We now have the answer to how we can eliminate foreign oil, which, as Thomas Friedman of the “New York Times” so aptly points out, is the primary source of funding for radical Islamic terrorism. In my view, the answer is hybrid automobile technology, even as it exists today in its still rudimentary form.
A few months ago, I bought a new Toyota Highlander Hybrid SUV, which is not a small vehicle, weighing in at just over 4,000 pounds. It is rated at 33 MPG city and 28 MPG highway and I am averaging nearly 31 MPG in combined city and freeway driving. Why is it higher in the city? Because the engine shuts off every time you coast or stop at a sign or red light and, if you’re careful, you can pull away from a stop without immediately having the engine start with the always functioning motor/generator. After driving this vehicle for a few weeks, I started to realize, to my amazement, that every other car around me at a stoplight was burning expensive gasoline and mine was not! I also discovered that when I am in slow-moving rush-hour freeway traffic that my car runs almost exclusively on its battery, with the engine only coming on every few miles to replenish the battery, but not to drive the wheels. This is truly amazing when I look at the hundreds of cars around me that are blatantly wasting imported oil. Then I started to ask myself: How much gas could be saved in this country if just half of these cars were hybrids?
So, I made a few admittedly simplistic calculations, which turn out to be pretty mind-boggling.
There are approximately 250 million cars and light trucks in the United States, which get an estimated 17 MPG in fuel economy, according to the online encyclopedia, Wikipedia. I’m sure that statistic is an average of the mileage ratings of all these vehicles, so I can accept it statistically, although I believe the number must be lower if you consider the millions of cars driven in stop and go traffic daily, which get a fraction of that mileage.
Let’s assume that the 250 million cars in the United States are driven 15,000 miles annually at an average of 17 MPG. That amounts to usage of 220.6 billion gallons of gasoline annually. Now let’s see what happens if those same cars become big SUV hybrids like mine, getting 31 MPG. Fuel consumption would drop to 120.9 billion gallons, a spectacular saving of 99.7 billion gallons annually! (This number would be even more impressive if we could include the correct proportion of higher-mileage hybrid Camrys and Priuses in the fleet.)
Depending on the grade of crude oil being refined, each 42 gallon barrel of oil nets between 30-50 percent gasoline, or about 17 gallons per barrel. Therefore, a saving of 99.7 billion gallons of gasoline would eliminate approximately 5.9 billion gallons of crude oil a year, an amazing 2.2 billion barrels more than the 3.7 billion barrels we import each year, from places like Saudi Arabia, Iran and Venezuela.
But wait, that’s not all. Current E-85 alcohol technology will allow us in the near future to use only 15 percent petroleum in each gallon of fuel that we burn in our hybrids. Also, remember that hybrid technology is still in its infancy and that more efficient batteries and the addition of high efficiency diesels burning bio-diesel, as charging platforms, will likely be available within a few years. All of these things taken together convince me that we do indeed have the answer to completely eliminate our dependence on foreign oil
Now, you might think that my statistics aren’t sufficiently conservative. So cut them in half and the answer is still mind boggling. And just remember that all the technology to which I refer is currently in existence and is going to get even better over the next few years, as future hybrid generations hit the road with better and perhaps plug-in batteries, and E-85, and bio-diesel become our standard fuels.
I have spent most of my 66 years as a student of the automobile industry, first growing up in Detroit and ultimately as treasurer of Chrysler Financial Corporation, until 1977. More than 35 years ago, while working on my MBA at night and studying statistics with a Westinghouse electrical engineer, we dreamed aloud one Sunday afternoon and drew a schematic of a car that would use an internal combustion engine to charge a battery, just like the diesel locomotives being built by General Motors. I took our “hybrid” idea to some Chrysler engineers and found no interest. So much for American ingenuity, and thanks to the Japanese for seeing the light three decades later.
I am very concerned about the American automobile industry, radical Islamic terrorism and global warming. All of these problems relate to our inefficient use of oil and something has to be done about it right now. What can you do? Just go buy a hybrid car or SUV that suits your needs. Detroit will get the message, or they will fail.
Note: Neither Jack or Peter Falker, nor any of the clients of FalkerInvestments Inc. hold positions in any of the companies mentioned in this report.
Wednesday, January 17, 2007
Monday, January 08, 2007
2007
Happy New Year!
