Wednesday, December 06, 2006

Back to Healthcare

When we sold United Healthcare (UNH) a few weeks ago, we did so with the intention of replacing it with something else from the Healthcare sector. We believe this is a thriving industry with good overall Return on Capital characteristics and the opportunity for continued future consolidation.

After a thorough look, we decided to take a position early last week in WellPoint Inc. (WLP), a “best-of-breed” health insurance provider and one of UNH’s primary competitors. WellPoint is the leading health benefits company in terms of membership in the United States and is an independent licensee of the Blue Cross Blue Shield Association, providing Blue Cross coverage in 14 states, including California, Colorado, Connecticut, Georgia, Indiana, Kentucky, Maine, Missouri, New Hampshire, New York (primarily NYC), Ohio, Virginia and Wisconsin. The company provides coverage as UniCare in several other states. It is also one of the largest Medicare providers and the largest Medicaid provider in the country.

WellPoint also extends managed care plans to the large and small employer, individual, and senior markets. In addition, managed care services are provided to self-funded customers, including claims processing, underwriting, actuarial services, medical cost management and other administrative services. Other specialty services include pharmacy benefit management, group life and disability insurance, dental, vision, behavioral health, workers compensation and long-term care insurance.

WellPoint nicely meets our investment criteria for both EVA and valuation. Twelve-month expectations from the analysts we follow range from $78 by Goldman to $93 by Bear Stearns. Our model confirms a valuation somewhere in the middle of that range. We see this as a low-risk holding with significant upside over the next few years, and a good replacement for UNH.

We would like to take a position in one more Healthcare related company to participate in further consolidation and the growth evident in some of the mid-sized carriers. Healthcare stocks have substantially underperformed the S&P 500 this year and we would expect to see better performance in the near term. Most of this underperformance relates to the sell off in the weeks prior to the election, as the markets discounted the possible change in legislation from a shift in control in the Congress. Even though Medicare Advantage will likely be scrutinized, significant change is unlikely, especially in the next two years. Certain issues such as private fee for service (PFFS) plans are likely to receive most of the attention, but this is a smaller growth component for such companies as WLP. We feel comfortable that the returns on investment and growth incentives for healthcare companies will remain attractive, as the US population ages and innovative products for the uninsured become a focus for the private sector.

As always we welcome your comments.

Peter & Jack Falker

Note: At the time of publication, neither Jack nor Peter Falker, nor the clients of FalkerInvestments Inc. had any positions in UNH.

Note: At the time of publication Jack and Peter Falker and the clients of FalkerInvestments Inc. had positions in WLP.

Friday, October 20, 2006

Enough of UnitedHealth Group

Enough is enough! We have been very patient with our holding of United Healthcare (UNH) since April, thinking that the unquestionable strength of their franchise would ultimately outweigh their options backdating scandal. Listening to the comments of CEO William McGuire in the early months of the inquiry, we were reasonably sure that what had happened, while inappropriate and possibly naive, would likely not involve blatant wrongdoing on the part of senior management and the board of directors.

We were too optimistic. The internal probe commissioned by the company’s board of directors and carried out by William McLucas, former director of the SEC’s enforcement division, and member of the law firm of Wilmer Cutler Pickering Hale & Dorr (WilmerHale), was released on Sunday. It concluded that 29 of the largest options grants at UnitedHealth over a 12-year period most likely were backdated to benefit insiders. Quoting the Wall Street Journal: “The WilmerHale report suggests that Dr. McGuire misled lawyers conducting the probe of the options grants at issue…. To the end, Dr. McGuire insisted that year after year he actually did call or otherwise contact a compensation-committee member to set an options grant in motion on what, in hindsight, turned out to be a wildly favorable day. ‘Certain facts run contrary to this assertion’, the WilmerHale report says, citing memoranda Dr. McGuire wrote on or after the purported grant dates referring to possible grants in the future tense. The report also takes a skeptical view of the circumstantial evidence presented by Dr. McGuire to document that the compensation-committee notifications did in fact take place.”

