This week marks the eight month anniversary of the Fed’s decision to pursue quantitative easing, which is a clever euphemism for the act of printing money. While the merits and necessity of this policy decision can be debated, the one thing that is certain is that owners of financial assets have benefited disproportionately compared to the rest of the country. The Fed’s newly printed cash is flowing into financial assets (stocks, bonds, commodity funds) and bank balance sheets as opposed to flowing into the real economy. Essentially what this is doing is making the owners of financial assets disproportionately more wealthy than those without financial assets.

If this were a “no harm no foul” situation where the non-owners were not at a detriment then maybe it is a non-issue, however, both the owners of financial assets and the non-owners are subject to the impact of the declining US dollar which is a byproduct of quantitative easing. In other words, while the Fed’s policies are propping up the value of financial assets I would argue that their policies are also exacerbating the divergence between asset owners and non-owners.

The market’s meteoric rise off the March lows has made life for the value investor increasingly more difficult as we are faced with unpersuasive valuations coupled with a very uncertain economic environment. Gone are the days of picking up quality businesses trading at 20% free cash flow yields.

However for those willing to take a contrarian stance and do the work, opportunities still abound in the market. One such opportunity that I am particularly excited about is First Industrial (FR).

With the stock market rally approaching its six month anniversary, a rally that currently has the S&P 500 up +54% from the intraday low set on March 6th, it is a good time to take a closer look at the internals of this rally and see what they suggest for the future. While a rising tide certainly lifts all ships, it is important to take note of which types of stocks moved and when.

I compiled total return data for the largest 3,000 US stocks as measured by market cap which serves as a good proxy for the overall US stock market. I then sorted these stocks by “quality” to see how the different “quality” levels have participated in the rally. I will be the first to admit that the “quality” of a stock is very subjective. After all, every stock has a certain price that makes it a good investment and conversely a certain price that would make it a bad investment. A very savvy colleague of mine told me that low-quality stocks are what people call the stocks they don’t own. In any event I think there are several quantifiable characteristics that can serve as a proxy for “quality”.

As you can see the leverage profile of the business is the same post-equity raise at 1.0x debt/EBITDA that it was in FY 2008, in other words the business did not actually de-lever despite paying down 20% of their debt because of the drop in income earned (EBITDA). Without doing the equity raise, the company would have seen their leverage increase to 1.25x so the deal avoided making the company more levered but did nothing to decrease leverage.

Disclosure: No Positions

Over the past two months the stock market has seen an explosive rally of roughly +40% from trough to peak. The rally was ignited by technical buying off an extremely oversold condition, however the move grew legs on the back of government policy announcements such as a ramp-up in quantitative easing, positive comments from the banking sector, and a deceleration in the deterioration of many macroeconomic data points.

This “improvement” in macroeconomic data was championed by stock market bulls as an early sign of an economic bottom because after all, an object in motion typically decelerates before it can actually reverse. Of the four influences listed above, the macroeconomic data points offered the only tangible fundamental underpinning for the rally (technical buying, printing money, and P.R. spin campaigns from the banks do not result in sustained economic growth).

Plum Creek Timber (PCL) is a REIT that owns and manages timberlands in the United States. Its products include lumber, plywood, medium density fiberboard, and related by-products, such as wood chips. The company sells its products to wood products retailers, home construction, and industrial customers. PCL is the largest private landowner in the nation with 7.4 million acres of timberlands in the northwest, southern, and northeast US. PCL owns and operates 10 wood product conversion facilities in the northwest.

Investment Thesis

PCL trades at a compelling discount to underlying net asset value (NAV), generates a fair amount of FCF, and pays a decent dividend. PCL has recently completed a series of large land sales to the government (The Nature Conservancy and Trust for Public Land) and a timberland investment management Group (Campbell Group). Applying the valuation multiples obtained in these deals suggests the NAV of PCL is about 2x higher than the current price. PCL asset value is derived from raw land which traditionally holds its value better than real estate because it is not levered up (no mortgage).

Chiquita (CQB) reported Q4 2008 results last week which missed analyst expectations due primarily to lower salad sales (more on that), foreign exchange headwinds, and an $8m expense from flooding in Panama and Costa Rica. CQB also took a $375m goodwill impairment charge which made the GAAP number look much worse, however the write-off has no effect on covenant compliance or borrowing capacity.

In response to this weaker than anticipated quarter, the stock had the steepest sell-off in its history, falling -56% in the past two days! This is not a highly levered homebuilder or RV manufacturer, these guys grow bananas, leading me to believe this sell-off is way overdone. Keep in mind that CQB has a solid balance and even paid down $2.7m in debt during Q4 2008. Furthermore, they have no significant debt maturities until 2014 so there should be no concern over liquidity.

