy turvy from the surprises and pressure from the credit crisis. Investors, scared of their own shadow regarding debt, are pricing all debt at a discount to gain safety in their positions. Yet Big Pharma, an industry with incredible cashflow margins on products and strong barriers to entry into their markets, has also seen it's securities priced at a discount. In the panic of the financial system, there are health care companies with products that customers literally cannot live without. Bristol Myers Squibb, the maker of drugs such as PLAVIX, a blockbuster blood clotting therapy, and Abilify, a blockbuster drug for treating the bipolar, is one such company that investors can buy senior debt offered as a preferred shares of a debt trust (NYSE: XFR).

For those not familiar with debt trusts, these shell companies are created for the benefit of the company and the small investor. The company issues standard debt, receiving favorable rates from the debt markets and tax advantages of issuing debt rather than preferred shares, to the trust. The trust, in turn, sells shares like any other stock sold on the NYSE on the open market. This structure allows small investors to invest with the liquidity of the NYSE market and without the large commissions of purchasing from the major brokers over the counter.

This Bristol Myers Squibb debt trust pays the buyer of the trust shares dividends from the notes held in the trust. The total issue is only 25.5m, and thus not attractive to big fish. Yet safety of the issue has to be considered high considering the size of the total debt, $6.1B compared to BMY's current SEPT 30 08 cash position of over $7B in cash on balance sheet and the 43B market cap. Bristol Myers Squibb, although stagnant in revenue growth of the last few years, has maintained consistent profitability, cost reduction, and a strong cashflow position. Many analysts are positive about the BMY pipeline, but that is not the primary concern for an income investor. Since the objective income investing is to not lose money, instead of looking for growth, buying this trust meets some of the highest criteria of safety.

The optimist amongst us may take a look at the common and wonder why take such a conservative approach to very profitable company. Comparing this security to the common shares which as of 2/13 closed at $21.75 and were yielding 5.7%, one might think the opportunity of principal growth is more attractive than the priority given to debt. That may be the case, but in this day of balance sheet surprises, debt holders do not have arbitrary reductions income at the discretion of management. That being said, any jack-in-the-box event should be covered by the cash on hand. Of the debt currently held, the first $2.5B is not due until Oct 2011. Yet there are plenty of areas that have yielded hidden value for BMY. In the 4Q of 2008, BMY generated $582m by selling it's minority stake in ImClone to Eli Lilly when it took over ImClone. In the first IPO of 2009, BMY IPO'd 20% of Mead Johnson, the baby formula subsidiary and the maker of Enfamil, for $680m. The company retained the other 80% of the company and management indicated it would use the cash from the IPO to pay down debt. Moreover, whenever the debt is retired, the shareholders of this debt trust will receive an immediate 11% return on the par value based on the 2/13 closing price.

Bottom line, the debt markets are the safest place to be in this current environment and Big Pharma may be one of the safest industries because in many cases their main payee is government insurance. There is no need to buy a 3.5% Treasury bond for 30 years or suffer principal losses in equities when solid securities like these offer 6.5%+ yield, the highest capital priority, and a shorter time horizon.

The author is long XFR at $22.35 with a 7% current yield.

XFR Description:

SECURITY DESCRIPTION: Lehman ABS Corp., 6.25% Corporate Backed Trust Certificates, Bristol-Myers Squibb Debenture-Backed Series 2002-18, Class A-1, price to the public $25 per certificate. Underlying securities are the 6.875% Debentures due 8/01/2097 issued by Bristol-Myers Squibb Co. (NYSE: BMY). The certificates pay 6.25% ($1.5625) per annum distributions semiannually on 2/1 & 8/1 to holders of record on the day immediately preceding the payment date. Certificates are callable at the option of the call warrant holder on or after 10/31/2007 at $25 per certificate plus accrued and unpaid interest. Certificate ratings at the IPO were AA by S&P and Aa2 by Moody's. Lehman ABS Corp. is an indirect wholly-owned subsidiary of Lehman Brothers Inc. (NYSE: LEH).

Monday, February 16, 2009

Don't fight the Fed, yet

There has been lots of chatter about the recent drop in the 30 year bond price. The debate is focused on “Is the Fed still in charge of monetary policy?” or “Is there really an deflationary scenario unfolding that justifies this currency debasing through debt?” For investors looking for low risk gains, this great theoretical debate provides ample opportunity to make a profit.

