Alan Schram's  Instablog

Since March 2009, the Federal Reserve bought $1 Trillion of Mortgage Backed Securities and $300 Billion of Treasuries.  It did that by printing cash.

 

We are the only country that has the privilege of paying our considerable debt by printing our own money.  This is a great privilege, but it must not be abused.

 

The 1^st rule of holes is, when you are in a hole, stop digging.  We got in trouble by borrowing too much, and the solution cannot be borrowing even more.

 

Yet the U.S. is pursuing policies that guarantee inflation and a weak dollar.  The purchasing power of cash is being eroded; and fixed income does not perform well in inflationary cycles.

 

So where does one find shelter when paper money is constantly diminished? 

 

I would argue large cap stocks have the best prospects to be an effective shelter.  Since the March lows, the 20% of stocks with smallest market capitalizations have on average outperformed the 20% of largest stocks by 72 percentage points.

By contrast, in the first nine months of all bull markets since 1926, the average outperformance of the small-cap sector was just 21 percentage points.

Only once since 1926 have the first nine months of a bull market produced a gap greater than this year’s. That was in the bull market that began in February 1933, in the middle of The Great Depression.

The reason to this phenomenon is the gigantic stimulus program.  By reducing the danger of incurring risk, the government encouraged huge risk-taking, and now over levered junk is beating financially solid quality.

The opportunity today is therefore in defensive, liquid, high quality, and still cheap large cap stocks.  Many large cap stocks are still flat for the year, despite the market’s rally.

Wal-Mart trades at a P/E of 14.  That implies a 7% earnings yield.  In addition, it has organic growth of about 2%, plus it regularly raises prices with inflation.  So you get a 9% yield, plus inflation, investing in a company with a strong brand and dominant industry position.  That is an attractive proposition compared to the 3.6% yield on ten year government bonds, which are NOT indexed to inflation.  And Wal-Mart’s finances are arguably better than those of the US government.  Incidentally, Wal-Mart is down 3% year to date.

 

Supermarket chain Safeway is another example.  Although its industry is tough and ultra competitive, Safeway’s stock is cheap.  The company will generate $1.4 billion in free cash this year.  With $8.5 billion market cap, that implies a cash yield of 16.5%.  Safeway is growing, very well managed, has a strong brand and pays a 2% dividend.  It also has considerable real estate: Safeway owns about 40% of its 1,739 stores.  Inflation lets Safeway raise prices and simultaneously devalue its fixed cost liabilities, so the company should benefit from an inflationary environment.  And the stock is down 10% year to date. 

 

The past decade has been incredibly productive.  Technological innovations from the Internet to Biotech have leapfrogged the entire world beyond what most people could even imagine only a generation ago.  Just think how much less productive would your own life be without Email or Google.

 

Yet the past decade was also a lost decade financially.  The S&P 500 has shown a negative return for the past ten years.  All this innovation has not yet benefited investors. 

 

Throughout U.S. history, a down decade was always followed by significant outperformance. I believe the coming decade will not deviate from that precedent.  And large cap stocks will likely close the historic gap in valuations, outperform small caps and protect investors from the vagaries of an inflationary environment.

Asset allocation has been a vexing issue for investors recently.

Because of our expansionary monetary policy (low interest rates, printing money) and stimulative fiscal policy (unprecedented budget deficits), inflation is inevitable.  Fixed income is not the place to be during inflationary cycles because bonds are pulverized under the pressures of inflation, as does the purchasing power of their coupon payments.  As an asset class, bonds are currently misunderstood and mispriced, with more risk than appears at first glance.

What about real estate?  At the end of the first quarter of 2009, about 27% of all outstanding mortgages in the US had negative equity, and that number may double before the housing market stabilizes.  Some experts expect half of commercial real estate loans to be in default by next year (compared to a historical average of just 4%).  Moreover, they expect severity of losses to be 40%, vs. a historical loss severity of just 10%.  Those numbers are truly staggering. 

People are now “strategically” defaulting even if they still have a job, as they lost hope of recouping the purchase price of their home, and can now rent a similar house at a price lower than their mortgage payment.

In addition, most banks do not have enough reserves to cover their losses from real estate still on their books.  If they took the appropriate marks on their loan books, they would probably be insolvent.