The report also points out that William Spears, a member of the UNH board of directors and chairman of the board’s compensation committee during most of the period under review, had a personal money-management relationship with Dr. McGuire and that Dr. McGuire was an investor in Mr. Spears’firm (according to “Business Week” Stephen Hemsley, then COO and now CEO, had, in 2006, a $56 million money management relationship with Mr. Spears). It also points out that Mr. Spears was chairman of an ad-hoc committee of the board formed to negotiate management agreements with Dr. McGuire and Mr. Hemsley. The implication for us is that the “fox was guarding the chicken coop” and no on else on the board of directors, either knew anything or moved to do anything about it. It is very hard to believe that the board’s compensation committee, the audit committee and the ad-hoc compensation subcommittee, were completely in the dark about options backdating and the financial entanglements of Spears, McGuire and Hemsley. A careful reading of the WilmerHale report reveals implications of hand-written notes, e-mails, discussions etc. that no one can specifically recall. This is very reminiscent of the short memories of certain politicians when facing imminent legal actions.

Dr. McGuire and the company’s general counsel, David Lubben have agreed to leave the company and Mr. Spears has resigned from the board. Mr. Hemsley, who also benefited greatly from the options backdating, will become CEO. However, the WilmerHale report finds that Hemsley did not participate in the actual backdating. Both his and McGuire’s options will be repriced to make them legal, but neither of them is giving up any options or their attendant wealth. In addition, an independent corporate governance watchdog firm estimates that Dr. McGuire will be given a $6.5 million separation payment and $5.1 million a year for the rest of his life under the terms of his management contract. Regardless of what his contract might say, this to us would be compensation for blatant wrong doing and would be an unconscionable act by this board of directors. Are there to be no consequences?

We are certain that this is only the beginning of what will happen to senior UNH executives, the board and the company in general. Hemsley’s involvement is sure to be challenged, leaving an open question of who is capable of running the company in the future. On today’s conference call, the Goldman Sachs analyst (who has maintained a sell rating on UNH for the past several months) asked what could well be the 64 dollar question: “What have you heard from AARP about this whole corporate governance matter?” Hemsley’s answer was very carefully worded (in the negative) because AARP is a huge client for Medicare drug plans and a long-time critic of both political and business practices. UNH can surely expect to hear more from AARP and other major customers.

The WilmerHale report, both in its frankness and between its lines, establishes a strong starting point for the SEC’s ongoing inquiry, as well as the adjudication of the several shareholder lawsuits already filed and those sure to follow. Our feeling is that we would prefer to watch this as disinterested parties, without client capital exposed. For our long-time clients, UNH has generated a handsome gain over the years. For several more recent clients, it represents a loss. In either case, we will redeploy this capital to companies where risk is something we can manage, instead of being exposed to the future actions of the SEC, the Justice Department and the courts on UNH. Enough is enough!

Note: At the time of publication, neither Jack nor Peter Falker, nor the clients of FalkerInvestments Inc. had any positions in UNH.

Monday, June 26, 2006

Big Oil

We have resisted taking a position in big oil for many years for two reasons: (1) None of the integrated oil producers/refiners were producing enough return on investment (ROI) to consistently create value for their shareholders; and (2) The business seemed too volatile, what with oil and natural gas prices bouncing all over the map, and political risks challenging foreign operations, thereby creating questionable risk/reward relationships.

However, things have changed with dwindling domestic oil and gas supplies, $70/bbl (plus) international oil prices, and the prospects of $3 per gallon (plus) gasoline as part of the permanent American life style. Quite simply, this means that the vast in-ground resources and producing assets of the big oil companies are now able to generate the kind of internal return on investment (ROI) that we have to see to interest us as long-term investors. Despite the political risks, which are not likely to ever go away, the value of higher-priced oil and natural gas, and permanently higher gasoline pump prices, have made the integrated oil companies much better long-term investments, in our view.

