Tuesday, November 11, 2008

The Aftermath

           “When it comes, it bears the grim face of disaster.  Those who had been riding the upward wave decided now is the time to get out.  Those who thought the increase would be forever find their illusion destroyed abruptly, and they, also, respond to the newly revealed reality by selling or trying to sell.  Thus the collapse.  And thus the rule, supported by the experience of centuries, the speculative episode always ends not with a whimper but with a bang.  There will be occasion to see the operation of this rule frequently repeated.”

-John Kenneth Galbraith
 A Short History of Financial Euphoria, 1990


So here we are with the bang of the collapse in the housing and debt bubble reverberating throughout the world.  October 2008 was the worst month for the stock market since 1987.  The total economic fallout, while uncertain, predictably worsens as we look to early 2009 with rising unemployment leading the way.  We are seeing the effects of deleveraging after a lengthy speculative episode.   The response has predictably been aggressive policy measures from Government and an increase in the cost of capital as risk premiums soar.  However, there are times, such as we face now, when the reaction is so extreme, the fallout so difficult, and the appetite for risk so diminished that financial memory will impede a return to excessive, leverage-driven speculation for a very long time.  The silver lining here, of course, is that investors are paid to take risk and markets are demanding higher returns.  The key is to find where risk is appropriately rewarded and how the reward is realized.  Sufficient return on capital is paramount and a predictable cash yield is essential.

Globally, governments are now responding in concert with stimulus packages and easier money.  Importantly, however, much of this is surprisingly late.  Gripped with fears of inflation which had already come to pass, and with apparently no attention paid to the effects of deleveraging and the developing recession, the European Central Bank raised interest rates on July 3rd.  The Federal Reserve also “jawboned” several times late in the summer about fighting inflation with higher rates.  These were attempts at instilling confidence and protecting purchasing power, but markets had difficulty adjusting to new expectations of tightening credit not just from investors, but also from central banks.  We believe this realization was critical in tipping us from a significant, productive recession to one much more harmful, driven by fear and panic.  Once the market decline began, it was fast and forceful.  Companies such as Lehman, AIG, and the Royal Bank of Scotland faced a sudden death of insolvency as their assets quickly revalued at much lower levels and funding disappeared.  Markets entered into a destabilizing period of forced liquidation and cash hoarding. 

To see what is happening now, let’s first revisit what we said in our March 2008 piece entitled Bubble Backlash.  “Given that we are unwinding possibly the greatest credit bubble this country has ever seen, the proportionate response from the Federal Reserve and lawmakers may be quite large in absolute terms.”  To illustrate, take a look at the chart below that we have been tracking from data provided by the Federal Reserve. (You can click on it for a larger view.)

The red line depicts the annual percentage change by month in what’s called the monetary base.  It is a measure of all currency and banking reserves in the economy; literally the base off of which our entire capital structure of investment, credit, and consumption is built.  As such, it is the bottom of an inverted pyramid.  The Fed has increased this base by close to 40% from last year’s level because so much money is currently being hoarded by those who have it and absorbed by those who need it to unwind leverage; a race to get those US Dollars at the bottom of the pyramid.   The Fed is injecting money to provide actual dollars needed to keep the credit markets functioning at a basic level.   We have never experienced a monetary injection of this magnitude in the US economy.   Add the $700 billion TARP being used to keep banks solvent and the upcoming stimulus packages, and the policy response is certainly proportionate and large.  As one might assume, while policymakers fight the onset of deflation, investors will keenly search for signs of emerging inflation down the road.

So far these measures avoid a direct hit on the issue at the core of our problems:  the deflating of an over-inflated and over-leveraged housing market.   Most of the previous liquidity measures are attempting to re-liquify the banking system and encourage lending but, in reality, many banks are drowning in available liquidity but hoarding it to protect their balance sheets.  Their biggest problem has been avoiding insolvency as they are loaded with bad mortgage debt.   The TARP has attempted to help this with direct equity injections into the banks.  The worst mortgages, which consisted of low quality two-year ARMs with pay-options and low teaser rates, were issued between 2005 and 2007.  As these mortgages reset at interest rates in the double digits, foreclosure rates have steadily risen.  The largest quantity and lowest quality of these loans were written in late 2006 and early 2007 and those are the loans that are defaulting right now.  By late spring 2009, there will be no more such loans to roll over and we may find the beginning of a housing bottom.  But in today’s credit-starved world, 6-8 months is an eternity.  We expect more aggressive action (i.e. hundreds of billions of dollars) aimed at assisting homeowners and banks to work out many of these remaining troubled mortgages.  Banks may then avoid insolvency and begin using these capital and liquidity injections to begin lending to good credits.