As we finish the holiday season and make our transition to the New Year, it’s a good time to take a look back and prognosticate a bit about what we might expect going forward. Usually we limit our investor letters to one page, but because of the intriguing issues we currently face and the ability to post our thoughts endlessly on the blog (which you have hopefully bookmarked and reread with interest) we have made this one a bit longer. So read on at your leisure and at your own pace.
Introduction
2006 ended up being a good year economically for the United States, despite persistent mixed signals, which sent perplexing and often contradictory messages to investors: (1) an inverted yield curve; (2) spiking, then collapsing, oil prices; (3) low unemployment; (4) a slowing housing market; (5) a weakening dollar; (6) a volatile, yet rising, stock market; (7) the Iraq War and all of the attendant problems of the Middle East; (8) a vote of very low confidence in our President; and (9) the persistent threat of terrorism. We consider all of these issues in aggregate when determining how to deploy our investment strategy. In this post-stock market bubble, post-9/11 world, we have chosen to step carefully, becoming fully invested at our own pace to create valuable and durable portfolios that will compound significantly over many years.
Consider the return of the market during the six-year period from the beginning of 2001 to the end of 2006. This period affords a snapshot of the market history of our country from after the bubble, but pre-9/11, to the current moment. People are always surprised to learn that the market was up only about 7.5%, in aggregate, during that entire period (i.e. only about 1.25% a year in simplified terms) despite the barrage of “new-record high” news we have been hearing almost every night for the last few months. The key in this period was to avoid the significant down market of 2002, because of the difficult recovery from such a loss, which is reflected in the above six-year statistic. We have learned a great deal in the past six years and have seen nothing to dissuade us from our belief that history could well repeat itself in the next five or six years.
The Inverted Yield Curve
Of the issues mentioned earlier, one of the most notable and interesting for the financial markets is the inverted yield curve and its implications for the economy (i.e. what does it mean when short-term interest rates are consistently higher than long-term interest rates?). There is much debate about what the curve is telling us about future economic growth versus the credibility of the Federal Reserve. By managing the federal funds rate (the rate at which banks borrow overnight to maintain their required reserve levels) from 1.00% in mid 2003 to the current 5.25% the Fed has signaled its commitment to fight inflation, while potentially slowing the growth of the economy. When considering that long-term rates are generally lower than short term rates, it would appear the Fed has gone too far. GDP growth has indeed slowed a bit recently, but still not near recessionary. In fact, in the last several weeks of 2006 the Fed has actually added liquidity to keep the current federal funds rate from rising above the target of 5.25%. This signals continued demand from banks for money and implies continued growth in the economy. Consequently, moves like this reduce the expectation in the market of the Fed lowering rates any time soon.
So it appears at this point that the inverted yield curve has less to do with predicting a recession and possibly more to do with a decrease in the volatility of inflation expectations, due largely to the persistent and, to date, successful actions of the Fed. Lower volatility creates less uncertainty, which results in a smaller inflation premium demanded by investors who own long term assets (i.e. lower long-term bond rates).
It is important to add that the demand for U.S. Treasuries has likely applied significant pressure to longer term rates as well. While most investors like ourselves don’t find 4.5% 10 year Treasury yields attractive, countries that carry enormous dollar reserves from their trade surpluses with the U.S., namely China and Japan, need a safe place to park their cash. As you can guess, many of the dollars we use to buy products from China turn right around and come back to us via the United States Treasury, adding to our ever-growing national debt.
We consider the current structure of interest rates to have been a net positive to the U.S. economy, the stock market, and the prospect for continued growth, for several reasons. First, the Fed has demonstrated its effectiveness in moderating core inflation and inflation expectations, thereby creating generally lower risk premiums for investors, as well as gaining credibility from the markets. Second, lower long-term rates have enhanced corporate profitability and allowed for continued capital spending. Third, the housing market has avoided a destabilizing decline due in part to the persistence of historically low fixed mortgage rates. Fourth, the Fed has ample room to lower rates and create liquidity in case of recession or an external shock such as terrorism.
As for the shape of the yield curve in 2007, we really can’t say for sure. It’s our guess, however, that the economy will sputter sometime late in the year as the economic cycle and the Fed will hit the tap for more liquidity by lowering rates. As long as we are not facing a severe recession, we would expect the markets to respond positively, as the Fed would be seen as promoting economic growth, while gaining credibility by controlling inflation. In particular, we would expect bank stocks to do very well, as they resume the business of borrowing short and lending long profitably. We are looking to add to our bank holdings and capturing some very attractive current dividend yields. Consider US Bank (USB) yielding 4.4%, Bank of America (BAC) at 4.2%, and TCF Financial (TCB) at 3.4%.
