Posts Tagged 'money'

“exogenous” events for securities markets: what they are

Published February 24, 2012 Constructing a Portfolio , exogenous events , Portfolio management Leave a Comment
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definition

Exogenous means “coming from outside.”  In economic modelling, it means an influence that arises from outside the scope of model and that is, therefore, neither predicted nor explained by the model.

In financial markets, an exogenous event has come to mean:

–some really bad thing that occurs, which has a significant, enduring negative effect on prices, and

–one that’s outside the realm of everyday competition among firms, the cyclical rhythms of a nation’s business cycle or the interaction among countries.

examples

The two “oil shocks” of the 1970s–both of which helped precipitate severe recessions in oil-importing countries–are the events most often cited as exogenous shocks.  Saddam Hussein’s invasion of Kuwait in 1990 is another, as is 9/11/2001.  So, too, is the near-collapse of the US financial system under the weight of dubious sub-prime mortgages.

A definitional point:  unless we’re talking about an invasion from space or a large meteor hitting the earth, no event can be exogenous for everybody.  When OPEC raised the price of oil from $1.70 a barrel to $30+, it was a bonanza for its members.  For the US and Europe, however, whose industry was deeply dependent on a steady flow of cheap petroleum products, the development was a disaster.

The sub-prime mortgage crisis was an exogenous event for the rest of the world, but an endogenous one for the US.

No one talks about the subsequent plunge of crude oil to below $10 a barrel as an exogenous event, either.  The term seems to be reserved for economic calamities that affect the large stock markets of the world.

exogenous events are predictable…

Anyone reading the founding documents of OPEC realizes that it’s a political organization, not an economic one.  It wanted justice, not monopoly profits.  And, although the full details weren’t apparent except after the fact, the production contracts between the oil majors and OPEC nations, which had sometimes been running for several decades, were extremely one-sided in the former’s favor.

…but they often come as a shock anyway…

Many times, professional investors’ focus is narrowly fixed on the domestic business cycle or the competitive interplay among firms in a given industry.  They don’t have any skill or interest in any other areas.  Experience also shows that “big picture” developments are often irrelevant for stocks.  The quality of the information generated by brokers–the biggest information channel professional investors use–about political/social topics is often very low.

…if nothing else, their timing is hard to gauge

OPEC was founded in 1960 but didn’t begin to make a significant impact on oil prices until 1970.  The roots of the sub-prime mortgage crisis can be traced back to Fed actions in 2002-2003, to G. W. Bush’s housing policy, or even to the Clinton administration.  Rampant housing speculation and sub-prime abuses were readily apparent in 2005-06.

In these cases, however, stock market consequences came much later.

being right can be a cold comfort for professionals

Any portfolio manager who adopted a very defensive posture in 2005 in anticipation of the Lehman collapse would doubtless have lost most of his clients before the event itself occurred in 2008.

In addition, one always has to calculate how the performance gained by being correct in predicting an exogenous event stacks up against the performance lost while waiting for the event to occur.  In my observation of “big picture” portfolio managers, their personal ego satisfaction is often the greatest gain they achieve.

In fact, I once had a PM who worked for me tell me that a stock bought eight years earlier, which had almost immediately dropped like a stone and was subsequently sold, hadn’t been a mistake after all.  How so?  The firm was in the process of being bought, by Warren Buffett, and at a higher price than the initial purchase.  Yes, that’s (more than) a little crazy.  But it shows how insidious cognitive dissonance can be.

That’s not to say we shouldn’t worry about exogenous events.  Quite the contrary, because they do occur.  And not all of them are complete bolts out of the blue.  But factoring them into portfolio strategy is a bit more complicated than it might seem.

the current worry

It’s Iran’s nuclear program.  More about this on Monday.

 


 

 

higher taxes on dividends? –implications for stock markets

Published February 17, 2012 cash flow/share vs. earnings/share , Constructing a Portfolio , currency effects , Current Market Thoughts , Dividends , Industry Analysis , Investment firms , Portfolio management , Recent Market Action , Strategy Leave a Comment
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the Obama proposal

President Obama has recently proposed that the current tax preference for corporate dividends paid to individuals be eliminated.  Instead of being taxed at most 15% of the amount received, dividends would be considered ordinary income and taxed by Washington at as high a rate as around 40%.

Personally, I’d prefer an overhaul–and simplification–of the current tax code instead of tweaks around the edges.  Rather than putting a foot into the  the quagmire of possible political motivations, however, let’s just take a look at what I think are likely results for US capital markets if it’s implemented.

what doesn’t change

1.  Tax-exempt and tax-deferred accounts would be unaffected.  For pension plans, 401ks and IRAs, and for non-profits, it will continue to make no difference whether they make money in the form of interest or dividend income, or of short-term or long-term capital gains.

