Thought my newsletter from last fall might help delineate my thoughts on real investing versus the ubiquitus speculating practiced by most of the major players.....
From The Bleachers
By
Christopher Royce Norwood, CFA®
Vol. 1, No. 1 October 17, 2008
A Market of Stocks
Much is made of the stock market these days in the newspaper, on television and in the halls of government. Everyone on the planet surely has heard that the derivatives market has finally blown up (Warren Buffett proved prescient when declaring them “financial weapons of mass destruction” way back in 2003). Mr. Buffett wrote in his annual letter to shareholders that some derivatives contracts appear to have been devised by “madmen”. His warning that derivatives could push a company into a spiral that could lead to a corporate meltdown appear virtually Nostradamus in nature now that AIG, Lehman Brothers, Bear Stearns, Fannie Mae, and Freddie Mac have all run aground on the sharp rocks of the derivatives market. Write downs already tally north of $650 billion and the International Monetary Fund (IMF) is predicting they will total $1.4 trillion (that’s Trillion with a T) before all is said and done. And that august international body’s forecast appears downright cheery next to Nouriel Roubini’s prediction that write-downs will top $3 trillion eventually.
Why should we care what Mr. Roubini has to say on the subject? Perhaps because the Professor of Economics and International Business at the Stern School of Business in New York had the intestinal fortitude to stand in front of an audience of economists at the IMF in September of 2006 and warn that the United States was facing a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession – all have come to pass in the intervening two years except the deep recession, which Roubini sees unfolding right now.
Of course, the stock market is on track for its worst year since the 1930s. A deep, consumer-led recession will make a recovery in the market a back half of 2009 or even a 2010 affair, should it come to pass. Investors will undoubtedly collectively wish they’d found something else to do with their hard earned money like, say, gone to Vegas and bet on black, should we experience anything close to Mr. Roubini’s prediction of the worst recession in forty years prove on the mark. 2009 earnings estimates for the S&P 500 will look laughably high in hindsight – they are currently forecast at around $96, but would likely come in closer to $76 in a deep recession.
Perhaps this is a good time to shift to the topic indicated by the title up above, before readers decide we’re just a bit off the mark with it. Our fervent hope is to both entertain and educate our readers on the art of stock picking for – as the title declares – it is a market of stocks not a stock market in which we invest. To be fair, we are contrarian by nature, and a bit old fashion to boot. We recognize that index funds exist, that exchange traded funds are available with which to place your bets on red, black, or even green, but we prefer to build a portfolio the old fashion way, one well researched stock at a time. We hesitate to declare that we’re looking for an undervalued business in which to invest since we will almost assuredly be (mis)labeled as a value investor. So we will avoid the claim. Rather, we simply recognize that a share of stock means a share of ownership in a corporation, which entitles the stockholder to a share of the profits, should there be any.
Now oddly enough, we have found over the years that companies that make increasing amounts of money are deemed more valuable (eventually) to investors than those who don’t, and the stock price of said company invariably rises over time as a result of the increasing stream of cash finding its way into the shareholders’ pocket, a truly wonderful outcome for those of us who enjoy turning a profit with our investing. It is our belief that we are buying ownership in a business that guides our search. Not for us the pursuit of a stock, simply because it is rising – that game belongs to the many speculators who invest with a six to twelve month time horizon. Speculators they are because they invariably buy a stock in the hope that it will trade higher in the coming quarters, allowing them to sell at a tidy profit and move on to the next piece of paper. The many mutual fund managers, institutional asset managers, and individuals who choose to rent a stock (and we are now fairly describing upward of 90% of the investors out there) are not interested in the value of the underlying business. They care only whether the stock price will rise in the short run, and turn to such devices as earnings revisions, upside surprises, relative strength indicators and insider buying to divine the short term future of a company’s stock price. We, on the other hand, care very much what price we pay for a company. Just as we choose not to overpay for a car, house, vacation, or that big flat panel TV that makes Peyton Manning’s flapping and stomping prior to the snap looking even more like a blue heron dancing in the shallows (Of course we are fans, season ticket holders as a matter of fact).
Don’t misunderstand however. We have owned all manner of stocks in our 20 years of investing. Technology stocks, drug companies (back when big pharma was considered a growth industry), the King of Beers, and the royalty of soda pop (Coke) have all found their way into our portfolios. We will buy anything in any industry if the price is right, and we are very patient in waiting for that happy event to occur. For instance, Coke was the poster child of expensive back in the late 1990’s, peaking in the vicinity of 55 times earnings if we remember correctly. We even used it as a marvelous example of a great company that was no longer a great investment. But we didn’t hesitate to pay some 20 times earnings in 2005, with the stock in the low 40s, nor did we hesitate to sell it some two years later in the high 50s when the price-to-earnings multiple no longer matched the company’s growth prospects. A market of stocks, not a stock market, and stocks as certificates of ownership in an ongoing business – two of the guiding principles of our investment philosophy.