As for the equity and fixed income markets, we look for stability to develop as a result of these measures.  In times of panic and distress, the uncertainty of expected outcomes is magnified as human financial behavior is inherently unpredictable.  The panic we see in markets may be justified by fear, but the existence of permanent fear is unreasonable and historically unsustainable.  At some point, when assets are revalued to provide a sufficient return and excess leverage is squeezed from the system, behavior will likely become more predictable and stable, discounting some form of recovery.    We are left to judge whether the resulting prices offer opportunity for investment.  Some companies that we own are trading well below book value while their balance sheets look healthy.  It would appear that no future growth is being forecast forever and assets are being discounted as significantly impaired.  This indicates that fear still pervades and uncertainty rules the day. 

While stability will no doubt take time to develop, it is important to understand that eventual growth in real GDP is, at a minimum, dependent on productivity gains and the basic needs of a growing global population.  We believe investors will begin to identify companies that are vital in those areas and are largely self-financed by sustainable cash flows from operations.  A cash return on investment will be favored and we will look to capture high dividend yield stocks and investment grade bonds where yields have risen to more appropriate levels.  That is where investors will flock when stability returns. 

We have tried to manage our portfolios to be relatively conservative, focusing on companies that meet our usual return on capital criteria.  While we have been opportunistic in selling when it seemed reasonable, it has been nearly impossible to aggressively to sell enough to avoid the fallout in the stock market for that last 45 days.    Our margin of outperformance over the market has been gained from the relative stability of several core holdings and our cash position during the course of the year.  We believe our holdings that are very depressed (i.e. energy, industrial, and commodity related) are worth holding because of the value of balance sheet assets, eventual inflation of commodities from aggressive monetary policy,  and the longer-term secular growth of emerging economies.  We will be very patient when investing available cash and may look to trim positions that have remained profitable.  We will continue to invest in short to medium-term bonds that offer compelling risk-adjusted returns and are paying us 8-10 percentage points more in current yield than what we receive in the U.S. Treasury Money Fund.  We are also focusing on a few key technology companies (such as Cisco and Microsoft) that are vital to long-run productivity gains of the global economy.  Finally, we will carefully add to depressed core holdings that are associated with basic non-discretionary needs of consumers.

It is probably an understatement to say this is a difficult time.  We expected hard times and difficult choices, but we were not investing for a total crash.  We did so in 2002 and largely avoided a very painful decline.  However, by being in Treasuries we missed the very profitable early stages of recovery in 2003 and remained cautiously invested for the past five years, outperforming the market in four of those years including this one.  Rarely is anyone so fortunate to completely miss a crash.  Planning in earnest for a catastrophic market event can take years, and with it comes increased risk of missing longer periods of prosperity while you wait.  Preservation of capital is always at the top of our list, yet, as investors, we inherently take risks that subject us to volatile times.  If history predicts the fallout from repeated bubbles, then it also clearly predicts the recovery that has repeated every time as well.

 To quote Galbraith once more: “Financial genius is before the fall.”  This sense of genius is fleeting and thrives on hubris.  That was certainly the case.   But that is history.  Everyone needs to learn from experience and look forward.   Collectively our nation has been humbled on many fronts.  A sense of humility combined with our freedom, democracy, and free-market capitalism will lead us back to prosperity.

We welcome your comments.

Peter and Jack Falker

"Note:  At the time of publication, Peter and Jack Falker, and the clients of FalkerInvestments Inc. were long the common stocks of Cisco Systems and Microsoft."

Thursday, October 09, 2008

What’s Happening and What We’re Doing

Given the state of the markets and economy, we would like to update everyone with our strategy and outlook. Over the past four weeks we’ve had some success trimming back and selling certain profitable long-term holdings that had not yet suffered from the broad-based selling of the last two weeks. These were gains that we had planned on taking under normal conditions that have helped build a significant cash position to buffer the portfolios during this downturn. Focusing on our bank stock exposure, we eliminated our US Bancorp position, near all time highs, and reduced our Goldman Sachs stock holding by taking advantage of dramatic short-term market swings. Given the uncertainty in financial stock valuations due to the need to raise capital, we decided to “move up the balance sheet" with senior bonds in Goldman and GE Capital that were trading at seemingly distressed levels. We have seen yields to maturity of 9% on Goldman and 7.5% on GE for bonds that mature anywhere from 2 to 4 years. At this point, those are the only purchases we are willing to make until we see signs of stability in the markets.