To add some perspective to our thinking, some analysts are saying that oil will drop to $50/bbl this summer. The oil analyst at Bear Stearns is using a $60/bbl assumption for 2006. However, oil futures are saying something else altogether, with a basing pattern in crude futures predicting a rally above the April high of $75.40. This gives rise to estimates among traders that crude oil will be headed above $100/bbl in the next 12 to 18 months. In any event, the probability that we will be seeing gasoline prices of $3 plus in the next several years, as a norm, seems like about 100% to us, especially when we consider that the Europeans, even countries with their own oil resources like Norway, are paying $5 plus at the pump.

The bottom line? Get used to it, and do something as investors that will allow us to cash in on the situation in the long term. We did our research, ran our valuation model on several integrated oil companies, and decided that ConocoPhillips (COP) is the big oil company we want to own. COP produced 17% ROI against a Weighted Average Cost of Capital of 10.7% in 2005, which nicely meets our EVA requirements, and our model conservatively indicates a valuation in excess of $80. The stock is currently trading in the low $60s, with a one-year forward P/E ratio of 6.5, pays a 2.4% dividend, and has a 12 month trading range between $57.05 and $72.50. Conoco is also using its very substantial free cash flow to aggressively buy back its own stock at these levels; something we really like to see.

ConocoPhillips is one of the largest integrated oil producers and its recent acquisition of Burlington Resources makes it the largest supplier of natural gas in North America. We were also pleased to learn that Warren Buffett has recently acquired a 17.9 million share position in the company (more than 1% of outstanding shares). We don’t always agree with Warren, but we think he is right on his oil and natural gas strategy, especially his choice of COP.

Jack and Peter Falker

Note: At the time of publication, the clients of FalkerInvestments Inc. and Jack and Peter Falker were long COP.

Tuesday, June 20, 2006

Misery Loves Company

More on Option Backdating

The announcement over the weekend that Home Depot (HD) backdated stock options in what appears to be an almost identical fashion as United Health Care (UNH) seems like pretty good news to us.

About 40 companies are currently under investigation by federal authorities looking into whether firms backdated options or otherwise gamed their timing to benefit insiders. In addition to Home Depot, that number also includes Microsoft.

The “Wall Street Journal” reported last week that Microsoft had previously disclosed to the SEC that they had engaged in a form of backdating before 1999 and had voluntarily stopped the practice at that time. Microsoft awarded options at monthly lows each July from 1992 to 1999, with varying dates, and also routinely issued options to new employees at the stock's lowest closing price in the 30 days after they joined. Those practices, which Microsoft ended in 1999 after seven years, amounted to a variation of backdating, since they couldn't be priced at the low for a month until the month was over. The big difference, of course, is that Microsoft voluntarily stopped the practice and disclosed it. In a news release issued on July 19, 1999, the company said it was ending the monthly-low policy and taking a $217 million charge.

It seems to us that these recent revelations are good news for UNH because, in this case, misery should indeed love company. Apparently all of the boards of these 40 companies approved these practices and all of the public accountants and lawyers signed off on them for many years until the Sarbanes-Oxley Act of 2002 apparently put a stop to it.

Does that make it right? Certainly not, but it seems like the whole options backdating issue could end up being pretty inconsequential, given its prevalence. In that case, the market will go back to looking at the fundamentals of each company’s franchise, and that will definitely benefit UNH. However, we still want to hear about the result of their internal investigation, before we take further action. We would expect an announcement sometime in the next month, when their second quarter results are made public.

Stay tuned.

Jack Falker

Note: At the time of publication, the clients of FalkerInvestments Inc. and Jack and Peter Falker were long UNH.

