Malcolm E. Polley - President and Chief Investment Officer, Stewart Capital Advisors, LLC
S&T Bancorp, Inc. (STBA) Q4 2008 Earnings Call January 27, 2009 10:00 AM ET
Greetings and welcome to the Stewart Capital Advisors fourth quarter 2008 market update and outlook. At this time all participants are in a listen only mode. A brief question and answer session will follow the formal presentation. (Operator Instructions)
It is now my pleasure to introduce your host, Malcolm Polley, President of Stewart Capital Advisors, LLC. Thank you Mr. Polley, you may begin.
Malcolm E. Polley
Good morning and thanks everybody for joining us on the fourth quarter conference call to talk about what happened in 2008. And I apologize in advance if I yawn a little bit. It’s because my son got a puppy yesterday, and it kept me up a good chunk of the night.
As I was quoted in our local Indiana paper yesterday, saying that 2008 was a difficult year, was about like saying Hurricane Katrina was a stiff breeze. It wasn’t a fun year for a lot of people, and what we’re going to talk about today is to find out in 2009 if we believe it’s going to be more of the same.
So if you would all turn with me to slide number two. I will start with a little bit of a commercial here. Stewart Capital Advisors, LLC is an active manager of both equity and fixed income portfolios. We believe that risk and return are strongly related and
while there’s nothing wrong with taking investment risks, investors should be paid adequately for taking those risks.
As such, when the fixed incomes (inaudible) rate, pay very close attention to historic yield spread relationships. In our equity portfolios all have minimum long term rates or return expectations built in. We are business perspective investors. In that we mean that business valuation is a central point in our investment philosophy. As we believe that owning a stock is simply nothing more than owning a piece of a business.
And since we’re buying a piece of a business we want to behave like business owners. And because we behave like business owners, we want to find business managers with which we can be a long term partner. When we buy a stock we expect to own it for a minimum of three to five years.
We have several products and styles including all-cap and mid-cap equity income. On the equity side, taxable fixed income style. We have the Stewart Capital Mid Cap Fund, ticker symbol, SCMFX. We also offer investment research and investment outsource solutions to institutions and community banks.
What I want to cover today is looking back at 2008. I want to give you an economic outlook for the coming year, look at interest rates and bond markets, and finally talk about equity markets and wrap up with questions.
2008’s equity market suffered its worst decline since the 1930s. All major equity industries were down in excess of 30%, with the biggest decline coming from the international markets, (inaudible) was down more than 42%, thanks primarily to a decline in equity markets where the strengthening of the dollar was kind of a double whammy for unhinged international returns.
Bond markets suffered through a credit freeze. Metal suffered a decline in prices. Gold was up 2.81%. Although, depending on what you’re looking at, it could have been up marginally. Copper was down more than 50%. Silver was down a little over 8% in 2008.
While oil went up to $247 a barrel in early summer of last year, and there were some expectations for near $250 a barrel, oil ended 2008 at approximately $40 a barrel, and so the energy market saw a significant collapse as the year moved toward its close.
And in November of last year, the NBER declared that we were officially in a recession. And by the way, that recession started December of 2007. Something that we have assumed for the last six months or so.
Please turn with me to slide number seven. I apologize for the busy-ness of the slide, but it’s important because what I want to look at is the cause and one of the sub-prime housing problems, which kind of led to the issues we’ve had in the credit market.
What this slide is showing you is the home ownership rate from 1968 to current. There are two important periods of time, pre-1997, and then that entire period, 1967 to 2008. The dotted lines represent the average and standard deviations as of between the years 1968 to 1997. The bottom dotted line represents the average home ownership rate from 1968 to 1997, roughly 64.3%.
The next three dotted lines above that represent one, two, and three standard deviations from the mean. And that top dotted line represents six standard deviations from the mean. The solid lines represent the period of time between 1968 to 2008, 40 years of home ownership rates.
The bottom solid line, that green solid line, represents the home ownership rate in its entirety, with what I would call the skewed data after 1997.