There are lots of solid alarmist reasoning from a theoretical point of view like the overall amount of debt, the increased frequency of Treasury auctions, etc. If we were debating in my college Econ 101 class, the idea of massive stimulous financed by lots of long term debt with the current outstanding account deficit would be considered an instant receipe for disaster in a perfect system. Sure, there is an increasing risk that we will hit a magical limit of borrowing and foreigners will flee and put their money under their mattress. But this is reality and the world does not operate according to models.

First of all, in the world of investment choices for sovereign nations, there are really very limited choices regarding where to put major currency. The Japanese economy is currently declining at a 13% annualize rate and heavily dependent on exports to suffering economies. The European banking system is still unraveling and considered to be insolvent. With this in mind, and a limited amount of canned beans, shotgun ammo, and gold bullion available to buy, the Treasury bond market will still see a thriving business.

The Chicken Littles love to tell stories about how the Chinese, Europeans, and Oil Barons are crazy for buying 30 Year Treasury Bonds at 3.5% and will soon take their money home for domestic investment for higher returns. This logic is flawed for two reasons. 1) A purchase of Treasuries increases in return if a government believes that it’s home currency could possibly devalue versus the USD due to global deflation. In such case, the USD denominated Treasuries provide a highest quality hedge for against any internal stability risk and also against lagging relative performance versus the US economy. 2) The second reason is because of the Federal Reserve's power as a market maker. Besides the Fed Discount rates, the Fed also has the ability to control rates buy choosing where on the yield curve it issues debt, or “paint the tape” as it is called.

From Across the Curve, Feb 4th, 2009 “The Treasury did announce that they will auction $32 billion 3 year notes, $21 billion 10 year notes and $14 billion Long Bonds next week. That package is in line with street estimates.

What was not in line was the profile of the new 7 year note which will be auctioned at the end of this month. Most street analysts had anticipated that there would be a 7 year note and it would be issued quarterly. The Treasury opted for a monthly 7 year note. The private sector Treasury Borrowing Advisory Committee has recommended that the new note should be auctioned for $15 billion at its initial offering at the end of the month.”

So although the amount of debt overall and amount debt sold over the next few years may increase greatly, the notes sold at the shorter maturities will probably be the bulk of the issue, not the 30 year. Thus the Fed will be able to use the proportionately small amount of 30 year Treasuries to request higher bids for the debt.

This is a significant event, and a prudent market move by the Treasury. It is easy to see a sizable profit margin in selling 3-yr, 5-yr, or 7 yr debt when one views the medium term view to present scenarios of zero to even high single digit deflation. For the Chinese, buying up these medium term instruments provides a high degree of safety and a high yield for a negative interest rate environment.

As much as you may not like it, or if it breaks all of the old rules of investing that you have learned, in short term, the Treasury will be able to issue more debt to fund even larger government economic initiatives. Yet we cannot increase or deficits too much or we face a situation where we will debase our currency.

What is an investor to do to profit from this situation?

There are only really two acceptable outcomes on which to base trading positions: 1) The Fed is on the brink and foreigners will flee in the immediate future 2) The Fed still has fighting power, even solid demand, and will have a linearly increasing chance of a day of reckoning in the unforeseeable future (foreseeable meaning a year or less in this chaotic environment).

In the case you are in the #2 camp, then like me, you need to go long TLT. Even with the new stimulus package and the plethora of financial stability programs du jour, the government will only have spent 40% of GDP. This is a comfortable deficit number considering the situation, according to economists like Paul Krugman and Mark Zandi. Thus in the short term the Fed will make purchases and bring the 30 year down to make house prices affordable using 30 year fixed instruments. With all of this uncertainty long term, that is all you need to know. Sure, there will be TARP 2.0, 3.0 and probably 4.0. But this is speculation for the next Federal budget cycle, and can only be addressed through futures or long term options. In the meantime, benefit from the Fed effort to manipulate the long term rates and let the future worry about itself.

Thus the author expects the Fed to bring Treasury 30 year rates down to 2.5% to enable the mortgage market to provide financing at a desired 4.5% 30 year fixed rate.

The author is short TLT $94 JUN 09 puts at $3.3 and long TLT $91 JUN 09 puts at $2.25.

The author is also long TLT $105 SEPT 09 calls at $5.5.

(Each investment will be treated as 50% of the total position)