"America can always be counted on to do the right thing, after it has exhausted all other possibilities." - Winston Churchill
The recently passed $700 billion bailout bill does contain the authority for the Government to buy new preferred stock in troubled financial institutions. At yesterday's news conference, Secretary of the Treasury Henry Paulson indicated that he might just do that. This would be following the lead of the U.K., which yesterday indicated that they are buying major stakes in its most troubled banks.
This is exactly the approach that will do the most good. The core problem right now is that we have an overleveraged financial system which is trying desperately to de-leverage. When all try to deleverage at the same time, it drives down asset prices, which pushes down equity even further, which actually causes leverage to go up.
Simply buying troubled assets is likely to be very ineffective in such a situation. If a firm is leveraged at say 25:1, with $1 billion of equity supporting $25 billion of assets, then an incremental billion spent buying assets will only reduce leverage to 24:1. On the other hand, injecting that same $1 billion onto the equity side of the balance sheet will reduce the leverage to 12.5:1.
In addition, equity prices are very transparent, so there will not be a question of whether the Government is deliberately overpaying to favor some institutions with more political pull. The "toxic assets" prices are anything but transparent.
Buying big slugs of preferred stock also accomplishes two other critical objectives. First, it gives the taxpayers the best possible shot at actually making money out of this whole mess. Second, it punishes the existing shareholders by diluting their stake. If those that enjoyed the fruits of all this poor lending on the way up do not suffer -- and instead are simply bailed out -- then people will be encouraged to act recklessly in the future.
We knew that the authorization was in the package, but honestly I did not think that this administration would use it. After all, government ownership of major financial institutions, even if only temporary, is pretty much the dictionary definition of Socialism. I was hopeful that the next administration would, however, and am very happy that Paulson has come to his senses and seriously considering such a move.
The coordinated rate cut last week by most of the major central banks of the world was also the right thing to do. The question is: Is it enough? There was a little bit of evidence that the credit markets were becoming unstuck, but it was tentative at best. The longer the credit markets are frozen the worse the damage will be on Main Street. A nasty recession is pretty much already baked into the cake, but a depression is not.
The market is deeply oversold, and is already 35% off of its highs, which is worse than the average bear market. Then again, the system is in far worse shape than in your average bear market situation. Still, I would expect at least a short-term bounce in here soon. It may be a deceased feline, but it will be big enough to be tradable. Use the bounce to realign your portfolio.
I would continue to avoid the Financials. Dividends need to be cut or eliminated (preferably eliminated), and instead of buying back shares, companies will have to be selling new shares, either to the government or to other private investors. Current owners of those stocks will be seriously diluted, and we have still probably have several more failures of financial institutions to come.
Consumers are in the process of switching from being borrowers to being savers. That process means that they have to cut back on their spending. The more easily deferred the product or service a firm sells, and the less essential it is for basic living, the worse position a firm will be in. Can the car make it one more year? Yes, probably, so why go buy a new car today? Can you wear last year's fashions and not be cold or naked? You betcha. Spend $60 for dinner for a family of four at a casual dining restaurant twice a week? I don't thinks so. People will eat at home or go to McDonalds (MCD) instead.
Avoid the manufacturers and retailers of such products. Retailers in the middle of the price point distribution such as Gap (GPS) , J.C. Penney (JCP), Macy's (M), Abercrombie & Fitch (ANF) and Kohl's (KSS) are most at risk. Discounters like Wal-Mart (WMT) and grocery stores like Kroger's (KR) and Safeway (SWY) along with Drug stores like Walgreen's (WAG) should hold up better.
On the other hand, are things going to get so bad that you don't buy toilet paper, or let the baby go without diapers? No, I don't think so. Thus companies like Kimberly Clark (KMB) and Procter & Gamble (PG) are good places to hide out, and when they get hit with everything else it is a good time to accumulate them.
The same goes for some of the pharmaceutical companies like Abbott Labs (ABT) and Bristol Myers (BMY). While people are driving a little bit less and that has driven down oil prices sharply from the highs of July.
The price of oil is still well below a year ago, and the Energy sector is the only sector expected to show any significant growth in net income in the near future. Valuations in the group have gotten just plain silly cheap with the sector as a whole (total market cap/total expected net income) trading below 7x 2009 earnings. Most of the energy firms are sitting on fortress balance sheets and are rolling in cash. Stocks to consider are: Conoco (COP), Exxon (XOM), Transocean (RIG), National Oilwell Varco (NOV) and Devon (DVN).
Posted By: Dirk van Dijk, CFA