Average home ownership rate moved up to roughly 65.2%. The next solid line representing one standard deviation from the mean and the top solid line representing two standard deviations from the mean.
The important thing to take away from this is that the vertical line in 1995 marks a period of time. And at that particular point in time, the Clinton Administration asked that Freddie Mac and Fannie Mae expand their definition of what would qualify as a mortgage for them to buy and put into the pool that they purchased them in, secured highest percentage into the securities market. That was a very successful program which really kicked off a major increase in home ownership rate, which is why you have a significant rise in home ownership rate in the years after 1997, peaking at just over 69% in 2004 and 2005.
It’s important to note the data pre-1997 because you’ll note that in the 30 years leading up to 1997, it was only one period of time where the home ownership rate even touched two standard deviations from the mean. That was the period of time roughly 1979 to 1982, where we touched the two standard deviation mark and went back down below the average for that time period.
That’s important for a couple of reasons. One is you note the extreme levels we got to in home ownership rates in the few years leading up to the sub prime (inaudible), and hitting more than six standard deviations from the mean which is, for those of you that aren’t familiar with statistics, three standard deviations covers 99% of all possibilities. So six standard deviations from the mean is such an unusual occurrence, as to be considered basically that it will never happen. Obviously, it did.
The other take-away is if you even include the skewed data, we peak at two standard deviations from the new mean of 65.2% in the period of 2004 to 2005, and we still have not even gotten back to one standard deviation. So assuming those of us looking for a bottom in housing prices, assuming we go back to what would be a normal level, and that would be the next question, what is normal? It looks like we would drop the home ownership rate to around 65%, which is a substantial decrease even from where we are currently.
The issue of where is normal really can tell you what the ultimate bottom is, and that is if we go back to the old normal of 64%, we’ve even got a more significant way to go to drop in home ownership rate. Whether or not we get to that point is another matter.
Please join me and turn to slide number eight, please. This slide looks at the home price index, and it’s not surprising to see that the house price index really closely follows that of the home ownership rate. Going back to slide seven, if you look at looking for the bottom in the home ownership rate, it would definitely lead to believe on slide eight that we have a significant way to go before we bottom in housing prices. Again the vertical line represents that period in time where the criteria for mortgages to be purchased by Freddie and Fannie changed.
Please turn to slide number nine. These are two different pieces of information here. The top graph shows you the percentage of loans and mortgages that are past due. The vertical lines indicate recessionary time periods.
And the first item to note is that typically the past due percentage in home mortgages peaks at or near recessionary period, which would show that we are in a fairly normal circumstance today. The other take-away is you’ll note that we have not necessarily peaked in that percentage of loans that are past due. And you really need a peak in that number in order to get a bottoming in house prices.
The bottom chart really indicates the foreclosure rates. Basically the take-away here is you don’t want to live in an orange state. The foreclosure rate in those states that are in orange runs from 8/10ths of 1% to 2 ¾%, which is a substantially large number. Pennsylvania is relatively in not that bad shape. It kind of falls in a blue area, so the foreclosure rate is running between 2/3rds and ¾ of 1%, and my guess is, as I have not seen the underlying data, most of that coming from the eastern side of the state.
Please turn with me to slide number ten. We showed this in the third quarter conference call, and I just wanted to give this as kind of some more background information. The de-levering problem is significant in terms of the amount of capital that has been taken out of the system. Through the third quarter of 2008 we had a roughly 700 billion dollar decline in commercial paper. We had about an 8 billion dollar decline in consumer credit right down through the third quarter with nearly 400 million dollars.
If you include a 5% reduction in non-financial leverage, you get 1.52 trillion dollars reduction in capital from non-financial leverage. For total capital reduction through the third quarter, that’s 2.6 trillion dollars.
