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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