Thursday, June 08, 2006

Backdating Backlash

We have a substantial position in United Health Care (UNH), which, even at current levels, has doubled in value over the last few years. When the Wall Street Journal revealed in April that a probe had been initiated into the company’s practices of issuing executive stock options at prices that were essentially “too good to be true”, we decided, as long-term investors, to wait and see what would happen. Subsequently, this practice has been identified as being more widespread, so UNH is not alone in the SEC probe. We believe that UNH is the best company in the HMO segment of the health care industry and, right or wrong, we have not been anxious to hit the sell button, as so many investors (including, we are told, Fidelity Investments) have already done. This scandal has significantly lowered the price the market assigns to the company; however, we do not believe that it has substantially changed the value of the company’s extraordinary healthcare franchise.

Here’s what we know at this point: Based on a chart we got from Bear Stearns, UNH has had 16 option grants since 1994, four of which were issued on the exact date of the low close in the quarter; three of which were also lows for the year. The dates were 4/20/94, 10/27/97, 10/13/99 and 3/8/00. Using Big Charts, we went back and created the charts for the several months surrounding each of those grants. Interestingly, the first two just look like good calls on the part of management. The stock had been tanking for several days so they picked a day they thought would be close to the low and authorized the options. It also appears they might have known that some good news was about to be announced, because in both cases the stock went up significantly in the next week. Unfortunately, that pattern does not follow through on the last two grants in 1999 and 2000. In both cases, the stock had been trending lower, they picked the exact date of the low, and the stock slowly began to improve from that point. It would have been virtually impossible to choose those exact dates, so backdating seems quite likely. In their 10-Q SEC report filed in May (which under the circumstances would have been blessed by their auditors), they say that “the Company has identified a significant deficiency in its controls relating to stock option plan administration and accounting.” The context that follows implies that the board had given some sort of blanket authority to management and that the authority had been misused by someone in “the Company’s human capital, finance and legal departments”, which, of course all report to Bill McGuire, the CEO and largest stock option beneficiary. The 10-Q goes on to say that the board has changed all of that and it won’t happen again, because future option grants “are to be made by the Compensation and Human Resources committee, and no authority to grant options is delegated to management.” In other words, the fox is no longer guarding the chicken coop.

As a former corporate treasurer, I’m in shock about what UNH apparently did, and why. My first reaction, when the probe was announced in late April, was that it would not be at all difficult for the management of UNH to grant options at or near the low trading points in their stock. Assuming that they did it the way we always did, options are very easy to grant with a telephonic meeting of the board compensation committee, to be ratified by mail etc. I saw it done frequently and it was entirely proper, albeit opportunistic. In UNH’s case, with board authority apparently already making it so easy to grant options, at or near a low point, why would someone in management engage in backdating to the exact date of a low? At the least, this is very greedy, and at the worst it’s outright fraudulent, not to mention stupid. In any event, if backdating is proven, Bill McGuire would likely have to take responsibility and he likely will not go unpunished. That could be messy, a la Ace Greenberg at AIG. Greedy CEOs have been kicked around a lot lately and it probably isn’t over yet.

Reading between the lines of UNH’s recent SEC filing, it seems that they have pretty much acknowledged irregularities, so it’s just a matter of time before the full story will be released in another SEC filing. The company’s board has hired the former enforcement chief of the SEC, who has a reputation as a very tough lawyer, to conduct an investigation into exactly what happened. This very constructive move was announced more than a month ago, so it’s likely that a report will be forthcoming shortly, and that’s when all the information should be available for decision making. If it’s not any worse than what the company has already reported to the SEC, we will keep the stock and consider adding to it at current levels, which represent a substantial discount from what our model tells us the ongoing franchise is worth in the longer term, with or without Bill McGuire. However, if the news is worse than what we currently know, we may have to quickly protect our capital.

Trading action in the stock during the last week or so seems to indicate that the street believes the worst news is already out. We will wait and see. Stay tuned.

Jack Falker

Note: At the time of publication, the clients of FalkerInvestments Inc. and Jack and Peter Falker were long UNH.

Monday, April 17, 2006

Management Compensation

Thoughts on corporate management and their rewards from a long-time business associate of FalkerInvestments.