2.  Aging Baby Boomers are developing an increasing preference for steady income over capital gains, which are sometimes there, sometimes not.  That won’t change either.

what does

3.  I think the biggest effect will be on company decisions to start making dividend payments or to increase a payout they already have.

It seems to me that most publicly traded corporations recognize the Baby Boom-induced change in investor preferences now happening in the US.  Understanding that a substantial, and rising, dividend is a positive for their stock, companies have been happy to return profits to shareholders this way.  They do this despite realizing that if you combine federal and state/local income levies, up to 25% of the payout will go to the taxman.

If dividends lose their tax preference, the percentage taken by the taxes will approach 50%.  That means a big drop in what the shareholder will retain, both numerically (a third) and psychologically.  For most companies, I suspect, it will tip the balance in favor of devoting free cash flow to share buybacks rather than dividend increases.

For my money, that takes a lot of the shine away from what I consider to be the most attractive part of the dividend-stock universe–companies with above-average dividends today and for which you can reasonably project a quickly rising free cash flow over the next few years.

4.  If the government continues to  keep interest rates at emergency lows and, by accident or design, it also removes much of the incentive for individuals to buy dividend-paying stocks, how do investors adjust?  Maybe there’s a boost in demand for junk bonds, although income-oriented investors have been buying riskier forms of fixed income for a long time.

I think biggest effect would be for investors to broaden their horizons further.  The 7%-8% yields on EU telecom stocks will suddenly look more attractive, despite currency risks.  So, too, emerging market securities, both bonds and dividend-paying stocks.

5.  Looking at #3 another way,  provided they’re large enough to lower the share count, stock buybacks raise earnings per share.  All other things being equal, that should mean a higher per share stock price.  If so, the higher share price would likely offset some or all of the negative effect of dividends increasing at a slower rate.  In other words, the mix of returns (price appreciation + dividend income) changes, and in a way that increases risk.  But the crucial investment question is whether the total return from both sources will be higher or lower than before.

No one knows the answer.  But if the total return is lower–that is, if the effect of higher taxes on dividends is to decrease the long-term value of US equities–then one would expect US investors of all stripes to look increasingly to stock markets outside the US.  In addition, on the margin, US companies might also begin to look to foreign venues to raise new capital, if they could achieve higher prices for their stock by doing so.

My bottom line:  this proposal is one to watch closely.  Like a snowball that starts rolling down a hill, its consequences could be far greater than just to raise taxes on older, upper middle class city dwellers.

searching for yield in a zero Fed funds rate world

Published February 13, 2012 Constructing a Portfolio , Current Market Thoughts , Dividends , Strategy , Utilities , Wireless Leave a Comment
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conventional wisdom

Two traditional general rules about the appropriate allocation between equity and fixed income are:

1.  Take your age in years.  That percentage of your assets should be in fixed income; the rest can be in equities.  A thirty-year old, for example, should keep 30% of his assets in bonds and 70% in stocks.  A seventy-year old should have the reverse proportions.

2.  For a retiree, figure what your yearly expenses are.  Keep enough fixed income so that the interest earned will cover these expenses; the rest can go into riskier assets like stocks.

Neither rule applies in today’s world, however, at least in my view.

Only a lottery winner has the luxury of using #2.  Fifteen years ago, when the 10-year Treasury was yielding 8%, $1.25 million worth of them would generate $100,000 in interest income.  Nowadays, you’d need a $5 million investment to earn the same.

Both rules subject the follower to considerable risk as/when interest rates begin to rise.  My friend Denis Jamison deals with this subject in detail in his recent posts on PSI.    …his conclusions.

my quandary

One of my former employers notified me recently that I’m being removed from participation in its fixed income pension plan.  I can either take lump sum distribution or buy an annuity.  I’ve chosen the former, which I’m rolling over into an IRA.

I want to keep the IRA money in income-generating assets, to counterbalance to some degree my growth investor desire to own stocks.

Believe it or not, it takes a month for my old company to process my request.  Also, quaintly enough, it will issue a physical check and send it in the mail to my IRA account.  Looking on the bright side, this gives me some time to figure out what to do.

