Is It Safe?

That question is a vital one right now, even though every time it is asked, I think of Laurence Olivier asking it to Dustin Hoffman in "Marathon Man."  Clearly there has been some very important progress on the policy front.  After weeks of delay -- as we started with an awful plan and struggled to make it mediocre -- we finally decided to do the right thing.  

Fortunately, "the right thing" was included as an option in the struggle to make it mediocre.  Injecting cash directly into the balance sheets of the big systemically important banks and taking ownership stakes in return is exactly the right medicine to stabilize the financial system.  The second major initiative is to guarantee interbank lending.  Think of it this way: the buying of big chunks of preferred stock is aimed at fixing the engine, the guarantee of new interbank loans is designed to fix the transmission.  

Is it enough?  Will it work?  Does the car also have three flat tires and is out of gas?  It's hard to say right now.  The stock market was certainly encouraged.  What it means is that we are now, in all probability, looking at tough times reminiscent of the early 1980's, not at tough times reminiscent of the early 1930's.  Did the early 1980's suck?  Oh yeah.  Were they far better than the early 1930's?  Big time.  We have a nasty worldwide recession already baked into the cake.  Finally, however, we have decided to turn the oven off.

To shift metaphors here, the stock market is the barometer, it is not the storm.  Has the storm subsided?  It was impossible to tell on Monday since the true storm is in the credit markets and the bond market was closed.  The early indications on Tuesday were that it has helped, but only a little bit.  The storm is still blowing, but its intensity has diminished a bit.  It is down from a Category-5 to a Category-3 storm.  

For example, the TED spread (the difference between the yield on interbank lending and T-bills) has declined from 4.57% on Friday/Monday to 4.28%.  Is that good news?  Yes, but it is still an awful reading.  To have any confidence that the storm has abated, we really need that spread to decline to under 1.0%.  Under completely normal circumstances it is less than 0.50%, especially given the low overall interest rates (a 4.28% spread is much more significant when it is 4.50% vs. 0.22% than when it is 14.50% vs. 10.22%).  However, even after the storm stops blowing we will have to go out and survey the damage, and the damage to the real economy is already extensive and severe.

The market was clearly very oversold on a technical basis, and the selling had be indiscriminate.  Good firms -- with solid balance sheets, with no need to access the credit market and products that people will continue to buy in hard times, and fat, well-covered dividends -- were getting trashed right along with companies that are knock, knock, knocking on heaven's door.  

While we may have seen the bottom on Friday, I strongly suspect that we will go back down and retest those levels.  The next decline is likely to be more slow and grinding, and will separate out the weak companies from the strong.  I have no doubt in my mind that earnings estimates for the fourth quarter and 2009 are far too optimistic, and will be cut dramatically over the coming months.  We are already seeing the cuts take place, virtually across the board.  Over the last four weeks, almost four estimates for 2009 earnings have been cut for every one increased for S&P 500 companies, and in no sector has the ratio been less than 2:1.  Most of the increases were leftovers from three or four weeks ago.  

The story is substantially the same for 2008 earnings.  Yes, P/Es based on current expectations are low, but they will rise as the expected "E" declines.  There will be many more dividend cuts than increases over the next year, so the fact that it is easy to find stocks with dividend yields far in excess of what government bonds are yielding is cold comfort.  However, the decline in earnings estimates will not be uniform across the board.  Not all companies will cut their dividends, and some may increase them.

For a value investor, the sell-off over the last month should leave you feeling like a kid in the candy shop (albeit one whose allowance has recently been cut).  Look for the right sort of companies that have been beaten down.  Strong balance sheets first and foremost.  Products that are needed (not just wanted) second.  High, well-covered dividend yields third.  

I would continue to avoid the Financial sector.  Quite frankly, with the mark-to-market rules eased, it is impossible to know if their books belong on the fiction or the non-fiction shelf.  They will be diluted, and frankly should not have the right to pay anything in the way of dividends.  The term "fraudulent convenience" comes to mind when thinking about a bank paying a dividend.