INTC $14.28
Intel closed today at $14.28 per share, but not before touching $13.37 intraday – a new 52-week low. The company is paying a dividend of $0.55 per share for a current yield of 3.85% and is expected to raise its dividend to $0.61 per share in 2009, according to Value Line – should reality meet expectations INTC will yield 4.27% for anyone buying at the current price, or some 40 basis points or so more than the 10-year Treasury. Now, of course, Intel common stock is riskier than holding a 10-year Treasury to maturity (although that premise seems increasingly uncertain given our government’s loose spending habits). On the other hand, we get much more than a debt instrument that pays par upon maturity when we buy part ownership of a company. We also get a growing stream of shareholder cash flow that can be returned to us by management either with increasing dividends, share buy backs or both.
In fact, INTC will pay out around $1.19 per share in 10 years if management raises the dividend 8% per annum during that period – only one quarter the growth rate of the last 5 years. Anyone buying and hold Intel’s stock for the decade will then be earning 8.3% per annum on their original investment. Now compare that juicy 8.3% to the measly 3.85% you can currently earn holding the U.S. 10-year note… and you quickly get it – Intel is a raging buy at the current price as long as the company is around in 10 years and as long as management is able to continue to grow the dividend. And our analysis doesn’t yet include the possibility of additional cash that might be available to oh, say, buy in stock, resulting in the dividend yield rising even faster.
In Intel’s case, a quick check of current year estimates reveals that the company will have approximately $0.55 per share in excess cash after paying its dividend and meeting its capital expenditure requirements. A three-year average is often useful in ascertaining a company’s ability to throw off excess cash consistently. According to Value Line, Intel has generated approximately $5.66 in cash flow from 2006 to 2008, while making $2.76 per share in capital expenditures and paying out $1.41 per share in dividends, leaving approximately $1.49 per share in excess cash available to buy back shares, or $0.50 per share per annum. Adding the $0.50 in excess cash to the current $0.55 dividend gives you a current dividend yield of 7.35% (what the dividend yield would be if INTC management devoted all of its excess cash to the dividend). Unfortunately, Intel, like many management teams often chooses to buy back shares with excess cash. We think it unfortunate, because managers tend to pay top dollar for their own shares rather than waiting to buy in shares after their stock takes a dive. Nevertheless, buying in $0.50 per share per annum retires 3.5% of the outstanding shares at the current stock price (call it 2.0% net of stock option issuance), raising current and future dividends accordingly.
Yet another way to do the math without the distortation of a changing share count: Intel generated $34.2 billion in Cash Flow After Taxes (CFAT) during the three years ending in 2007, against $17 billion in Capital Expenditures (CAPEX), leaving $17.2 billion available to shareholders. The entire company was available for purchase for a mere $154 billion at the beginning of 2008 (you could buy it lock stock and barrel right now for $82.8 billion). Taking the three year average shareholder cash number of $5.7 billion and dividing it into the current fully diluted shares outstanding gets you $0.99 per share in stockholder available cash – a nice current yield of 6.9%, some 3.1% better than the 10-year’s current yield.
A couple ways then of looking at the yield to shareholders currently and a decade into the future in comparison to the 10-year Treasury – all favorable. We just need to make a judgment on whether INTC is likely to be around and prospering a decade from now.
The company is currently the world’s largest semiconductor chipmaker based on revenue, according to its 2007 10K SEC filing. INTC develops advanced integrated digital technology products, primarily integrated circuits, for industries such as computing and communications. Intel also develops platforms, which they define as integrated suites of digital computing technologies that are designed and configured to work together to provide an optimized user computing solution compared to separately. Intel currently controls about 80% of the PC processor market.
For starters, Intel has grown revenues from $30.1 billion in 2003 to an estimated $40.4 billion in 2008, or a little over 34% during the five-year period. Net profit is forecast to hit $7.3 billion in 2008, up from $7.0 billion in 2007 but well off the company’s peak profit logged in 2000 ($10.7 billion). Nevertheless, profit has grown steadily, albeit erratically, since the bottom fell out during the last recession in 2001 (profits bottomed in 2002 at $3.5 billion).
Clearly the company is likely to still be in business and growing earnings given its dominating position in the microprocessor industry and strong balance sheet (almost 13 billion in cash on the balance sheet at the end of 2007). On the other hand, just looking at the increasing variability in earnings leads one to the conclusion that the company is no longer a true growth company and should be bought after business conditions (and the stock price) have weakened and sold when investor enthusiasm carries the share price outside of the realm of reasonable valuation. We believe the current valuation is in the buying zone, given our discussion of dividend and shareholder yields.
AND A STOCK MARKET
You can unglazed your eyes now and refocus on the casino – that is to say the stock market. The truth is that few investors really want to spend the time rooting around in the financial statements of publically traded companies with a view toward discovering an undervalued business worth buying. It takes time and patience and more time. We ourselves have found it a profitable way of spending our time and we’re always fascinated by the inner workings of a business and the question of its true worth. But investing is boring compared to speculating – which over the last 20 years has more or less become the nation’s national pastime in our eyes.