To put that in some perspective, the entire money supply in the third quarter, as evidenced by M2, was 7.64 trillion. So we lost nearly a third of the money supply from a capital perspective and right down through the third quarter, a huge number. What’s not that surprising is that even though the Federal Reserve has taken interest rates to zero or near zero, we have really not seen any dramatic or any move in economic activity, as the Fed is really basically treading water.
Looking at what’s happened in the credit markets, and we’ve all heard that the credit markets are frozen in treasury, and the federal reserve have been acting vitally to try and provide liquidity to the markets. This chart really is to give you an idea of how big the problem is and why the problem really is not going to go away any time soon.
The top two portions of that bar, the black and the light blue, represent corporate debt issuance, high yield and high grade corporate issuance. Everything below that is asset backed, whether its collateralized debt obligations or asset backed securities represented by credit cards or student loans or commercial mortgage backed securities or residential mortgage backed securities.
And you’ll note that the issuance in asset backed securities peaked in 2006 at nearly two trillion dollars. So it’s rather shocking to see that as of the fourth quarter 2008 all that issuance disappeared. There’s been no asset backed issuance per se since the first quarter of 2008. And we really won’t get a noticeable increase in lending activity until and unless the asset backed market comes back to a certain extent. Because it doesn’t matter how much lending the banks do. The banks can not take up the capacity that was provided by the asset backed securities market.
In terms of economic outlook, we’ve gone back through history and looked at, there are really two periods in time in US economic history. There is pre-World War II and post- World War II. There were 21 recessions pre-World War II, with the average recession lasting just under two years, at 21 months. The longest recession oddly enough was not the Great Depression. It was right after the Civil War, 1873 to 1879. That recession lasted over five years.
In the post-World War II era, the average recession lasted about 10 months. So assuming this is a normal recession it would be over. So obviously that’s not the case. The longest recession in the post war era was 16 months, and that was 1974 to 1975. So assuming this is roughly, the current recession is roughly equal to the longest post war recession on record; this recession would end in April of this year. Again we don’t believe that is going to be the case.
Please turn with me to slide number 13. We believe that this will be the longest recession in the post war era. It will probably rival a typical pre-World War II recession. In other words, we expect this recession will last roughly two years, eventually coming to an end at the end of this year, early 2010. The timing and size of the current stimulus package being debated in congress may ultimately determine the length and the severity of the recession that we go through.
Be in mind that even if you get a trillion dollars in additional fiscal spending that, in infrastructure spending, that money probably won’t get released until fall of this year. So you really won’t get any economic activity or impact on that until at least the end of this year.
An economic expansion we don’t believe will begin until late 2009, early 2010. And quite frankly we believe the expansion will be very anemic from historic standards. We think if we get 1 to 1 ½% growth coming out of this recession, we’ll be doing pretty good.
Please turn with me to slide number 14. This is a little bit out of date as this was put together about two weeks ago. Interest rates as defined by treasure rates are unnaturally low, but they are higher than they were in December. Three months yield roughly less than 1/10th of 1%. Two year treasury is at under 1%. Ten year treasury is at around 3%, and 30 year treasury is around 3%.
Fed funds as indicated by the Federal Reserve will remain near zero for the foreseeable future. And we believe that long rates for our purposes, long interest rates are defined by the ten year treasury, will head back above 3%, and potentially touch 4% by year end.
Bonds are providing and have been providing very attractive and competitive returns to stock, particularly the early part of January. Interest rates have come down significantly since then, and corporate spreads have narrowed since then. So they are not nearly as attractive as they were in the early part of this month. But we are getting paid very well to take credit risks. High grade corporate spreads are still roughly 300 basis points ahead over treasury rates.
We expect that treasury rates will move up along the yield curve with the exception of fed funds or short term treasury securities. And commercial mortgage backed securities look very cheap if you paid close attention to credit markets. Municipals look attractive with rates above treasuries; however interest rates in the municipal market are very low. So you will probably get sticker shock looking at the interest rates in municipal bonds.
I had a question asked to me that are efforts to lower mortgage rates fix the housing market, or does it just delay the pain that the housing market goes through?