Housing and Employment
We feel it is important to look at jobs and housing together. The single most important factor in a healthy housing market is a healthy jobs market. Much has been said about the collapse of the housing bubble and the shock to the economy. Having significant experience with residential and investment real estate ourselves it is painfully obvious that housing has endured a significant correction that has yet to fully run its course. For those homeowners looking to sell, the pain has generally been felt in reduced expectations of what they can get for their property, rather than actual loss of initial investment.
The greatest risk is the leverage used against overzealous return expectations and the consequent fallout of foreclosure and bankruptcy. The fastest growing and highest risk segment of the mortgage market is sub-prime loans. Recently the New York Times addressed a report from the Center for Responsible Lending claiming that 1 in 5 sub-prime mortgages made in the last two years are likely to see foreclosure in the coming year, as adjustable rates are ratcheted up. Although possibly a worst-case scenario given the subjectivity of foreclosure models, with these types of loans accounting for 25% of the mortgage market the potential negative fallout is obvious.
We have always felt the consumer/homeowner has been vulnerable in the past several years with rising oil prices and higher short-term interest rates. However, the unemployment rate has remained at historically low levels of about 4.5% and workers have seen a recent rise in real wages due largely to the year-end decline in energy prices. Always aware of the certainty of economic cycles, being at a trough for so long in unemployment makes us nervous about its duration. We are certainly not out of the woods and the risk definitely gives us caution in making our investment decisions.
Oil and Energy
2006 saw us invest in the oil and gas sector for the first time. With the rise in oil prices and the expectation for continued global demand, we are seeing companies in this segment finally meet our return on capital criteria. We believe that $50 per barrel oil prices allow for sufficient returns on capital, while not overburdening the consumer.
We are among those who believe in increasing global demand with tighter supplies (supporting higher prices) of both domestic and foreign oil and natural gas over the next several years. Those in the opposing camp believe that oil demand will lessen as the world economy (read primarily China) slows down and perhaps recesses from its current growth pattern. In that case, we would probably have an even bigger problem of world recession, but we see that as quite remote at the moment. China, in particular, is creating growth to support its massive employment base while aggressively acquiring oil assets.
According to a report in 2006 from the Energy Information Administration (the statistical arm of U.S. Department of Energy) world oil demand will increase 47% from 2003 to 2030. 43% of this increase is projected to come from developing Asian countries, including China and India. A commensurate rise in output is needed to maintain stable oil prices and favors companies involved in exploration and production, as well as oil services. We are looking to invest approximately 10% of our assets in these areas over the next year or two. We have currently chosen ConocoPhillips (COP) and Noble Corporation (NE) as initial investments. COP gives us global exposure for exploration and production and a stake in the largest supplier of natural gas in North America. Noble Corporation is engaged in global deepwater drilling, where demand is currently outpacing the supply of equipment. We expect these holdings to be quite volatile and move with the short-term speculation in oil futures, which may take some short-term patience. However, we believe the underlying value and cyclical forces in the oil and oil services sectors will prevail.
Within the energy sector, we also believe there will be a massive move toward hybrid automotive technology over the next 3-5 years, as we try to reduce our reliance on foreign oil and attack the sources of global warming. We have run the numbers ourselves and can see how conversion of approximately half of the U.S. automotive fleet to hybrids would virtually eliminate foreign oil dependency, particularly if “plug-in” hybrid technology comes to pass, resulting in 50 mpg SUVs burning alternative fuels, such as E-85 gasohol or bio-diesel.
Many people have made the choice to drive a hybrid but cost and vehicle selection have inhibited wider use. With Toyota entering production of their 4th generation hybrid technology and U.S. auto makers making future production announcements of 5th generation hybrids, based on a consortium of General Motors, Daimler and BMW, it is only a matter of time before substantial portions of the U.S. fleet are converted. We have identified Johnson Controls (JCI) as the front runner in U.S. automotive hybrid battery development, as they have received significant contracts to develop next- generation, lithium-ion batteries.
If that sounds like we are playing both sides of oil demand, that would be correct. Oil exploration and production and offshore oilfield services should see significant gains over the next 2-3 years, while hybrid battery development will be very important in the longer term.