I read with interest the comments of the FI customer regarding your posting of March 31 about GM. I agree with his/her observation about the need for a complete management change. I would take it a step further and say that both management and directors should be changed.

As an investor I am inundated at this time of year with annual reports and stockholder meeting agenda. Most of these request shareholders voting in favor of the adoption of some new or updated management or director incentive stock or compensation plan. In some instances, the proxy materials include proposals by shareholders which would limit either form of incentive compensation (cash or shares) if the company doesn’t meet certain criteria. These proposals are almost always recommended to be voted AGAINST by the directors. The corporate mentality seems to be to continue to provide more rewards for less performance. When you read the proxy and annual report materials and observe the compensation levels these executives and directors are receiving, it is mind-boggeling in light of their performance. Further, there is no incentive for them to change.

It is with this continuing frustration in mind that I read with joy the report in today’s Wall Street Journal of Coca Cola Company’s plan to require that earnings targets be met in order for their directors to receive any compensation. Immediately the naysayers have said that this is a bad idea. They claim it is dangerous to tie directors compensation to EPS because of the temptation to mis-state earnings in order to receive compensation. They also claim that people from academia and the non-profit sector will be less willing to serve as directors if their compensation is not assured. If that is the case, then so be it.

I agree that Coke’s approach is not a final and complete solution to the problem. But it is a great start. If we continue to pay executives and directors millions of dollars for substandard performance, our businesses and the economy will continue to wallow in mediocrity. Congratulations to CocaCola Company for exhibiting some courage and attempting to break the mold to achieve better things. More companies should do the same.

Thursday, April 06, 2006

GM and Ford Prescription

The following post about the auto industry was submitted by a client of FalkerInvestments.

The biggest difference between GM/Ford and Toyota/Honda is their mentality toward suppliers. GM and Ford look to their job regarding suppliers as a purchasing mentality. How can we purchase parts for less? Toyota and Honda have, in contrast, an engineering mentality. How can we together come up with better designs and methods?

Toyota and Honda have reputations for severe pressure on their suppliers to reduce costs, and both customer and supplier then benefit. This has the result of getting more cost out, as well as better designs and stronger suppliers. Compare the amount of warranty claims, recalls, launches on time, and customer loyalty, just to look at what the public sees. Review the kind of help that Toyota and Honda give to their supplier base vs. what GM and Ford do. When I was working for a GM supplier and GM "help" was arriving, it was greeted with dread. GM would pick the best opportunity to save money, do a kaizen class, calculate some (highly questionable) savings, often with a large capital requirement, then extrapolate the findings over the whole plant and demand those "savings" as a price reduction. In contrast, Toyota suppliers generally greet Toyota's help gladly, because both sides benefit.

Why do GM and Ford keep doing this, when the results of the purchasing mentality are so destructive and the results of the engineering mentality so beneficial? The answer is: they want quick fixes, and price reductions are quicker. And the suppliers don't trust them to actually share information (because they've had their suggestions/ideas given to other suppliers who offer lower prices). I believe it will take a total management shakeup. I'm talking an entirely new team, not just Rick Wagoner and Bo Anderson, which will deal with reality as it is and change the incentive and reward systems in place. Plus, I believe they will need the time--and the clout--that the bankruptcy process provides. Yes, that would be disastrous for the public to buy a car unsure about warranty, dealer support and resale value. So much of both companies probably would have to be sold off, allowing the public to buy a car without worrying about the future.

I do not see either Ford or GM being able to change their cultures fast enough to reverse their downward trend. All of the wage cuts and plant closures are to deal with the past problems, and they don’t deal with making the future different. Having a lower-paid (disgruntled) workforce doesn’t sound like a recipe for developing the kind of thinking workforce that Toyota has, with hundreds of thousands of suggestions a year—from Americans. For a different future, they need to have a different present. It won’t happen without a totally different management—and that is more than Kirk Kerkorian can deliver.