The rest of our positions likely represent extraordinary opportunities for long-term investment. Unfortunately, because of the massive credit freeze, a disorderly unwind of leverage and a race to cash for those in distress, particularly hedge funds with significant energy and commodity holdings, has heaped enormous pressure on the entire stock market. This process is having a definite impact on economic fundamentals, which affect overall equity valuation in the market. The problem for investors is discovering when the liquidation of assets has run its course. This unwind is happening very fast and when it ends we can assess the collateral damage to the economy.

We expect markets to stabilize with the assistance of an unprecedented amount of money being made available from the Federal Reserve and Treasury. While somewhat controversial and by no means a panacea, these efforts must be done efficiently and quickly to provide needed capital and lending facilities where credit markets are dysfunctional. In a way, this injected money can be considered a surrogate for the capital that investors and institutions are hoarding. It essentially buys time for good credits until confidence and clarity return. The risks of inflation are low because the money already in the system is unwilling to be invested and will not, in the short term, result in the classic “too much money chasing too few goods” scenario. However, there is likely to be a period down the road when inflation risks will run higher, as the Federal Reserve attempts to drain the excess money supply from the system.

Our investment strategy remains the same. We continue to look only at companies with strong cash flow and limited needs for credit. Companies with significant cash flow and steady returns on capital will be rewarded with premium valuations in years to come. We will continue to look for companies with stocks and bonds that pay steady and sustainable dividends and interest. As we have maintained for several years, returns on most assets will be subdued. Quality and consistency will be rewarded over time.

Let us know of your thoughts and questions.

Peter and Jack Falker

"Note:  At the time of publication, Peter and Jack Falker, and the clients of FalkerInvestments Inc. were long both the common stock and bonds of Goldman Sachs and General Electric."

Tuesday, September 30, 2008

How We See Things

We were very surprised and disappointed that the Paulson plan did not pass the House of Representatives on Monday. The markets’ reaction was not unexpected and, while we did not expect this to happen, we were prepared for it. Here is where we stand:

  • We have approximately 20% cash in all of our accounts, which is securely invested in U.S. Treasury money market accounts. This is the result of consistently taking profits off the table for the last several months.

  • Last week we invested approximately 2.0% of our portfolios in Goldman Sachs’ AA3/AA- rated senior notes, yielding 8.5% to maturity in January 2011. We saw this as an opportunity to position ourselves two steps ahead of Warren Buffett on the Goldman balance sheet, after Berkshire Hathaway invested $5 billion in Goldman preferred stock, yielding 10%, and Goldman simultaneously raised another $5 billion in the public equity market.

  • The balance of our portfolios are invested in strong, undervalued companies, many of which have been relatively unaffected by the market downturn, while some, particularly those in oil, metals and infrastructure, are being affected by a now well-documented world recessionary scenario. Many of our companies present compelling values, but we are being patient in committing additional capital, while waiting for stability to return to the markets.

  • Our year-to-date performance, while in negative territory, continues to track well ahead of the S&P 500 Index benchmark.

We are paying very close attention to everything that is happening in the markets and it is our opinion, at the moment, that we will still see some form of bailout plan in the next week or so.

As always, we are happy hear from you.

Jack and Peter Falker

Note: Both Jack and Peter Falker, and the clients of FalkerInvestments Inc., are long both the common stock and bonds of Goldman Sachs, as well as the common stock of Berkshire Hathaway.

Tuesday, September 23, 2008

Trading in a Turbulent Week

Our clients know that our strategy ordinarily does not involve short-term trading, but last week was a notable exception.

Goldman Sachs (GS), which in our judgment is the premier investment bank (now commercial bank) in the world, fell sharply last week and by Wednesday was trading at its book value of just over $100 per share. This was such an unusual circumstance that we felt we should take advantage of it to average down our cost basis in this core holding. We bought the stock at 108 on Wednesday, which had the effect of significantly lowering our average cost.