Healthcare
We increased our exposure to the healthcare segment this year with recent acquisitions of Aetna (AET) and Wellpoint (WLP). This adds to our healthcare related holdings of Medtronic, Johnson & Johnson, and Abbott Labs. For the year, this segment has underperformed the S&P 500 and continues to persist as undervalued in our model. Much of this underperformance relates to the sell- off in the weeks prior to the election, as the market 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. We feel comfortable that the return on investment and growth incentives for healthcare companies will remain attractive as the U.S. population ages and innovative products for the uninsured become a focus for the private sector.
Summary
For our part, we ended 2006 fully invested in all but our newest accounts. Our emphasis has continued to be defensive, with the notable exception of positions we took during the year in the oil industry, both in exploration and production, and offshore oil-field service. As always, our outlook is long-term, with particular attention toward capital conservation. This results in low-beta portfolios, which can be expected to do well (but not quite as exciting) in a frothy market, and decidedly better than the market in downturns. Our only objective is to outperform the market in the long term, which we are very proud to have accomplished during the period of our management experience.
In general, our other investments include major banks, consumer product companies, and medical technology and biotechnology companies, which, as always, must meet our criteria of generating internal rates of return on invested capital that consistently exceed the companies’ costs of capital, and are undervalued based on our EVA/DCF modeling technique.
We also have a core holding in Berkshire Hathaway, which is primarily a casualty insurer, but has broad portfolio holdings not unlike our own, including oil and gas and consumer products, among several others. We strongly subscribe to Warren Buffett’s current thinking about the markets and keep always before us his prediction of several years ago that he expects 6-8% returns in the markets over the next “decade or two”. So far, he has been fairly accurate, if not a bit generous. Most importantly, Warren Buffett is totally unconcerned about the short term and the current gyrations and records set by market averages. His two rules of investing are always worth repeating: Rule #1, Never lose money; Rule #2, Never forget Rule #1. We believe our portfolios have significant room for appreciation while limiting our risk of loss.
As always, we welcome your thoughts and comments.
Peter and Jack Falker
Note: Jack and Peter Falker and the clients of FalkerInvestments Inc. hold positions in the companies mentioned above, with the exception of General Motors, Daimler, BMW and Bank of America.
As we finish the holiday season and make our transition to the New Year, it’s a good time to take a look back and prognosticate a bit about what we might expect going forward. Usually we limit our investor letters to one page, but because of the intriguing issues we currently face and the ability to post our thoughts endlessly on the blog (which you have hopefully bookmarked and reread with interest) we have made this one a bit longer. So read on at your leisure and at your own pace.
Introduction
2006 ended up being a good year economically for the United States, despite persistent mixed signals, which sent perplexing and often contradictory messages to investors: (1) an inverted yield curve; (2) spiking, then collapsing, oil prices; (3) low unemployment; (4) a slowing housing market; (5) a weakening dollar; (6) a volatile, yet rising, stock market; (7) the Iraq War and all of the attendant problems of the Middle East; (8) a vote of very low confidence in our President; and (9) the persistent threat of terrorism. We consider all of these issues in aggregate when determining how to deploy our investment strategy. In this post-stock market bubble, post-9/11 world, we have chosen to step carefully, becoming fully invested at our own pace to create valuable and durable portfolios that will compound significantly over many years.
Consider the return of the market during the six-year period from the beginning of 2001 to the end of 2006. This period affords a snapshot of the market history of our country from after the bubble, but pre-9/11, to the current moment. People are always surprised to learn that the market was up only about 7.5%, in aggregate, during that entire period (i.e. only about 1.25% a year in simplified terms) despite the barrage of “new-record high” news we have been hearing almost every night for the last few months. The key in this period was to avoid the significant down market of 2002, because of the difficult recovery from such a loss, which is reflected in the above six-year statistic. We have learned a great deal in the past six years and have seen nothing to dissuade us from our belief that history could well repeat itself in the next five or six years.
The Inverted Yield Curve
Of the issues mentioned earlier, one of the most notable and interesting for the financial markets is the inverted yield curve and its implications for the economy (i.e. what does it mean when short-term interest rates are consistently higher than long-term interest rates?). There is much debate about what the curve is telling us about future economic growth versus the credibility of the Federal Reserve. By managing the federal funds rate (the rate at which banks borrow overnight to maintain their required reserve levels) from 1.00% in mid 2003 to the current 5.25% the Fed has signaled its commitment to fight inflation, while potentially slowing the growth of the economy. When considering that long-term rates are generally lower than short term rates, it would appear the Fed has gone too far. GDP growth has indeed slowed a bit recently, but still not near recessionary. In fact, in the last several weeks of 2006 the Fed has actually added liquidity to keep the current federal funds rate from rising above the target of 5.25%. This signals continued demand from banks for money and implies continued growth in the economy. Consequently, moves like this reduce the expectation in the market of the Fed lowering rates any time soon.