As an unequivocal believer in the virtues of the fundamental stock analysis influenced by the teachings of Benjamin Graham and Warren Buffett, it is a bit odd for me to comment on technical analysis. Although I do believe that technical analysis can work under the right strategy executed by the right people with the right emotional temperament (my friends over at Tudor Investment Corp being the most obvious example), I have always been a fundamental investor in search of determining the fabled “intrinsic value”. The underlying principals of technical analysis seem too blunt in my opinion, everything in this world has some level of inherent value based on the utility it provides and a properly trained investor willing to do the necessary analysis should be able to determine this value within a range and trade accordingly.

Regardless of my theoretical beliefs, many market participants use technical analysis to drive their investment decisions. These collective actions result in real tangible changes in asset values and as such need to be understood even by fundamental investors. A fundamental investor need not agree with the reason why a stock is moving but it behooves him or her to understand why a stock is moving. Just as a hitter in baseball does need to know how to throw a curve ball but he does need to be able to recognize a curve ball and anticipate the ball’s movement.

DHT Maritime (DHT) owns nine double-hull tankers consisting of 3 very large crude carriers (VLCCs), 2 Suezmax, and 4 Aframax tankers. All nine tankers are chartered out under long-term contracts to Overseas Shipholding group (OSG). These two companies have a solid history together as DHT was spun out from OSG in October 2005. Of the nine vessels, seven are chartered until the end of 2010 to early 2012 while the remaining two are chartered until 2014 to 2018. These long term charters allow DHT to completely avoid the sometimes volatile spot market but also include profit sharing agreements with OSG that allow DHT to participate in the upside should spot rates be higher than the chartered base rate.

Investment Thesis

Annaly Capital (NLY) offers investors a way to profit from the government’s intervention in Freddie (FRE) and Fannie (FNM) as well as from the various other bail-outs. NLY is a REIT whose principal business objective is to generate net income for distribution to investors from the spread between the interest income earned on its mortgage-backed securities and the cost of borrowing to finance their purchase. NLY owns only AAA-rate, highly liquid GSE mortgage backed securities on their balance sheet.

• Attractive total return and valuation: NLY is classified as a REIT so they pay out substantially all of their free cash flow to investors. NLY offers an attractive and fairly certain total return opportunity as the stock is currently yielding 15%. Investors have stayed away from the stock due to concerns about the credit markets, Freddie and Fannie drama, and the exodus from financial stocks in general. NLY earns revenue from the cash flows of the GSE MBS that they own in their portfolio. The GSE MBS are now backed by the explicit guarantee of the US government so NLY is not subject to any credit risk. The beauty of NLY is that investors do not need the stock to appreciate to still earn +15% which, with no credit risk, is an attractive return in this chaotic market environment.
• Asset value provides downside support: The assets on NLY”s balance sheet are liquid and transparent agency debt issues resulting in a tangible book value of $13.32 that should provide a fairly firm valuation floor. The firmness of the asset support has been shown throughout this year as NLY has managed to hold around these levels even in the panic surrounding the Bear Stearns collapse, the Freddie and Fannie drama, and the various panic selling days. The historic average book value multiple is 1.4x which would equal a price target of $18.64. Below is a historical perspective on price/book multiple for NLY: the high was 1.77x in 2004 and the low was .76x set earlier this year. The eight year average is 1.32x.

Will the future be inflationary or deflationary? The answer to that economic question is likely to be the most important variable in developing a profitable investment strategy to navigate the next few years. Some investors point to the recent drop in October’s Consumer Price Index, the slowing velocity of money given tighter credit, or the precipitous decline in asset values such as real estate and equities as support for the deflationary view.

I think one would be well served to look at this debate from a “cui bono” perspective - in other words, who benefits from the different outcomes? The goal of the US government with all of these interventions/bailouts is first and foremost to stay relevant, i.e. stave off a complete financial system melt-down because it is hard to collect taxes from a barter system, and second to keep this de-leveraging process orderly. Given the current state of affairs and the subsequent responses by the Treasury and Fed, it is becoming very clear that the only way out of this debacle is to inflate our way out.

Surely the stock market collapse of 2008 should present amazing buying opportunities for those fortunate enough to have hidden a pile of cash under a mattress at the beginning of the year…right? Certainly this bear market has caused tremendous wealth destruction, and based on the most recent market low it has been the second worst bear market on record. However, before investors plow back into this market, they should consider why the market has declined and how much further the market could still fall. If we do see a bear market similar to that of 1930 – 1932 we could still see another -50% decline from here.