As the week went on and the entire financial system literally began to fail, the U.S. Treasury announced, on Thursday night, its plans to initiate a huge purchase of the toxic mortgage-backed debt that had frozen the system. On Friday, financial stocks rallied strongly on the news, and that enabled us to lock-in a 21 point (19%) gain on the GS position we had just taken. We decided that taking this gain was prudent in the face of the turbulence of the market. We also took additional gains in U.S. Bank (USB), which, despite the fact that it is one of our favorites, had gotten well ahead of its valuation on Friday, in the euphoria following the Treasury announcement.

In combination with other actions we have taken over the last few weeks, these moves have enabled us to protect a significant amount of client capital, which we believe is prudent, given the seriousness of the situation. All of this cash is invested in a U.S. Treasury fund; not quite under the mattress, but close to it.

We have continued to outperform the market, year-to-date, and we intend to keep it that way.

If there are any questions about our strategic moves, we will be pleased to respond.

Jack and Peter Falker

Note: Both Jack and Peter Falker and the clients of FalkerInvestments Inc. are long both GS and USB

Thursday, September 18, 2008

Breaking the Buck ’08 (Not!)

Last November we moved all of our cash holdings to Schwab’s U.S. Treasury Money Market Fund in anticipation of conventional money market funds potentially “breaking the buck”, i.e. falling below $1 share value as the result of losses in asset backed commercial paper or the commercial paper of bankrupted companies.  Therefore, our clients’ funds have been protected from that unfortunate scenario for nearly a year now.  We have paid a price in terms of lower yields on cash that result from this level of security, but we have felt it was worth it.

We wrote a blog note in November 2007 describing our concerns and actions.  You can read that post: “Breaking the Buck (Not!)” by clicking on the 2007 on this link.  Breaking the Buck (Not!)

Here are a few words from that article: 

“We had been suspicious that this might happen for some time now, so we have moved all of our clients’ cash investments to U.S. Treasury money market funds (or the equivalent), thereby insuring that we will continue to receive some positive return on all of our cash investments.  Even though it is widely assumed that major brokerages would support the value of their funds, a large exodus from money funds could impair their ability to do so on a timely basis.  We feel it is important to be early in our decision if in fact this scenario develops.”

With all the attention being paid to money market funds in the press over the last few days, we thought it would be a good idea to remind everyone that their cash is invested in U.S. Treasury securities. 

Jack and Peter Falker 

Tuesday, September 16, 2008

Current Thoughts

Here are a few of our thoughts in the midst of a very turbulent time. First, it is important to recognize that what we are experiencing right now is probably equal to or greater in magnitude to anything that has happened in the history of our financial system. The mechanisms that were set in place after the great depression have protected the financial markets thus far but, make no mistake about it, these mechanisms are currently being severely tested.

At this time, it is yet to be seen if the Federal Reserve will be able to offset increasing systemic risk in the financial system by extending their charter to the protection of commercial banks from the counterparty risks of non-commercial bank financial entities, such as investment banks and large insurance companies. As we write this note, they have opted not to directly backstop the counterparties of Lehman Brothers in the way they protected the counterparties of Bear Stearns; a rather strange and oddly political call in our minds. Now, it is unknown if they will protect the counterparties of AIG, which is a potentially far more serious problem for virtually every large bank in both the United States and Europe. In our judgment, they must step up to this situation to avoid financial chaos, but their unwillingness to try and calm the markets seems odd to us. We can only assume that their own capacity may be in question.

Having said all of this, it’s worth repeating what the CFO of Goldman Sachs said in their conference call this morning: “In difficult times, nothing is ever as bad as it seems at the bottom and, in good times, nothing is ever as good as it seems at the top.”

With that in mind, we have left considerable cash on the sidelines to protect ourselves from downside and to take advantage of some rather extraordinary opportunities that we are currently seeing. Recently, our biotech, consumer staples, and medtech/pharma sectors have held up very well, offsetting some of the weakness in commodities, infrastructure, and energy, where many good values are being exposed. While we are well aware of the weakness in the economy, all of our holdings have significant value that will continue to rise over time. Under current circumstances, we may trim positions, where sensible in the near term, while keeping an eye toward investment opportunities that are developing.

Given the challenges of today, we find comfort and confidence in sticking to our conservative strategy and valuation process. It will guide us through these chaotic and volatile markets and provide significant returns to our investors over time.

We welcome your comments and questions.