I would avoid the retailers, with the possible exception of those that fit the "inferior goods" theme.  Examples of this would be Wal-Mart (WMT) and Costco (COST).  This is going to be a Christmas controlled by the Grinch, not Santa.  With the housing ATM gone for the foreseeable future, and virtually nothing in the way of savings, consumers will have to cut back.  The mid-priced retailers will be hurt most of all.  Firms like J.C. Penney (JCP), Kohl's (KSS), Gap (GPS) and Macy's (M) come to mind.   Drug stores like Walgreen's (WAG) and grocery stores like Kroger's (KR) would be places to hide out if you simply must have a retailer in your portfolio.

Despite the decline in oil prices due to falling demand, I still like the Energy sector.  Think about the consequences if demand for the major oil services firms or the offshore drillers were to decline.  It would mean an acceleration in the decline of world oil production, and would permanently cripple any hope for an economic recovery down the road.  This is a fantastic opportunity to invest in names like Halliburton (HAL), Baker Hughes (BHI) and National Oilwell Varco (NOV).  The deepwater drillers have their earnings virtually locked in for the next three years, and yet are trading at P/Es that suggest that their earnings are about to go over a cliff.  This is the time to be buying names like Transocean (RIG), Diamond Offshore (DO) and Pride (PDE) with both hands.  

The major drug companies are also a great place to look for bargains.  Pfizer (PFE), Merck (MRK) and Bristol Myers (BMY) are good examples of the bargains that can be found in this area.

Posted By: Dirk van Dijk, CFA

Comments

[Evan Grey Owl:]

Here is how to make the little car run: Open prices at yesterday's closing price. Do not allow unregulated trading in the pre-market and post-market, or rigged bids at the opening cross, to dictate the opening prices. Second, there must be limits on the degree to which a bid may deviate below the current trading price. Rigged bids are being used to trigger all the stop-loss orders. Finally, NASDAQ rules need to be changed to require that an actual trade is required to trigger stop-loss orders, so that a bad bid alone cannot be used to trigger all the stop-loss orders. There is going to have to be more public monitoring of the minute-to-minute details of daily trading, and more insistence that orderly markets and a fair and level playing field be maintained. Only then will confidence come back and technicals come to mean anything again.

2008 Oct 15 08:07 AM

[john s. gordon:]

enrico - well said.
> jack

2008 Oct 15 08:37 AM

[MSmailbox:]

"What it means is that we are now, in all probability, looking at tough times reminiscent of the early 1980's, not at tough times reminiscent of the early 1930's. Did the early 1980's suck? Oh yeah."

Hmm... I'm getting 3.3% on a large CD. I had a small CD, back then... It was 11.5% on a 6 month maturity. I will never for get that... 11.5%. :-)

2008 Oct 15 09:40 AM

[Shiv Kapoor:]

I agree with energy and oilfield services and drillers have sound long term fundamentals. But we are nowhere near the point at which an investment makes sense. There is huge demand for drilling rigs capable of deep and ultra deepwater work. The supply of such vessels was just not there and so several 3rd, 4th and 5th gen rigs have enjoyed super normal day rates. During the past cycle, there have been large investments in building of jack-ups, semi-submersibles and drill ships. Several of these are spec builds, while many are built with underlying contracts. I have no doubt that the fantastic backlogs will pay for these assets and leave behind a high quality fleet largely paid for with modest debt remaining on the books. But all of this is priced. What is not priced is a return to long term margins once day rates fall because utilization will fall with the coming of a huge fleet onto the markets. While healthy demand is a given, fleet supply will be in place to match demand. During y/e 12/31/04 net profit as a % of revenue was under 1%. By end 2007 it has risen to 51%. The long term profitability of the sector once fleet supply and demand are in balance is roughly 15%; add to that significant moderation in day rates - rates will fall very significantly once supply and demand are in balance. Expectations of long term growth need to come down to earth. Transocean is an absolutely brilliant company; top management, top engineering talent, top asset quality; the company has every reason to be proud. It is a good buy once the valuations make sense. Just now we are nowhere near that point; I would not be surprised to see a 50% cut from where we are today on bearish extremes.