So I’m looking for dividend-paying stocks.  I’m not the only one, of course.  And with this account I’m starting at a time when the search for such equities by individual investors is close to entering its third year.  Has everything been picked over already?

first thoughts

My preliminary look around for information has turned up two interesting articles:

-the first comes from BCA Research, an independent organization headquartered in Canada (BCA stands for Bank Credit Analyst, its best-known publication).  BCA continues to be very fundamentally sound.  At one time it served primarily individuals and was somewhat technically-oriented and decidedly bearish in tone.  Not so much any more.  Today’s clients are mostly institutions.

In a February 2nd article titled US Equities:  The Total Return Trap,  BCA opines that traditional high income stock groups–utilities, telecom and REITS–are currently overvalued.  It recommends looking for yield among pharmaceuticals, integrated oils and hypermarkets.

–A February 5th piece in the Financial Times points out that significant dividend yields are available among stocks in the EU and in the Pacific.  The article lists the following current yields on various FT regional indices:

Europe (ex the UK)     3.80%

UK          3.40%

Asia Pacific (ex Japan)          3.16%

Global          2.70%

Japan          2.51%

US          1.96%.

my first stops

My order of preference is:  US, UK, Asia ex Japan, Europe.

I’m not so keen on Japan.  I think companies there prefer to pile up cash rather than pay dividends.  The high yield is more a function of wretched stock market performance than rising payouts.

I don’t have strong thoughts on the relative strength of the € vs. the $.  My hunch is that the € is going to be relatively weak, though, undermining the attractiveness of any dividend payment to a dollar-oriented recipient.  If we’re going to enter an extended period of economic stagnation in Euroland, much like the “lost decade(s)” in Japan, however–and I think that’s the most likely scenario–one can reasonably make the argument that, like the ¥, the € could show surprising strength.   I just don’t know.  Until I have more conviction, why take the chance?

The UK is a very income-oriented market and doesn’t carry the same degree of currency uncertainty as the Eurozone, in my opinion.

I’ve got a couple of weeks to do some research.  I’ll write more as I make progress.

profit margins: how I look at them

Published February 10, 2012 Constructing a Portfolio , economics , margins , Portfolio management Leave a Comment
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what they are

They’re the portion of revenue, usually expressed as a percentage, that remains after costs of s certain type have been deducted.  The most common types of margins used in financial analysis are:

gross margin, meaning what’s left after deducting the direct costs of providing the goods or services

operating margin, meaning what’s left after deducting both direct costs and sales, general and administrative (SG&A) expenses.  Sometimes depreciation is also considered an operating cost, sometimes not, depending on the convention being used.

pre-tax margin, meaning what remains after deducting all costs other than taxes

after-tax margin, meaning income remaining after all costs, including taxes–but not including preferred stock dividends, if any.

do high margins mean a good company?

Many growth investors, especially tech-oriented ones, look for high margins as proof that a company owns patents, copyrights or other intellectual property that defend it against competition.  MSFT or INTC might be good examples.

Low margins, these investors believe, are indicators that a firm is in a commodity business.  This means that competition forces revenues down to levels very close to the cost of production.  Profits accrue either to no one or mostly to the low-cost operator.  Entrants in such industries are continually in a dog-eat-dog fight to push their costs below those of rivals.  No one stays in the low-cost seat for long.

Value investors, with their customary dour dispositions, take the opposite view.  They think high margins are like waving a red flag in front of a bull.  Firms that demonstrate them are disasters waiting to happen.  Sooner than you’d expect, they opine, competition will emerge, margins will compress and the stock will implode.

I line up more or less with the value guys on this one, even though I don’t agree with them 100%.  There are some perennial high-margin firms, where competition hasn’t proved an issue over decades.  Nevertheless, it’s hard to argue that either MSFT or INTC have been anything but disasters as stocks so far in this century, despite their near-monopoly positions.

taking margins at face value is foolish, in my view

How so?

–If you assume that margins at any level are fixed, you’ll miss perhaps the crucial element in forecasting future earnings–operating leverage.  This is the idea that some costs are fixed and don’t rise in line with unit volume.  As a result, the expense involved in selling an extra unit may be much less than that of selling the average unit.

–Rising margins almost always do invite competition.   Companies like MSFT are the exception, not the rule, in my view.  In most industries, the best companies will reinvest much “extra” margin in lowering their costs, as a way of discouraging new entrants.

–High margins usually aren’t “free.”  Jewelry or furniture companies, for example, have very high margins.  But they have to maintain very high inventories, which they turn only once or twice a year.  That’s risky.  The high margins in these cases don’t signal “free lunch”; they signal risk.

–I think the distribution company model–low margin, high inventory turnover–is attractive.  Distribution companies can be very high growth, high profit firms.  They can also have lost of operating leverage.  WMT in its heyday is an example, as is any industrial wholesaler.  Anyone fixated on high margins will miss this important class of firms completely.