Thursday, July 31, 2008

Mid-Year Thoughts

Is there a recession or isn’t there? Technically speaking, we aren’t in a recession, because GDP continues to grow slowly. Ok, tell that to the American who just put 25 gallons into their gas-guzzling SUV and added $100 to an already overflowing VISA, at 18% interest, which they can’t pay off. Tell it to the family that stopped making payments on their 12% floating-rate home mortgage, because they have to keep their credit cards alive so they can get to work and eat. Multiply that by the thousands of people who do that every week and it gives you some perspective that all is not well out there.

Many people made poor financial decisions and corporate executives, especially those in the banks, didn’t understand their risks. The world economy is more competitive, as we realize that demand from countries such as China and India now dictate the price of scarce commodities that we have taken for granted. A recession is generally upon us, and the lessons are being learned. However, there is tremendous opportunity in the global economic world for everyone, and the key is to encourage investment toward the efficient use of capital.

Through these very turbulent times, we believe that we and our clients are well positioned in a volatile market that we think will continue over the next several years. At mid-year our fully invested accounts were generally 6-8% ahead of the S&P 500. That followed our strong 2007 performance in which we also exceeded the benchmark.

Within our strategy we have been pursuing long-term investments in global infrastructure, commodity and energy companies that meet our internal rate of return and valuation criteria. Our investments in oil, natural gas, biotechnology, infrastructure, and steel did particularly well for us in the first half, but some have turned down in July, which we believe is a temporary phenomenon that may afford the opportunity to average down several positions.

We hold two companies in the financial space (Goldman Sachs and U.S. Bank), which continue to be negatively impacted by perceptions that anything in this space is toxic, despite their own internal performance and long-term prospects. However, it’s not too hard to understand why the perception of financial companies is so negative, given that the majority of banks, brokers, insurers and rating agencies, as well as the government sponsored entities Fannie Mae and Freddie Mac, apparently did not understand their own lending activities in the housing space and did not see the mortgage securitization problems coming until it was too late to act. Witness the multi-billion dollar disasters of Bear Stearns, and Countrywide Financial and the potential disasters of Lehman Brothers, Merrill Lynch, Wachovia and Washington Mutual, to mention just a few, and you begin to understand why this area remains so difficult to invest in, despite any good that is being done by companies like Goldman Sachs and U.S. Bank.

To get an idea of the current status of the problems in housing and mortgage financing, take a few moments and read this excellent analysis, entitled Mooooooo!, published this week by Bill Gross of PIMCO Investments: http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/Investment+Outlook+Bill+Gross+Mooooooo+August+2008.htm

When we see things happening that seem proportionately worse than the events that caused the stock market disasters of 1929, 1933 and the ensuing depression (which really didn’t end for most people until after World War II), we have to remind ourselves that we live in a global economic environment that is far more able to endure the kind of financial shocks that essentially shut down the U.S. economy and stock market nearly 80 years ago. The actions of the Federal Reserve and the U.S. Treasury in the last six months are clear evidence of the progress we have made since 1929. Also, take note of the multi-billions of off-shore dollars flowing back into this country as capital investments in some of our ailing financial institutions. These kinds of things could not have happened 80 years ago.

And yet it’s important to realize that the Fed and Treasury do not have all the answers and are not omniscient in their respective abilities to solve all of the ongoing problems of our financial system and economy. In the short-run, they are largely powerless in dealing with the price of oil and the related weakness of the dollar. Such problems must be fixed by changes in our consumption behavior accompanied by long term fiscal and monetary discipline (i.e. reduced government borrowing and responsible monetary policy).

Accordingly, we believe the issues that directly affect investments of capital in the stock and bond markets are likely to be with us for several years. People will get used to paying five to 10 dollars a gallon for gas (as Europeans have for years because of taxation that has deliberately held down their consumption) and maybe just might get the message to shut-off their engines and open the windows when sitting still, instead of burning gas to run the air conditioner. Or they might just get out of their cars to get a cup of coffee at Starbucks instead of idling in line at the drive through window (not to mention the related pollution). Or, heaven forbid, they might just ride the bus or train to work, like people all over the world have been doing for many years.