-FI Client

Friday, March 31, 2006

Generous Motors

Growing up in Detroit and working for years at Chrysler, we always referred to GM as “Generous” Motors. That was tongue-in-cheek sarcasm, because in those years GM was anything but generous. In the ‘50s, ‘60s, ‘70s and beyond, they were always the guys to beat. They built a car for less than $500 in variable costs, while Chrysler struggled to get down to $1,000; Ford wasn’t much better, and AMC was the accident waiting to happen. GM management was so tough that they became known around town as the “heart attack machine”. Senior managers beat so hard on middle managers that the heart attack rate among these people, became alarmingly high. I know from personal experience: My wife’s father was chief mechanical engineer of GM’s realty and construction division and he had two heart attacks as a young man, which ultimately cut short his promising career. He was literally one of hundreds affected by the ruthless, cut-throat management environment that was GM in those years. I formed an opinion during my years in Detroit that the managers who shouted the loudest were people who had indeed risen to the level of their own incompetence.

Paradoxically, what happened to GM (as well as the others of the “big three”), primarily in the ‘70s, ‘80s and ‘90s, is that they actually did become “generous”, for all the wrong reasons. The UAW found managements’ weak spot: they just couldn’t bear to take a strike and possibly give up market share to one of their competitors. So, if the union bargained hard enough they virtually always got what they wanted and everybody laughed all the way to the bank. Management didn’t have to bite the bullet of labor strife, thereby risking their own status and inflated compensation packages, UAW officials always got re-elected, and hourly workers got ever-increasing pay checks and benefits, as did all the salaried workers who automatically received the same benefits and pay raises. So everyone was fat, dumb and happy. I can remember shaking my head at the idea that I would have a whole week off (with pay of course) at Christmas, as well as my birthday every year. I was always too busy.

So, all of this compounded over the years to the point that the American auto industry became so financially cumbersome, poorly managed, and virtually controlled by the UAW, that they literally could not compete with foreign manufacturers building cars with non-union U.S. labor. Can you imagine a labor provision requiring a company to keep thousands of laid-off workers in a “jobs bank”, doing community service for years while collecting full pay and benefits? I can’t, and neither can the Japanese manufacturers down the road.

I am often asked if I believe GM can avoid bankruptcy. My answer is always: “They shouldn’t”. In my view, Chapter 11 is the only way to save GM from themselves and the union. Like the airlines, management in bankruptcy can eliminate ponderous salary and benefit provisions (and the jobs bank!) once and for all. Also, it presents a once in a lifetime opportunity to bring fresh management thinking to an industry that has always been run by people who grew up in the business; usually in the same company. Nepotism has also run rampant, from the shop floor to top management. Note the Fords, who always seem to rise to the top job at Ford in times of strife, whether or not they are competent (usually not). In my view, this inbred management tradition is the primary reason they haven’t made good product decisions. People in Detroit really don’t get it about product, and that isn’t something new. So, if the bankruptcy court is wise, they will cede management of a bankrupt GM to outside professionals, who could care less about “how we have always done it around here”. Also, that ultimate old boys club, the dealer network, needs to be changed drastically, but no one in Detroit has ever been strong enough to tackle it. Jacques Nasser, who was CEO of Ford several years ago, began making noises in that direction, just before he was sacked and succeeded by the ultimate PR man, Bill Ford. In the world of the internet, cars should not be sold from vast inventories held by dealers and floor-planned by captive auto finance companies. This is a huge misuse of capital, but very convenient for keeping assembly lines cranking when cars aren’t selling. Cars should be ordered on-line and delivered “just-in-time”, and dealers should be delivery and servicing agents; obviously very different from today and probably only achievable “in extremis” of bankruptcy. By the way, I’m waiting for the Japanese to figure this one out.

Frankly, I have very little hope that much of this is going to happen. I’m pessimistic about Detroit and I do not believe the U.S. auto industry is too big to fail. However, we have no way of knowing when the band-aids will fall off. In the meantime, we will continue to insulate ourselves as much as possible from financial shocks by owning value-creating companies vs. value-destroyers like Ford and “Generous Motors”. And, yes, there are others out there, but none quite so bad.