This will be a different kind of inflationary cycle.  The dollar will decline, but Real estate prices will not be going up because few property owners can raise rents right now.  

In contrast, the spread between stocks and bonds prices is the widest it has been in four decades.

Since stocks and bonds are always in competition for investors’ money, it makes sense to monitor the relationship between bond yields and stocks’ earning yield (the inverse of a P/E). That relationship has a major impact on equity prices.  When you can buy a stock with an earning yield equivalent to that of a similar credit quality bond, the stock is more appealing because it gives you both the earnings yield and the growth of earnings over time, whereas a bond has interest payments that are fixed and aren’t even protected against the eroding power of inflation.

Even after this year’s rally, many stocks are still reasonably priced.  Warren Buffett says if you buy stocks when the total market value of US stocks is 75% of GDP, you are likely to do well over time.  We are there now, and there are unique, high quality opportunities selling at bargain prices.

For example, Wal-Mart’s earning yield is 7%.  Add their 2% growth rate, and you have a 9% “coupon”, plus inflation (Wal-Mart raises prices in line with inflation).  Compare that to the 4.5% coupon on US government bonds, or even to the average corporate bond yield of 6.17%, which are without inflation protection, and Wal-Mart seems very attractive.

Wal-Mart is currently down 7.5% for the year.  Other large cap stocks present a similar opportunity, as this year’s rally skipped them.  Johnson and Johnson is flat for the year.  Berkshire Hathaway is up less than 5%, and all three are unlevered, well managed and very reasonably priced.  This is the best risk/reward proposition available to investors right now.

The stock market has a history of appreciating 31% on average in the year following a bear market bottom.  I obviously don’t know what the indices are going to do in the short run.  But I happen to think that the panic selling crescendo in March 2009 was a generational bottom for stocks.  We will not go back there even if the economy double dips. 

March 2009 may be analogous to 1942, when the market averages bottomed and started a rally that lasted a full generation.  At the 1942 bottom, the Dow was at 100.  In the late 1960’s, it was at 1,000.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm (email at aschram@wellcappartners.com).  Wellcap is long WMT, JNJ and BRK.

What happened at Citigroup last week was very interesting.  They sold their Phibro commodities unit to Occidental Petroleum for $250m.  That is a pittance.  Phibro had average earnings of $371m in the past five years.  The sale price is actually below Phibro’s net asset value.  So why would Citi give its assets away at such bargain basement level? 

They had to do this deal so they could mollify the public’s anger with the $100m contractual bonus Phibro had to pay star trader Andrew Hall. This is the result of government involvement in business, because it is too embarrassing to pay someone a bonus he will be paid anyway (similarly, pay restrictions at AIG led to massive departure of senior staff, and that couldn’t have been beneficial to the value of tax payers investment in AIG).  

This is indicative of the feeble management at so many of the nation’s banks and financial companies.  There are other examples, chief of which is the perplexing manner in which they construct their balance sheets.

Gerald Ford is an authority on banks, given that he made over $1 billion investing in banks and financial companies during several market cycles (he bought his first bank in 1975).   The well respected Ford recently told Forbes magazine (for its Forbes 400 issue) that even now too many banks haven't put enough money in reserves to cushion losses. If they took the appropriate marks on their loan books they would be insolvent, says Ford.

So instead banks are stalling, in the hope that an economic recovery, coupled with a steep yield curve, would boost their margins and save them.  This is not new, as banks have pulled similar tricks in almost every previous credit cycle.  But now, regulators are also complicit in that they are dragging their feet on seizing weak banks.  So far, 416 banks were put on the Federal Deposit Insurance Corp.'s troubled list.  But many more should be added. 

At the end of June, Citigroup was levered 12:1.  Other banks have similar debt ratios.  If it turns out that consumers are too extended and the recovery proves tepid, or the economy stalls again, many more struggling banks will fail.  A new wave of losses from commercial real estate loans could also get more banks in trouble, not to mention all these mortgages where the borrower isn’t required to pay down the principal, and often can’t even keep up with the interest accruing. Recall that as of the end of the first quarter of 2009, about 14% of all mortgages had negative equity, and that number may double before the housing market stabilizes. 

Poorly managed and over exposed, banks are not a very safe place for investors to be.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at aschram@wellcappartners.com.