Economic growth will depend more on investment and less on the largest component, consumption. Reduced credit availability will slow the pace of any future home price appreciation and end the indiscriminate use of home equity to fuel consumption. Higher commodity and energy costs will alter economic decisions and personal behavior. For example, we are using three to five percent less gasoline than just a year ago; use of public transportation is up over 2%; wind power investments are motivated by a goal of providing 20% of U.S. electricity demand; current investments in natural gas will provide access to a plentiful source of domestic energy that can be used to replace much of our dependence on foreign oil. China’s growth mandate along with growth in India and neighboring emerging economies, while slowing from time to time, will continue to drive demand for technology, infrastructure development, and industrial commodities such as copper and steel. Also, investments in diverse, internationally exposed companies that provide essential products for a more conservative U.S. consumer, as well as an emerging global population demanding increases to their standard of living, will continue to do well.

In other words, we continue to see the glass as half full, even though we are well aware of the problems that are causing it to be half empty. Until we see significantly higher long-term bond yields, we continue to believe that the best place to invest capital is in the high-quality, dividend-paying equities defined by our investment strategy. That encourages us to take profits when we have them and not be reluctant to hold 10-15 percent cash from time-to-time (as we currently do) when we believe greater opportunities might lie ahead.

Our strategy, which rigidly takes into account internal rate of return performance and long-term valuations of every company we own, or expect to own, is literally made for the circumstances we expect to face in the years to come, as our country works its way through one of the most difficult economic times in its history. One thing remains very clear to us, however: History has taught us that the United States is remarkably resilient in times like this. It is definitely not the time to bet against this country.

That’s the way we see it at mid-year 2008. Let us know what you think.

Jack and Peter Falker

Note: At the time of publication, Jack and Peter Falker, as well as the clients of FalkerInvestments, owned the common stock of Goldman Sachs and U.S. Bank.

Sunday, March 09, 2008

Bubble Backlash

We try to make our investment discipline as clear and concise as possible. If you are a client you’ve heard us say it many times over (Jack has a tendency to lecture at length during our meetings), but here are our two guiding principles again.

1. Only own companies that generate returns on capital that exceed the cost of capital.
2. Never overpay for an expected future stream of cash flows.

These principles can be adapted for particular circumstances, but are too often ignored or forgotten by business owners and managers, households, and financial market participants. Because of this, our country finds itself in a serious economic predicament, as we go through the second post-bubble backlash in seven years.

As the financial markets have declined due to fears of recession, foreclosures, deflation, inflation, etc., etc., it is important to look across the valley for a path to higher ground. In the meantime we can use our guiding principles to help us find better investment returns along the way. So let’s take a brief trip down into the valley and look at the “crisis” facing the US economy. First, a look at how the US Dollar Index illustrates, literally, the road map we have been on.

This decline in the dollar can be summed up easily: the demand for dollars is significantly less than the supply available. Many believe this reflects the relative direction of our global economic position.

At risk of oversimplifying, we all know that US consumers have an insatiable appetite for “stuff”, and their eagerness to borrow (often against their houses) to buy that “stuff”, has created a growing disparity between what we use and what we produce in this country. This was greatly enhanced in recent years by the Greenspan rate cuts to 1% after the fallout from the tech bubble, and by financial markets deploying creative and complex ways of aggregating global capital that was starving for return. The perfect marriage of a fiscally irresponsible consumer, and capital invested at a reduced, or most likely false, expectation of return, created the potential for widespread destruction of value. Our clients and those familiar with our investment discipline will recognize this as similar to the reason we invest only in companies that are fiscally responsible and respect the cost of the capital they are using.

For most of the last century, the US has enjoyed the position of being the global economic leader and producer of goods. The reality is that economies previously labeled emerging (a fairly non-threatening term) have now emerged and are competing globally. While competition is healthy in a free market system, it also requires efficiency and discipline with respect to capital investment. Our consumption patterns, lack of saving and willingness to over-leverage are all weaknesses that are being highlighted and exploited by our newfound competitors (think China, India, etc.). The resulting fallout from this behavior, seen specifically in the highly leveraged housing and financial markets, has lawmakers and the Federal Reserve ready to intervene.

Government has been mastering the art of the bailout since at least the early 1900s and, therefore, the markets have high expectations for a rescue. While our capitalist, market-driven economy benefits from regulation and occasional targeted intervention, the focus on a rescue when things go awry can distort the market mechanism of finding equilibrium asset prices and flushing out bad financial decision making. The headlines of a looming recession and realized losses on financial investments coupled with constant rhetoric from politicians and central bankers, stoke the uncertainty and volatility present in markets today. Given that we are unwinding possibly the greatest credit bubble this country has ever seen, the proportionate response from the Federal Reserve and lawmakers may be quite large in absolute terms.