Let me know what you think.

Jack Falker

Note: At the time of publication, neither the clients of FalkerInvestments Inc. nor Jack and Peter Falker held long or short positions in GM or F.

Thursday, March 30, 2006

Safe Harbor

The following post about the inverted yield curve was submitted by a client of FalkerInvestments.

“The Fed Chairman said recently that the Fed is studying the concept that a growing excess of global investment liquidity (which may continue to grow indefinitely) has found its way into the long term U.S. Treasury market. This excess global investment liquidity may be the principal source/cause of the current U.S. inverted yield curve. If this supply of liquidity continues to exceed alternative business investment opportunities on a global basis, an inverted yield curve could become the rule, not the exception.

“Apparently an excess of global investment liquidity was the principal cause of an inverted yield curve situation, which existed for a number years during the late 50's and early 60's, until Federal deficit spending associated with the Vietnam War and a fear of long term price inflation came to dominate the thinking of global investors, who abandoned long-dated Treasuries, thereby causing long-term interest rates to escalate relative to short term interest rates.

“Let's face it, the USA, even with all of its many problems, is still the safest harbor in the world for investors to "park" long term idle investment capital.”

-FI Client

Saturday, March 11, 2006

FI Update - 3/11/06

To Our Investors and Friends:

The equity markets ended the week on a positive note, with short-term good news on U.S. Payrolls. That seemed to counteract long-term macro-economic news earlier in the week on the ever-worsening U.S. trade deficit. If the order of the announcements had been reversed, market results would likely have been significantly worse, since the trade-deficit implications greatly outweigh employment data in the longer term. But that’s how the markets work in the short term, irrational though that may seem.

We have seen nothing to contradict our opinion that we are in the midst of an economic dichotomy, i.e. in a micro-economic, short-term context, things are going pretty well, but in a macro-economic, long-term context, they’re not going well at all. The bond market continues to reflect this dichotomy, with a virtually flat yield curve. For example, at the end of the week, the 30-year Treasury bond yielded 4.74% vs. the 10-year at 4.72%, the three-year at 4.76% and the 90-day T-bill at 4.46%. Anyone want a 30 or 10-year bond when you can get virtually the same yield at 90 days? Hardly! There is clearly something wrong with this picture, and the economists we read (who don’t have a political agenda) are rending their garments waiting for the next shoe to drop, and long-term interest rates to start rising.

So far, it hasn’t happened, and it may be some time before it does, because there are so many dollars in the hands of foreign governments who need to keep those dollars invested. In other words, it’s a matter of supply and demand, until some better investment comes along for those foreign dollar-owners. The Dubai ports deal, which we have heard so much about recently, is a good case in point of a vast excess of foreign dollars trying to find a permanent equity ownership home in the U.S.A., their country of origin. Look for many more such efforts by foreign governments, particularly China and the Arab oil producers.

We saw some movement this week toward higher international interest rates when the Bank of Japan abandoned its long-standing zero interest rate policy (ZIRP), signaling an end to five years of deflationary economic trends. Long-term U.S. rates immediately moved up several basis points; in other words, long-term U.S. government rates were actually lower (and more inverted) a week ago than those quoted above.

For the moment, we feel comfortable with a close to fully invested position in properly valued, dividend-paying stocks. This week we deployed some of the profits we took earlier in the year (see our 2/09/06 blog note) by taking a core position in TCF Financial (TCB). We have done very well with this high-quality holding in the past and have re-entered at a level lower than our last very profitable sale of this stock. Incidentally, when we last sold TCB we redeployed that capital in Moody’s (MCO), which has since doubled in value. TCB is an excellent Minneapolis-based national bank, with a growing retail base, which keeps its cost of funds (which it calls “Power Liabilities”) among the lowest in the business. TCB ranks first among the 50 largest banks in Return on Equity (ROE), one of the most important statistics in the banking business. It also pays a very bond-competitive 3.5% dividend. Right down our EVA alley!