Which brings us full circle in this, our first edition, to the derivatives bomb that has gone off in our faces and the resulting mess in which we currently find ourselves. We’ll give you a quick recap, since most of this is now fairly well known. We hope to save some space to sketch out a roadmap for the market in the coming years as well as for the economy that underlies it.
The root cause of our current pickle is easy money. The Federal Reserve dropped rates in response to the 1987 stock market crash and has been a one trick pony ever since (or at least until very recently). The consumer led recession of 1990-91? No problem, cut rates. Mexican Peso and Asian currency crises of 1994-95? No problem, cut rates. Long Term Capital Management implosion and Russian debt crisis of 1998? No problem, cut rates. Technology stock bubble implodes? No problem, cut rates and leave them at a historically low level for a very long time, ensuring that negative real rates will spike the velocity of money and force a veritable tsunami of liquidity into … housing markets around the world! Credit markets freeze as a mountain of bad mortgages and mortgage derived financial products lose their value once house prices start following? No problem, cut rates AND PROSTITUTE THE FEDERAL RESERVES BALANCE SHEET TO THE POINT THAT HYPERINFLATION IS A VERY REAL POSSIBILITY!
Ahem, we hope we now have your undivided attention because we’d like to throw out some thoughts on what the next 10 years or so holds for stocks, bonds, commodities, and our economy. The Federal Reserve appears to have reached the limits of what a one-trick pony can accomplish and so, under Ben Bernanke’s watch, the Fed has transformed itself into a multi-trick pony, all with the aim of preventing the mountain of debt that underpins our economy from crushing our major financial companies and, in a chain reaction, the companies and consumers that depend on them for credit.
In the process, the Federal Reserves balance sheet has ballooned from around $850 billion to some $1.7 trillion in just a matter of weeks, and is likely to reach $3 trillion by year-end. We will devote the rest of this edition to explaining just why that mammoth increase in the Federal Reserves balance sheet is likely to lead to inflation on a scale not seen since the 1970s (don’t worry, we’ll save a little space for telling you what’s likely to happen in the stock market in the next few months as well).
Ready? Okay, here it is…. inflation results when too much money chases too few goods and services. Double the amount of money in circulation but hold the amount of goods and services produced constant and inflation will result. The Federal Reserve has gone one better by doubling its balance sheet on the way to tripling it from what we’re hearing. What’s more, the dollars they are pushing into the system are now backed increasingly by collateral of dubious quality, to say the least. Boat loans, subprime credit card loans, and fancy triple A rated (and worthless) CDOs now represent a goodly portion of the assets backing the greenback. Not convinced that inflation is coming? How about the Federal Reserve buying debt directly from the Treasury? Here’s how that will work if Bernanke, as is currently rumored, elects to monetize the debt. The U.S. Treasury needs to raise the dough to buy up bad assets and make equity injections into insolvent banks, insurance companies and various other corporate miscreants. No one wants the debt because they already have too much of it so the Federal Reserve simple prints up a few hundred billion more of the good old greenback and uses the newly minted cash to buy the debt from the Treasury, which turns around and hands it over to the Titans of commerce in order to salvage our financial system. Sweet deal for sure, except for the fact that no one, and I mean no one will want to hold the dollar anymore if history is any guide. And all of that new paper will push prices higher and higher and higher. We hope the Federal Reserve doesn’t do it, but then we hoped they wouldn’t give J.P. Morgan $29 billion for a bunch of Bear Stearns assets that are almost certainly worth far less because, as taxpayers, we didn’t really want to take a loss on the overvalued paper…
As for the stock market? Our forecast for almost a year now has been for a substantial low in place sometime this fall with a retest sometime next spring. We see no reason to change it at this point. In fact, here’s what I wrote a buddy just a couple of days ago
Scott,
My forecast since last winter was for a significant low in the fall, a rally into winter and a retest by next spring. My fundamental reasons were that by this fall the horrifying extent of the credit market excesses would finally be laid bare for the masses to see, resulting in a selling climax sufficient to set a bottom that would hold for a few months. My retest was based on the thought that earnings estimates for the back half of 2008 and 2009 were way too high and the institutional weenies would start selling the misses and downward revisions by the winter pressuring the market into the spring. I also felt and still feel that the recession we're in (since about last fall) would be longer than normal, lasting up to a year and a half to two years - call it over by next fall/winter (fall of 2009/winter of 2010) at the latest. Figuring the market tends to lead us out by about six months also pointed to a springtime low/retest.
For the first time in 16 months, I’m excited about doing a little buying of some of the increasingly cheap stocks out there, recognizing that we were probably six to nine months early (but I don't want to get too cute with the spring of 2009 retest thing).
Regards,
Chris