So, let’s look at what the geniuses at the Federal Reserve are up to. After several months of uncertainty, the Fed has clarified its position: Offset the deflationary and recessionary effects of deleveraging on the economy and worry about inflation later. To be clear, the greater risk in the very short run is deflation, as the rapid unwinding of credit and credit availability limit capital investment, consumption, and overall aggregate demand in the economy. Declining credit availability is similar to a decline in the money supply, which is exactly what the Fed is trying to offset.

The unwillingness (in some cases inability) for banks to lend, as well as the difficulty of credible borrowers to obtain capital, is at the forefront of the Fed’s concern as it continues to use the blunt force of lower short-term interest rates by injecting money into the banking system. As the Fed was apparently late in assessing the risks of the situation (or possibly ignorant as was much of Wall Street), the short end of the yield curve is currently indicating the need for substantially lower rates to induce capital flows. For much of the past two years, banks have faced weak net interest margins (interest received less interest paid) due to short-term rates equaling or exceeding long-term rates. In addition, some of the largest banking institutions and brokers (the best examples being Citigroup and Merrill) have sought massive capital infusions to bolster bloated balance sheets loaded with “toxic” loans that are subsequently being written down in value (in accordance with some debatable accounting standards). The Fed is attempting to allow banks to earn money at all maturities of the yield curve by lowering the Federal Funds Rate. As seen in past rate reductions, the target Federal Funds Rate may be somewhere below the two-year Treasury yield, a proxy for the short end of the yield curve. Currently that rate is close to 1.6%, but it can fluctuate greatly day to day.

Even though the banking system as a whole is well capitalized, restriction of the flow of capital is a real and destabilizing threat to the economy that the Fed needs to address. The risk here is being too aggressive for too long. By inflating our way out of this problem with an increasing supply of money, a substantial portion of those “extra” dollars unfortunately will be used to consume imported goods, which will expand the difference of what we use versus what we produce as a nation. By forcing dollars into the hands of our foreign competitors and essentially asking for them back as a loan to fuel further consumption and government spending, we give away ownership interest in our national assets, as well as the discretion over how those dollars are invested. For example, when we use dollars to buy toys with lead paint from China, they can use those dollars to invest in US Treasuries, which helps keep our long term interest rates low but also makes us dependent on them to finance our deficits. Or they can reallocate and buy other stores of value. If they choose to do the latter because the returns here are insufficient (i.e., practicing principle number one from above), it will raise our interest rates, exacerbate tight commodity markets (commodities are already expensive due to global demand and ethanol subsidies), and raise the cost of imported goods. These are all symptoms of inflation. Worse, it is inflation with very little real growth, or “stagflation”.

The key here is this: no pain, no gain. Deleveraging and the revaluation of asset prices (e.g. houses, mortgage backed securities, leveraged loans) is taking place right now. So far the Fed’s action can be seen as attempting to stabilize defunct credit markets. We should expect (or hope for) the Fed to take back anything extra that has been put on the table, as soon as markets have had time to heal. Healing might require going into a recession, but it is often the best remedy. Consider how the Fed inflated its way out of a surprisingly mild recession in 2002. Possibly the credit bubble we face today could have been avoided with less aggressive monetary policy and a deeper, more effective slowdown. As Stephen Roach, chairman of Morgan Stanley Asia, opined in the New York Times recently, “The greater imperative is to avoid toxic asset bubbles in the first place.” (click here to read his op-ed, after you finish this blog post of course)

Additionally, right or wrong, the government will bail out many people who made poor financial decisions (by the way there is some real evidence of fraud in mortgage lending being uncovered). At the very least, Congress and the Treasury will attempt to facilitate a workout of the mortgage problem to get people back on their feet. There are many pitfalls along the way, but the real challenge is to moderate assistance, so those that get help learn to stay on their feet. Some ideas that are being floated include reform (or possibly a bailout) of Government Sponsored Enterprises known by their chummy nicknames Fannie Mae and Freddie Mac, expansion of the FHA, and a public awareness campaign called The Hope Now Alliance, which is sponsored by the Treasury Department. In the end, free markets guided by the boundaries of sound laws and the efficient transfer of capital will eventually get it right and money will flow when returns are appropriate. Lessons will be learned (possibly to be forgotten as history suggests) and we will make progress.