We welcome your comments and observations.

Jack and Peter

Thursday, February 09, 2006

FI Update - 2/9/06

To: FI Clients

From: Peter and Jack Falker.

Subj: FI Update

Here is a summary of our investment activities over the last several months, along with some of our thoughts:

In early February 2006, we sold ATK Systems (ATK) for a profit of 51 %. The stock had reached an all-time high and was somewhat overvalued based on our modeling assumptions. Also, a question had been raised in the January 9th edition of Forbes Magazine about the size of ATK’s unfunded pension liabilities. After talking with the company, we concluded that, as so often happens in the popular press, the pension issue was probably overblown. However, perception often becomes reality in this world, so we decided to book our profit the day before the company’s quarterly conference call. The street was disappointed by their results (which had little or nothing to do with their pension issues) and the stock dropped nearly $5.00 (6.2 %) that day.

Also in early February, we sold J.P. Morgan Chase (JPM) for a small profit. During the two years we held JPM we collected an annual dividend of 3.5% which was better than we could have earned on cash and approximately equal to the yield of a high-grade bond of similar duration. Now, with cash yields up, we will look for the opportunity to re-deploy this capital in another bank with an equivalent or better dividend and a better potential for a capital gain going forward.

In late January 2006, we sold PNC Bank Corporation for a profit of 18.5%. We also collected a 3.6 % dividend in the 13 months we owned PNC, giving us a 22% overall yield on our investment. We originally bought relatively small positions in PNC and U.S. Bank Corporation (USB) as weak dollar hedges, since they were both undervalued, compared with most other large banks in the U.S. Based on our reading, the thought was that they would make attractive acquisition targets for European banks with a surplus of strong Euros. With the U.S. dollar strengthening in 2005, our hedge strategy became irrelevant, but PNC had good results and the stock responded, making it somewhat overvalued, so we took our profit. We still own USB, which is slightly above our basis and continues to pay us a 4.5% dividend (as good as a 10 year government bond). We may decide to sell USB, as well, when we see a better investment opportunity for the funds.

In mid-December 2005, we sold Briggs & Stratton Corporation (BGG) for a small (.6%) profit. The stock had performed poorly since we bought it last February, and at one point had lost about 20 % of its value. In late October, we talked with the company’s CFO, with a thought toward exercising our long-standing stop-loss policy. After that conversation, we suspected that the company might report a good quarter, based on generator sales after the hurricanes, plus a pricing initiative they had undertaken for 2006 lawn and garden sales. Apparently a few other folks in the market thought so too, because the stock literally rocketed up in December. On the old theory of not looking a gift horse in the mouth, we sold BGG and reclaimed our capital investment. In January, BGG reported a disappointing quarter and the stock has subsequently gone back down.

In late October 2005, we sold Techne Corporation (TECH) for a profit of 54 %. While we still really like this little-known Minneapolis biotech raw-materials supplier (and know them very well), our analysis indicated that it had reached a valuation we felt was unsustainable. We believe we will have a chance to own it again when its valuation is more in line.

In late September, we sold Conagra Inc. (CAG) at a small (3%) loss. Unfortunately, we had seen a nice profit in the stock erode on the basis of disappointing results, and decided that things might get worse before they got better (we were right). Fortunately, we had collected an annual 4.6 % dividend on the stock over the two years we owned it resulting in an overall 2 year total return just over 6%.

Most of our remaining portfolio is doing quite well, with a few exceptions such as Dell, Wal-Mart and Gap, which all should recover in time. We are holding a little more cash than normal, because of our recent profit-taking, but we are also looking at a few companies we would like to own at the right prices. In the meantime, money market yields have improved considerably and we can afford to wait. In that regard, it still seems likely to us that bond yields should move higher over the next year or so. If and when those yields become as attractive as overall market expectations, we may want to hold a few bonds.

Best regards,

Peter and Jack