What do I use instead of margins in projecting the income statement?  I break down unit costs–labor, raw materials,…–as much as I can and forecast each.  Some are simple functions of unit volume.  Many, however, like advertising, administration, or sometimes labor, are relatively unchanged as volume increases.  That’s where operating leverage and earnings surprises lie.

two more years of emergency-low interest rates!

Published January 31, 2012 Current Market Thoughts , from growth to value: the life cycle , growth vs value , Recent Market Action , Shaping a portfolio for 2012 , Strategy Leave a Comment
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the January 25th Fed meeting

Last week’s meeting of the Federal Reserve’s Open Market Committee had two important results:

1.  Chairman Ben Bernanke said the Fed funds rate, which has been at effectively 0% for just over three years (since December 16, 2008–how time flies) will likely remain at or near the current low rate into 2014.

2.  The Fed gave more detail than ever before on its thinking about prospects for the US economy and the appropriate level for the Fed funds rate.

The Fed thinks:

–the long-term growth rate of the US economy is  +2.4%-2.5%  a year (vs. 3%+ a decade ago).  The agency is content, however, to allow growth at somewhat above that rate from now into 2014.

–the appropriate long-term level for the Fed funds rate is about 4.5%, which amounts to a 2.5% real rate of interest (“real” means after subtracting inflation from the nominal rate).  This contrasts with the current rate, which is a negative real rate of about 2.5%.

–although the process of normalizing interest rates will probably begin before the end of 2014, the Fed is unlikely to raise the funds rate above 1% until at least 2015.

–despite the immense monetary stimulation going on now, inflation will not be an issue.  It will remain at 2% or below.

–the “natural” rate of unemployment, that is, full employment, is 5.5% of the workforce (in theory, the 5.5% is friction in the system–like people in transit from one employment location to another, or who decide to take a short break between jobs…).

According to the Fed’s projections, the unemployment rate will remain above 8% until some time in 2013.  It probably won’t crack below 7% for at least the next three years.

implications

The forecast itself isn’t a shocker.  The Fed has been talking about slow but steady progress for the economy, with no inflation threat, for some time.  The real news is that the Fed expects the current situation to persist into 2105, a year longer than it had previously indicated.

1.  To my mind, the biggest implication of the Fed announcements is that it makes less sense than ever to be holding a lot of cash.  How much “a lot” is depends on your economic circumstances and risk preferences.  But the Fed is saying that a money market fund or bank deposit is going to yield nothing for the next two years and well under 1% for the year after that.  Yes, you have secure storage in a bank and substantial assurance you won’t make a loss, but that’s about it.

To find income in liquid assets–as opposed to illiquid ones like, say, rental real estate–you have to look to riskier investments, dividend-paying stocks or long-dated bonds.  That in itself is nothing new.  Savers have been reallocating in this direction for the past couple of years.  Last week’s Fed’s message, though, is that it’s much too early to reverse these positions.  If anything–and, again, depending on personal circumstances and preferences–investors should think about allocating more away from cash.

2.  When the process of normalizing interest rates is eventually underway, the yields on long-dated bonds and dividend paying stocks will be benchmarked–and judged–against cash yields of 4%+.  For stocks, a static dividend yield of 3% won’t look that attractive.  At some point, low payout ratios (meaning the percentage of earnings paid out in dividends) and the ability to increase cash generation will become key attributes.  Both are indicators of a company’s ability to raise dividends.

3.  It’s my experience that when the Fed begins to tighten, Wall Street always underestimates how much rates will rise.  Last week, the Fed told us that when the Fed funds rate goes up this time, its ultimate destination is 4.5%.

4.  Investors taking a top-down view, that is, looking for the strongest economies, will have to seek exposure outside the US–which will only look good vs. the EU and Japan.  The main issue is demographics–an aging population.  It’s probably worthwhile to try to figure out what characteristics of the latter two economies, both of which have older populations than the US, are due to social/cultural peculiarities and which are due to aging.  The second set of traits may well turn up in the US market as well.

5.  The mechanics of how growth stocks and value stocks work may change in a slower-growing economy.  It’s hard to know today how that will play out.  True growth stocks may be harder to come by.  Value investors who say they buy asset value of $1.00 at $.30 and sell it at $.70 may have to buy at $.20 and sell at $.60 if there’s less room for second- and third-tier companies to succeed.

I think it’s way too soon to be worrying about anything other than #1.  The rest are thoughts to be filed away for next year, maybe.

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