There is a path that leads us to higher ground and there will continue to be opportunities to invest profitably. Since it is difficult to say it any better, here is a quote from Warren Buffett’s 2007 letter to shareholders: “Despite our country’s many imperfections and unrelenting problems of one sort or another, America’s rule of law, market-responsive economic system, and belief in meritocracy are almost certain to produce evergrowing prosperity for its citizens.” This is the belief in our country to get it right. The realities of a global economy have revealed our weaknesses and it will take time to adjust and correct our errors and imperfections. Now is the time to focus on fiscal discipline, sound capital management, sound free trade policy, and innovation to compete and export in a global marketplace.

It is very important to look across the valley at future growth and investment returns. The U.S. economy continues to increase productivity, more companies are focusing on return on capital (we see it most in working capital management), and many U.S. corporations are well positioned internationally to take advantage of the rapid growth of infrastructure and technology on a global level. Those opportunities are most prevalent today in China and India, which are voracious consumers of resources and goods, as they build out to accommodate a surging urban population.

No matter how long the duration of the credit crisis, we stick to our principles of investing, which are serving our clients well. Many well run businesses will feel minimal effects from a slowdown. Stock market values may go down, but as long as businesses continue to create value and preserve capital, intrinsic values will rise. While by no means the beginning of a long term bull market, current levels are presenting opportunities to invest. We continue to be conservative in our choices and maintain our current theme of preserving capital by maintaining some defensive positions. We will continue to add undervalued names that will benefit from global expansion and the general level (not just the rate of change) of commodity prices. We are closely watching some financial companies that have been significantly discounted in the market. Retail is not as interesting quite yet as consumer spending and employment will likely be under pressure through much of 2008. We will also take full advantage of opportunities to take profits when appropriate. Finally, as a reminder we will:

1. Only own companies that generate returns on capital that exceed the cost of capital.
2. Never overpay for an expected future stream of cash flows.

These should not simply be treated as truisms, but should be discussed and practiced in all matters of economic consequence.

We welcome your questions and opinions.

Peter Falker, CFA

Thursday, January 10, 2008

Selling a Long-Term Holding

Selling a stock we’ve held for quite a while, and which has done well for us, is always a difficult decision. We are often asked how and why we do that, and it’s always a good question.

Here’s a good example: We just sold WellPoint, Inc. (WLP), one of the largest healthcare insurers in the country, which we had held for the last 13 months. We bought WLP, along with Aetna (AET), to maintain our position in the healthcare insurance segment, shortly after taking our profits in UnitedHealth (UNH). That proved to be a good decision, since both WLP and AET have outperformed UNH, as well as the S&P 500 Index, since we bought them. (See our blog post “Back to Healthcare” dated December 6, 2006.)

So why sell WLP now? The most important reason is that the company no longer meets our investment criteria. Their current stock price is just below an all-time high and it now exceeds what our valuation model tells us the company is worth. Secondly, they are no longer an EVA company, meaning that their return on capital has drifted below their cost of capital while we have held the stock. That’s reason enough when we can book an 18 % long-term gain, even though we think there could be some appreciation in the stock over the next year, based on what the company has recently said in an analysts’ meeting.

However, there was another rather compelling reason for us to sell WLP here. We recently had access to a somewhat obscure, but very well done, piece of research that said that WLP has approximately $300 million in sub-prime, mortgage-backed securities on their books, which they probably will have to substantially write-down, as of the end of 2007. While $300 million is a relatively small portion of their investment portfolio, it is still a lot of money, and the write-down would come at a time when no one wants to hear about another company losing money on sub-prime mortgage investments. If this happens (and we can’t say for sure it will), we think the stock could trade down for a period of time, thereby impairing our gain.

So, this combination of factors (i.e., the company becoming overvalued, as well as not meeting our EVA criteria, plus the desire to protect our 18 % gain in a difficult market) gives us our sell signal. Of course, we can’t know for sure what will happen after we’re gone. But one thing we do know is that we beat the market with this holding and we are quite sure we’re going to have other places to deploy our cash, as the market continues to give up the meager gains it made in 2007.

Note: At the time of this posting, Jack and Peter Falker and the clients of FalkerInvestments Inc. were long Aetna (AET).