So it appears at this point that the inverted yield curve has less to do with predicting a recession and possibly more to do with a decrease in the volatility of inflation expectations, due largely to the persistent and, to date, successful actions of the Fed. Lower volatility creates less uncertainty, which results in a smaller inflation premium demanded by investors who own long term assets (i.e. lower long-term bond rates).
It is important to add that the demand for U.S. Treasuries has likely applied significant pressure to longer term rates as well. While most investors like ourselves don’t find 4.5% 10 year Treasury yields attractive, countries that carry enormous dollar reserves from their trade surpluses with the U.S., namely China and Japan, need a safe place to park their cash. As you can guess, many of the dollars we use to buy products from China turn right around and come back to us via the United States Treasury, adding to our ever-growing national debt.
We consider the current structure of interest rates to have been a net positive to the U.S. economy, the stock market, and the prospect for continued growth, for several reasons. First, the Fed has demonstrated its effectiveness in moderating core inflation and inflation expectations, thereby creating generally lower risk premiums for investors, as well as gaining credibility from the markets. Second, lower long-term rates have enhanced corporate profitability and allowed for continued capital spending. Third, the housing market has avoided a destabilizing decline due in part to the persistence of historically low fixed mortgage rates. Fourth, the Fed has ample room to lower rates and create liquidity in case of recession or an external shock such as terrorism.
As for the shape of the yield curve in 2007, we really can’t say for sure. It’s our guess, however, that the economy will sputter sometime late in the year as the economic cycle and the Fed will hit the tap for more liquidity by lowering rates. As long as we are not facing a severe recession, we would expect the markets to respond positively, as the Fed would be seen as promoting economic growth, while gaining credibility by controlling inflation. In particular, we would expect bank stocks to do very well, as they resume the business of borrowing short and lending long profitably. We are looking to add to our bank holdings and capturing some very attractive current dividend yields. Consider US Bank (USB) yielding 4.4%, Bank of America (BAC) at 4.2%, and TCF Financial (TCB) at 3.4%.
Housing and Employment
We feel it is important to look at jobs and housing together. The single most important factor in a healthy housing market is a healthy jobs market. Much has been said about the collapse of the housing bubble and the shock to the economy. Having significant experience with residential and investment real estate ourselves it is painfully obvious that housing has endured a significant correction that has yet to fully run its course. For those homeowners looking to sell, the pain has generally been felt in reduced expectations of what they can get for their property, rather than actual loss of initial investment.
The greatest risk is the leverage used against overzealous return expectations and the consequent fallout of foreclosure and bankruptcy. The fastest growing and highest risk segment of the mortgage market is sub-prime loans. Recently the New York Times addressed a report from the Center for Responsible Lending claiming that 1 in 5 sub-prime mortgages made in the last two years are likely to see foreclosure in the coming year, as adjustable rates are ratcheted up. Although possibly a worst-case scenario given the subjectivity of foreclosure models, with these types of loans accounting for 25% of the mortgage market the potential negative fallout is obvious.
We have always felt the consumer/homeowner has been vulnerable in the past several years with rising oil prices and higher short-term interest rates. However, the unemployment rate has remained at historically low levels of about 4.5% and workers have seen a recent rise in real wages due largely to the year-end decline in energy prices. Always aware of the certainty of economic cycles, being at a trough for so long in unemployment makes us nervous about its duration. We are certainly not out of the woods and the risk definitely gives us caution in making our investment decisions.
Oil and Energy
2006 saw us invest in the oil and gas sector for the first time. With the rise in oil prices and the expectation for continued global demand, we are seeing companies in this segment finally meet our return on capital criteria. We believe that $50 per barrel oil prices allow for sufficient returns on capital, while not overburdening the consumer.
We are among those who believe in increasing global demand with tighter supplies (supporting higher prices) of both domestic and foreign oil and natural gas over the next several years. Those in the opposing camp believe that oil demand will lessen as the world economy (read primarily China) slows down and perhaps recesses from its current growth pattern. In that case, we would probably have an even bigger problem of world recession, but we see that as quite remote at the moment. China, in particular, is creating growth to support its massive employment base while aggressively acquiring oil assets.
