Sunday, March 31, 2013

Leadership Change Late in the Game

Regular readers of these posts already know that I have been prematurely speculating about the risks of a top of the market. Most securities analysts date the last important bottom as of March 9th, 2009. Almost exactly four years later, the Standard & Poor’s 500 Index (S&P500) reached a new high on the last trading day in March, 2013. Market cycles vary in length from bottom to peak, but generally they are in the 40 month range. (One of the sounder investment management organizations uses a rolling four year period as the shortest benchmark for its internal incentive compensation.)  Each market cycle is a bit different than those of the past, but they have many of the same characteristics. Most often on the rise up, the sectors that lead make sense as they come from deeply discounted price levels. In this particular case the second best performing group from the market cycle bottom was the financials, a group that is of particular interest to me. (I believe that a market boom needs to excite the owners of financial shares. With that thought in mind, I manage a private financial services fund that has been enjoying this rise because among the financial leaders within the S&P500 were Discover Financial, McGraw Hill, American Express and AIG. All of these, I have owned for many years.) 

Buyers need a quantity of sellers before they can push stock prices higher. The coming week or weeks will likely supply some sellers and some will say the doubling off the bottom is enough. Others may feel that after low double digit gains in the first quarter, the time would be right to lighten up on their positions. They would be urged to do so by those who insist that there should be a tight correlation between the prices in the market and their generalized view on the domestic and global economy. (As long as there are numerous economic pundits that are somewhere between wary to negative on the market, I can take a relatively relaxed view of the future for long-term investment accounts similar to what we manage.) 

The drivers so far

Arranged by the leading central banks, the best thing driving the stock market higher is the impact of the banks’ experimental policies to force interest rates to confiscatory levels. These efforts have done much to the maligned credit ratings which have proven on balance to be correct in the long run. Recognizing that it is almost impossible for a credit rater to speculatively lower credit ratings, they do provide a useful purpose of confirming current opinions as to the chances of timely payment of principal and interest. At the top of the credit rating pyramid is the Nine-AAA league composed of the sovereign debts rated AAA by S&P, Moody’s, and Fitch. According to the Financial Times the size of this pool has shrunk by 60% from $11 trillion to $4 trillion since the beginning of 2007. (US, UK, and France are no longer AAA rated.) The size of the drop is first a measure of the scale of the combined fiscal and monetary overreach by governments and the sharp reduction of the size of the pool of so called totally risk-free assets from a credit standpoint. The message delivered to investors is that there is relatively little in risk-free assets available, so if you want to earn a somewhat reasonable rate of return you must assume other risks in the bond and stock markets. 

As many of you probably already know, I spend a great amount of time analyzing mutual fund data. I do not pay much attention to the net flow data that combines the dollar totals of sales and redemptions, since I believe that the motivations behind each stem from very different needs. I do pay attention to gross redemptions. According to the Investment Company Institute (ICI), gross redemptions of equity funds in the first two months of 2013 declined $12.7 billion to $224 billion whereas gross redemptions of fixed income funds rose $21.6 billion to $ 141.9 billion. Strategic Income funds rose $12.8 billion in redemptions for the year to $65.7 billion, followed by increased redemptions in high yield and government funds. The Strategic Income fund bucket includes those fixed-income funds that can move from one type of fixed-income market to others. I believe that the shareholders are concerned that they were not exiting governments and high yield fast enough. My guess is that these figures are just showing a bit of nervousness on the part of some mutual fund holders; the largest single category of redeemer was institutional investors who redeemed $158 billion up $29 billion from the first two months of 2012. These numbers do not support the much-heralded great rotation out of bonds into stocks. I believe that thus far the biggest single contributor to the increased gross sales of equity funds is coming from a $121.8 billion increase in money market redemptions to a total of $2.4 trillion. Thus there is a reasonable chance that when individuals and their managers recognize that for the moment they shouldn’t fight the Federal Reserve, they could commit their assets that may well drive the stock market higher. Or they could decide that the risks are too high already in stocks. 

Need for new leadership

On the rise from the 2009 bottom, the leading large portfolio funds have been managed by value-oriented managers. They have bought and owned stocks of companies that were statistically cheap using the company’s financial statements as a guide. This is one of the reasons that the financials appealed to these portfolio managers globally. Many of these stocks were yielding an above stipulated inflation rate or would if permitted by the central banks. Other stocks that were found in these portfolios had rising operating and before tax margins. This was mostly achieved by capital and labor efficiencies in spite of limited sales growth. Without a global pickup in sales many of these companies will not be able to show earnings growth. This is exactly the problem facing those who need the stock market to move higher between now and the next Congressional elections. 

Possible new leadership

With fewer and fewer high quality bargains available the value-oriented investor is finding it is difficult to identify new large names. At the same time a growth-focused investor is being limited by the expected lack of volume growth. One possible area for future strength is broadening the concept of value beyond statistical value based largely on reported financial statements. I am suggesting an old merger & acquisition gambit of searching for strategic value.  Strategic value rests on a well-researched view of significant change. In an oversimplification, one could look at these opportunities through the eyes on the cash flow statements or a materially different earnings structure.

One of the key questions is: are there significant opportunities for the company and its peers to materially reduce their capital expenditures? As a relatively young analyst I spent time with an older leading analyst of aluminum producers. He became bullish on these stocks when the companies were shutting down the hot lines and factories. His bullishness was based on the idea that with less available competitive capacity, demand would force prices up until the next wave of expansion would take place a few years in the future. Airlines have followed a similar strategy through their mergers to reduce excess capacity. In a minor way we have seen a similar thought pattern in the financials, with the waves of expanding and contracting fixed-income trading and branch building. The final objective of these strategies is to use cash flow to pay off debt, pay dividends and shrink the number of shares outstanding. Some practitioners of these art forms have produced brilliant results. To some degree the asset allocation skills of Warren Buffett and Charlie Munger at Berkshire Hathaway* and those of Leucadia* fit into this model.  

Currently on offer are two very different investments with dramatic change elements. The first, alphabetically, is Dell. The question here is whether a change to a more patient capital structure and/or change in management can produce good long-term results. While it is possible, I personally have my doubts, as the original driver of these discussions was an embarrassed (or should have been embarrassed) shareholder. Those involved are more financial engineers than sustainable company builders. I could be wrong and this type of shareholder action could become a model for the new leadership. There are lots of candidates for this kind of operation, but not without risk.

The other stock on offer and somewhat a competitor to the first is Hewlett Packard which likewise has been gravely wounded by the computer wars and unfortunate acquisitions. The difference is that the current CEO is in an announced five year turnaround plan. She has solid marketing and management experience. I believe that it is clear that the future company will not be producing the same products if at all or in the same way.   

While less attractive to me is what I have called “the three M” Strategy. The three “M”s stand for McKinsey, (a consultant with a dubious track record of success; e.g., Enron), Merrill Lynch and Morgan Stanley*. The two financials have used the consultant to provide cover for what their managements wanted to do and have hired former McKinsey partners. Both of the two operating companies are trying to improve their balance sheet by selling off elements of their empires to improve their balance sheet ratios. They are doing this rather than materially improving their products and delivery systems. Nevertheless, they may well succeed; I hope so, as they have a number of talented people on board.

Each of the three alternatives to build increased strategic value could be part of a new market leadership which I think is needed to go from the newly established highs to materially higher stock prices. 
*Owned in both my financial services fund and personal portfolios

What Do You Think?
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