The lower interest rates in the housing market does not necessarily fix the housing market. It provides a vehicle for which some of the excess capacity can get pulled off the market, but it doesn’t fix some of the systemic problems. And it may delay some of the pain the housing market has to go through.
We are seeing a return in something called jingle mail. Banks refer to it as a deed in lieu of foreclosure, which is a far less expensive route of potentially foreclosing and taking back a house on the market, which may allow the banks to work through some of the inventory a little bit better. But there is going to have to be some kind of right sizing of the housing market. There are simply too many houses and condominiums built for the demand, the real demand that is there. And it’s going to take a while to work through that problem.
I remember driving through northern Texas in the late 1990s and seeing house shells along major interstates, from the housing crisis that resulted from the oil boom in the 1980s. This was a decade later. So it could really very well take quite some time to clean up the housing process.
Please turn with me to slide number 16. Before we get to slide 16, I had another question. Will the size of the anticipated stimulus package have a negative affect on the US credit rating, or will the expansion likely allow us to recover from the debt?
For those of you that have questions, you do have the ability to e-mail. There is an ask a question button on your screen. Please click on that and send a question, and it will come to me as we get through this presentation.
The size of the stimulus package is roughly a trillion dollars on top of a 1.2 trillion dollar deficit, as it was official through the end of calendar 2008. From a keen economic perspective it’s not the size of the deficit itself that matters. It’s the size of the increase of the deficit that impacts whether or not it spurs economic activity. And in fact there are those that believe that it was FDR’s alphabet soup approach, programs in the Great Depression that got us out of the depression. In fact that was not the case. It was really World War II that got us out of the depression. And spending in order to fund our war effort took the deficit up to 129% of GDP in World War II.
In order for us to get to that level of spending we would need to look at not a one trillion dollar increase in deficit but at ten trillion dollar increase in deficit. From my perspective that is mind blowing. I don’t think we need or want to get to that level and think we will ultimately come out of this thing with substantially more modest spending issues.
And I don’t believe that a stimulus package will have a negative affect on US credit rating currently. But it may, and our spending habits have had some concerns from international market places in terms of our ability to pay in the future, not today.
What is helping us right now in maintaining our status is the US is the global reserve currency, is the fact that we have a very stable political environment and a relatively stable economic system, so that people don’t have to worry about whether or not they are going to get their money back, at least as of this morning.
In the equity markets we think that the first quarter of 2009 will be very difficult as we think the market, particularly in late December and early January, had discounted economic recovery way too soon. We refer to this as the Obama bounce, because we don’t believe that we are going to have a pick up in economic activity until the end of this year. And equity markets typically start discounting economic improvement six months in advance.
We think we are probably six months too soon in the market turnaround. Having said that, we think that this year equity returns will be at least okay, low to mid-teens returns from equity markets, which means that from this level you’re probably looking at high teens to low 20%.
Just a little bit of background information, historically, when the market has seen a 50% drop, then the year after that 50% drop, the market has been up 30% plus percent. We don’t think we’re going to get that kind of return at all, but we think that the prospect for decent returns from equity markets are pretty constructive.
Typically, small-cap stocks lead out of a bear market, and we really don’t see any reason for that to not be the case this time, but we would be somewhat cautious. We’d also pay attention to the beginning of your trading rules. There’s some things—these are trading rules that don’t always work, and I would caution that we are not by training and by background traders, but last year they worked and stayed.
The first one is called the Five Day Rule. That is, basically you look at the first five trading days of a new calendar year, and what happens during those first five trading days typically gives you a picture of what will happen for the full year, and last year, we were down in the first five trading days. Had you sold out then, you would have avoided the vast majority of the pain that you incurred for the balance of the year.
The second one is what would be called the January Rule, which is very similar to the Five Day Trading Rule, and that is, typically what happens in the month of January will give you an idea of what will happen for the balance of the year. And last year, January was down. So again, had you gotten out, you would have been down roughly 5% as opposed to being down nearly 40%.