2008 Oct 15 09:42 AM

[MSmailbox:]

I agree, that the banks shouldn't be paying a dividend, at this point in time. When you are receiving "assistance" from the government, it doesn't look good, passing it through to just the banking sector. This is preferential treatment... Taxes will increase for investors in every sector, to pay for this, so investors in the banking sector should not be the only beneficairy of a "pass-thru" dividend.

2008 Oct 15 09:51 AM

[yank:]

Shiv:
I generally agree with everything you said except for the RIG comments. If you look at RIGs valuation with a PEG of 0.4 and other metrics, it suggests a forward oil price of $25-30. Is that realistic? I don't think so. In all the hysteria this week about oil demand destruction the news out of China yesterday went completely unnoticed. They imported a record 20 million tons of oil in September, a 10% increase yoy. So much for demand destruction. RIG is basically being given away at these price levels. The full value of this stock is around $160, making it a "double from here.

Newby

2008 Oct 15 10:02 AM

[Shiv Kapoor:]

Yank - I do not see oil falling below $50 on a worst case scenario for the next several years. What I do see is global rig utilization dropping to 85%-90% levels once new rigs start becoming available (roughly 2012).

When the utilization hits these levels, day rates are hit very hard (a 50% drop in average day rates from peak to trough is common place). At this point in time, cost management is important, a lot of it happens automatically as variable pay elements come down drastically. Because Transocean is an exceptionally well managed company, you can look for long term margins to be preserved at 15%-20%. But on a lower revenue base this hits EPS hard. Day rates tend to stop falling once some rigs are removed from the fleet through cold stacking. Transocean has strong backlog which will cover it through 2011, even 2012; its after that I am concerned about. Analysts closely monitor utilization, new builds and day rates and the minute you see clouds on a falling backlog build you will see an exodus from RIG (clouds gather on distant horizons once the rate of backlog growth starts slowing - that has started and should start escalating pretty soon). The Jeffries Report is an excellent source of information for an industry review but it is expensive. Have a look at the prior price history of drillers during the 98 time period it went from $60 to $20 over 10 months; during 2000 it went from $65 to bottom at $18. Now I am not suggesting the same will re-occur; it is a different time, energy has just started a huge secular up-move, but a panic bottom of $40-$50 can happen before it moves up again. I do not expect this to happen because I think the backlog will carry Transocean through this downcycle; but it would not surprise me if it did happen - simply because it has been the nature of the industry. I have absolutely no doubt that Transocean will trade at $160 again. But I do believe there will be better price points to enter. I do see value now and it is certainly worth a nibble, but not yet time to bet the bank in my view. RIG has had a relatively long timewise correction since it peaked in Oct 07; it should complete its unwind pretty soon now - for me its a buy at $75, a strong buy at $65 and a bet the bank at $50. I would be much happier if they kept the tentative special dividend as I feel they are somewhat over-leveraged (though the backlog should cover debt nicely).

FYI - my past experience is with oilfield services (SLB) & drillers (RIG); both are top in their respective fields, both class employers, both with top notch management.

2008 Oct 15 12:22 PM

[Blueknight:]

Yank.....astute observation...logicall... there should be a great trade on RIG in here. My experience, sadly, is that being right does not always make you money...the trick is knowing what the market will do before it reacts. Then there is the OBamma factor which also hurts prospects here.


On Oct 15 10:02 AM yank wrote:

> Shiv:
> I generally agree with everything you said except for the RIG comments.
> If you look at RIGs valuation with a PEG of 0.4 and other metrics,
> it suggests a forward oil price of $25-30. Is that realistic? I don't
> think so. In all the hysteria this week about oil demand destruction
> the news out of China yesterday went completely unnoticed. They imported
> a record 20 million tons of oil in September, a 10% increase yoy.
> So much for demand destruction. RIG is basically being given away
> at these price levels. The full value of this stock is around $160,
> making it a "double from here.
>
> Newby

2008 Oct 17 01:22 PM

[Blueknight:]

Any thoughts on when the energy trusts like pwe, pbt, etc are right to buy. The divs are great and nat. gas is not going out of style any time soon. Deflation fears and falling demand are cons, I know, but at these prices they are tempting

2008 Oct 17 01:31 PM