I ran some screens over the weekend and thought I it would be interesting to take a look at the trading behavior of our universe (market cap > $200m, daily dollar volume > $4m) as it relates to short interest. There is a theory making rounds on the Street that short covering has been propping up the market to some extent and has kept this equity sell-off from being even worse. As hedge funds unwind positions (either voluntarily or involuntarily) they are forced to cover their short positions.

Following this line of reasoning, stocks with high short interest should have performed better as artificial buying would result from funds covering their short positions. Interestingly the actual data refutes this theory. When sorting the universe by last reported short interest, you can see that stocks with higher short interest have performed worse than stocks with lower short interest. Stocks with a short interest of 40+% of the float were down on average -35% over the past four weeks while stocks with a short interest of less than 5% are down -28.5%. This phenomenon is shown across the different short interest groupings with lower short interest correlated to less price decline.

Aircastle (AYR) engages in the acquisition, management, and lease of commercial jet aircraft to passenger and cargo airlines worldwide. As of June 18, 2008, its aircraft portfolio consisted of 136 aircraft that were leased to 59 lessees located in 31 countries.  

AYR is currently trading at a compelling valuation ($6.26) on a free cash flow and asset value basis. AYR generates a huge amount of cash flow which they have historically paid out via dividends. The market has punished AYR as fuel costs have increased, domestic carriers struggle, and credit concerns spook investors. The extreme drop in the stock price has resulted in the market severely undervaluing the asset value of AYR. Stated book value of AYR is $16.50 but this number is artificially low as AYR has depreciated as much of their assets as possible for tax purposes. Lease rates thus far have actually increased due to strong demand in emerging markets and the fact that Airbus and Boeing (BA) are sold out until 2012.

The US Treasury, with the assistance of a distracted and overwhelmed Congress, is replacing the  American Dream with the American Scheme. The American Scheme calls for a $700 billion bailout in which the government would buy troubled assets from the financial sector in hopes of melting the credit freeze. The government’s hope is that this bailout will allow capital to resume flowing fluidly to efficiently invest in value-creating activities and spur economic growth.

In reality, America is yet again refusing to let capitalism purge the economic system of excess. This situation is sadly reminiscent of the last time we saw this movie in the aftermath of the Tech Bubble collapse earlier this century. The Fed held interest rates artificially low in an attempt to thwart a recession which led to an unprecedented run-up in credit, leverage, and lending. We as a nation want all of the benefits of capitalism; the American Dream, merit based success, ability to create amazing wealth, innovation, and rising standards of living, but we refuse to accept the consequences of abusing the situation. America has become the lady in the diet pill commercial who wants to eat chocolate cake all day but still look good in a swimsuit.  

I thought it would be interesting to take a look at what a Lehman (LEH) take-over would imply for the valuation of financials.

I ran a screen for financials with market caps above $900m that trade in the US and trade below current book value. I then removed some of the more obscure names to narrow down the list and make it more succinct.

Company overview

Idearc (IAR) is the second largest print directory publisher in the US. The company runs the Verizon Yellow Pages and superpages.com which has the second highest share of internet Yellow Pages usage. IAR was spun off by Verizon (VZ) in November 2006. IAR has an exclusive agreement to publish the VZ directories for 30 years. IAR operates 1,200 directories in 35 states with circulation of 130 million and 850k advertisers.

Investment Thesis

IAR is compelling based on an incredibly cheap valuation, strong free cash flows, overly pessimistic market expectations, stable demand, and inherent competitive advantages. The stock has been destroyed (-88% from 52-week high) due to investors' concerns over deteriorating advertisement spending, CEO turnover, and an elimination of the dividend.

Celadon Group (CLDN) provides long haul, full truckload services between the United States, Canada and Mexico. It also offers truckload transportation services within the United States, including long-haul, regional and logistic services.

Investment Thesis: The Tide is Turning

Smith & Wesson (SWHC) designs, manufacturers, and markets revolvers, pistols, rifles, shotguns, and handcuffs. The company distributes the products to law enforcement (9%), military (5%), and retail stores (78%) primarily in the US (92%), Asia (4%), and Europe (3%).

Investment Thesis

Amerigon (ARGN) designs, develops, and markets products based on proprietary thermoelectric [TE] technologies for heating and cooling applications. The company's only commercial product is the Climate Controlled Seat [CCS], a system that provides active heating and cooling to automotive seating surfaces.