We would caution that these rules don’t always work, and that you get some conflicting signals, and in fact, depending on the market you would look at, the first five trading days were flat to modestly up to modestly down. So it’s not a real clear picture. It looks like, unless we get a massive rally next week, that January itself will be modestly down. So that would seem to indicate that we’re going to have a difficult year in 2009 as we expect.
The last trading rule is what we—is and old trading song which goes, “selling man go away”, and it really has to do with the fact that many people on Wall Street go on vacation in the summertime, trading volume is light, and so you really want to get out of that where bad news can tend to accentuate either good or bad directional movements in the market. Had you sold out in May of last year, and not gotten back in, and typically you would get back in after Labor Day, then you would have only been down about 9% or 10% for the year; again, substantially miss a lot of the major pain for 2009.
Again, we would point out that these trading rules don’t always work, but it’s something worth paying attention to.
In conclusion, in slide 17, as we enter the new year, we are more then a little bit concerned about the outcome. Negative forces facing the economy and the markets are unprecedented since World War II and the Great Depression. There have been a lot of firsts over the last year, market returns, and economic environment unlike that which we’ve seen in the Great Depression.
We don’t believe that we’re facing a depressionary environment, but a very severe recession. We would look at what happened in 2008 and is currently happening. It’s something that was referred to pre-World War II as a bank panic. Bank panics pre-World War II happened with alarming regularity, and we believe that’s what we’re going through right now and unfortunately for us, there are very few people in the market today, active or not, that remember the Great Depression, let alone having traded in the Great Depression.
So that most of us around really don’t know what happened, what it was like back then. Those of us that study history can get an idea, but we weren’t actively trading in that environment. So, in many ways this is a new environment for a lot of people.
Ultimately, economic transitions are disruptive, but ultimately helpful and that’s because we believe that we are in the midst of a global economic transformation, very similar to what happened in the late 1800’s, when back then the United States was entering the Industrial Revolution. We were a developing economic power, and developing military power, and the United Kingdom was really the global, economic, military super-power. We are there today.
We believe that Asia is becoming the global, economic, super-power, which it would become eventually, and we won’t go away, but we won’t lead the Globe as we have in decades past. It’s disruptive, it’s helpful, and you can make a lot of money in these kinds of markets, but you just have to be very careful what you do.
Ultimately, we believe 2009 will be better than 2008, but we think there will be dangers on the horizon.
And with that and slide 18, we would open it up to questions. Thank you.
We will now be conducting the question and answer session. [Operator instructions].
Malcolm E. Polley
While we’re waiting for that, I did get one more question via email, and it was a question of what do we expect to happen with energy? Well, prices rise back up dramatically and gradually. Our expectation on oil prices is that we’ll probably end 2009 in the $50 to $60 a barrel range.
Oil prices, energy prices, do follow global economic activity, so we should not get a dramatic move in oil prices upward unless and until the global economic environment improves. If, on a global basis, we continue to be in a recession for all of 2009, then we will expect that oil prices will probably continue in the same range. Once the global economy starts expanding again, then the supply and demand issues will again take over and we would expect oil prices to rise.
Long-term, and we’re talking probably in the next three to five years, we would not be surprised to see oil prices head back above that $100 a barrel range. They got there much more rapidly than we expected, and we would expect at some point to see them go back to that range, but we will get a bit of a break over the next year or so, until global economic activity moderates.
Are there any questions via telephone?
There are no questions at this time sir.
Malcolm E. Polley
We’ve got another question via email and it asks, what strategy will we pursue this year to take advantage of opportunities in equities and bonds? That’s an interesting question. What we’ve been telling people is that in the fixed income arena that we are paying very
close attention to credit spreads, we’ve always done that, and we will continue to use that approach.
What that has meant is that we were very aggressive in the corporate equity market in late November and December, a little less so in early January, and have a little less attracted to the corporate market as spreads have come down to around 200 basis points over treasury.