According to a report in 2006 from the Energy Information Administration (the statistical arm of U.S. Department of Energy) world oil demand will increase 47% from 2003 to 2030. 43% of this increase is projected to come from developing Asian countries, including China and India. A commensurate rise in output is needed to maintain stable oil prices and favors companies involved in exploration and production, as well as oil services. We are looking to invest approximately 10% of our assets in these areas over the next year or two. We have currently chosen ConocoPhillips (COP) and Noble Corporation (NE) as initial investments. COP gives us global exposure for exploration and production and a stake in the largest supplier of natural gas in North America. Noble Corporation is engaged in global deepwater drilling, where demand is currently outpacing the supply of equipment. We expect these holdings to be quite volatile and move with the short-term speculation in oil futures, which may take some short-term patience. However, we believe the underlying value and cyclical forces in the oil and oil services sectors will prevail.
Within the energy sector, we also believe there will be a massive move toward hybrid automotive technology over the next 3-5 years, as we try to reduce our reliance on foreign oil and attack the sources of global warming. We have run the numbers ourselves and can see how conversion of approximately half of the U.S. automotive fleet to hybrids would virtually eliminate foreign oil dependency, particularly if “plug-in” hybrid technology comes to pass, resulting in 50 mpg SUVs burning alternative fuels, such as E-85 gasohol or bio-diesel.
Many people have made the choice to drive a hybrid but cost and vehicle selection have inhibited wider use. With Toyota entering production of their 4th generation hybrid technology and U.S. auto makers making future production announcements of 5th generation hybrids, based on a consortium of General Motors, Daimler and BMW, it is only a matter of time before substantial portions of the U.S. fleet are converted. We have identified Johnson Controls (JCI) as the front runner in U.S. automotive hybrid battery development, as they have received significant contracts to develop next- generation, lithium-ion batteries.
If that sounds like we are playing both sides of oil demand, that would be correct. Oil exploration and production and offshore oilfield services should see significant gains over the next 2-3 years, while hybrid battery development will be very important in the longer term.
Healthcare
We increased our exposure to the healthcare segment this year with recent acquisitions of Aetna (AET) and Wellpoint (WLP). This adds to our healthcare related holdings of Medtronic, Johnson & Johnson, and Abbott Labs. For the year, this segment has underperformed the S&P 500 and continues to persist as undervalued in our model. Much of this underperformance relates to the sell- off in the weeks prior to the election, as the market 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. We feel comfortable that the return on investment and growth incentives for healthcare companies will remain attractive as the U.S. population ages and innovative products for the uninsured become a focus for the private sector.
Summary
For our part, we ended 2006 fully invested in all but our newest accounts. Our emphasis has continued to be defensive, with the notable exception of positions we took during the year in the oil industry, both in exploration and production, and offshore oil-field service. As always, our outlook is long-term, with particular attention toward capital conservation. This results in low-beta portfolios, which can be expected to do well (but not quite as exciting) in a frothy market, and decidedly better than the market in downturns. Our only objective is to outperform the market in the long term, which we are very proud to have accomplished during the period of our management experience.
In general, our other investments include major banks, consumer product companies, and medical technology and biotechnology companies, which, as always, must meet our criteria of generating internal rates of return on invested capital that consistently exceed the companies’ costs of capital, and are undervalued based on our EVA/DCF modeling technique.
We also have a core holding in Berkshire Hathaway, which is primarily a casualty insurer, but has broad portfolio holdings not unlike our own, including oil and gas and consumer products, among several others. We strongly subscribe to Warren Buffett’s current thinking about the markets and keep always before us his prediction of several years ago that he expects 6-8% returns in the markets over the next “decade or two”. So far, he has been fairly accurate, if not a bit generous. Most importantly, Warren Buffett is totally unconcerned about the short term and the current gyrations and records set by market averages. His two rules of investing are always worth repeating: Rule #1, Never lose money; Rule #2, Never forget Rule #1. We believe our portfolios have significant room for appreciation while limiting our risk of loss.
As always, we welcome your thoughts and comments.
Peter and Jack Falker
Note: Jack and Peter Falker and the clients of FalkerInvestments Inc. hold positions in the companies mentioned above, with the exception of General Motors, Daimler, BMW and Bank of America.
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.
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.
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.
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.
Subscribe to:
Posts (Atom)
Posts