We’re also seeing some really strange things happen in a new issue market, which reminds us a lot of what happened in the dot com bubble in the late 1990’s, where if you would have an issue come to the market, it would be several times over subscribed, and you’d end up getting a very small fraction of what you indicated an interest in.
We’re seeing that in the bond market as a corporate issue, or it will come to the market with a 5, 10, and 30 year issuance. It will be seven, eight, nine, ten times over subscribed. We’ll put in for 1,000,000 bonds and maybe get 100,000. So we’re having to substantially pad our order book in order to get even modestly close to the kinds of things we would like to see.
In the commercial mortgage-backed securities arena, which we think is extremely attractive, we’re still seeing spreads anywhere from 500 to 700 basis points above treasuries, and I apologize for the (inaudible), that’s 5 to 7 percentage points above treasuries.
But we’re paying very close attention to the underlying credits. We’d prefer bonds that put secure ties on loans that are 7 years old or longer, and that they’re very well seasoned. We’d prefer loans that are geographically diverse and not concentrated in Florida, California and Arizona. We’d also prefer those commercial mortgage-backed securities that are not concentrated in retail; obvious problem areas.
But we do like commercial mortgage-backed securities because you’re getting a lot of credit enhancement. Usually close to 50% or more in some cases defease, which means that basically the security is based by treasury.
The equity market, it’s all about balance sheet. As I’ve been telling people around here, balance sheet, balance sheet, balance sheet. We have never liked companies that employ a lot of debt in their capital structure. We think that it’s very important that you pay attention to capital structure when you’re buying securities, and that if you can move up the capital structure by buying corporate securities, and debt securities, or preferred stocks, or convertible securities do so.
Particularly if you—looking at convertible securities—if you want equity exposure, and if you’re buying stocks, buying companies that have no debt or little debt or no net debt, and able to finance themselves completely through internal sources. In other words, they can generate the cash internally to meet their capital expansion needs. Because while it is possible to get financing, you have to be at top line credit in order to get financing from banks today, which is not necessarily a bad thing, given a recessionary environment, but it makes the ability to get credit that much more difficult.
So we think that the balance sheet is extremely important, and it’s not specific to any one industry, so there really are no specific industries to pay attention to, other then, as Bill Gross said, “Buy what the government’s buying or buy what the government is investing in”. And those areas should do fairly well.
We also had a question via email; what dangers do we expect and how is S & T planners, Stuart Capital planning to deal with these dangers? I’m assuming by dangers, this is meant by market dangers.
Basically, we are trying to stay away from sectors of the market that are exposed to what we would call event risk. The primary area of the market that’s exposed to event risk is financial services and in fact banks, or companies that have financial services arms.
One caution, in the corporate debt markets, many times you will find a corporate bond where the year looks extremely attractive, but you need to look and see if it’s from the corporate parent, or from a finance company subsidiary; because the finance company subsidiaries are going to have a difficult time financing themselves to fund loans, because most of those companies did it through the commercial paper market, and that market’s still frozen.
So pay attention to financing companies, (inaudible) industrial companies that have financing arms, that it’s a big component of their business we would be very leery of.
As much as we like GE for example, GE has a very large component of their business coming from finance, and they need access to capital and they need to maintain their capital ratios. While we know where the problems are, we don’t necessarily know the extent of the problems, so steer clear of areas that have event risk.
Are there any further questions?
There are no questions at this time sir.
Malcolm E. Polley
Okay. We’ll give you a minute or so to get any email questions if you have any? And as the moderator said, if you have a question via telephone, don’t be afraid to ask, was it *1 sir?
Yes, please press *1 to queue yourself up for a question.
Malcolm E. Polley
If there are no other questions, I would thank you all for attending this quarter’s conference call. Your next call should be three months from today, and we look forward to visiting with you either in person or via email or via this conference call.
Thank you once again for participating, and we’ll see you in a quarter.
Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.
THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.
If you have any additional questions about our online transcripts, please contact us at: email@example.com. Thank you!