What Ever Happened To Yield Support?

What is yield support?

It’s a notion that was prevalent in the Eighties and earlier, back when the S&P had a long history of significant nominal dividend yield.  The idea is that, in a downturn, the fall in the market as a whole–and in dividend-paying stocks in particular–will be cushioned by the fact of continuing dividend income.  At some point, the argument goes, a 4%-5% dividend yield means “you’re being paid to wait” for earnings to recover.  This current income means you can buy the stock sooner, and at a higher price, than you would without the dividend.  Therefore, the price never gets to the level of the most bearish prediction.

In the old days dividends were important enough as a component of total return that a famous Wall Street strategist sounded a stern warning in the mid-Eighties that the stock market was about to collapse.  His reason?–the dividend yield on the market had broken below 3%.  He had charts showing that this had occurred only a few times in the post-WWII era, and then only for short periods.  Every time, the market had soon entered a severe correction.

Unfortunately for this prediction, and for this guy’s career as a strategist, the stock market powered ahead from that point for fifteen more years.  The dividend yield on the S&P steadily declined to around 1%, returning to the 3% level only during the 2008 market decline .

What went wrong?  What didn’t he see?  I think the most important factors were:

* investor preferences changed.  Baby Boomers wanted capital gains, not dividend income.

* this allowed younger, more capital-hungry companies (who wouldn’t pay any dividends) to list, changing the composition of the market.

* disinflation raised the real value of even a static nominal dividend (the story of consumer staples and utilities in the Eighties).

“Paid to wait” is the operative phrase now

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Testing the Bottom–technical analysis

 

THE END OF A BEAR MARKET

In the post-WWII period, inventory-cycle bear markets have tended to last about a year.  More serious bear markets, like 1773-74, 1981-82 or the one we are in now, have tended to last about two years (although this is generalizing from a small number of instances).  In virtually every case, however, the bear market ending has followed a set formula, containing two elements.  

*Enough time must have passed that the worst of the downturn has already run its course and profit growth will resume in six months or so.  Market participants only recognize this in hindsight, however.  At the time,  investors act as if they have lost conviction that profits will ever recover.

*The market establishes a low, bounces up from the low point by perhaps 20%, but then returns after six weeks to three months to “test” the low at least once, before beginning a relatively steady climb upward.  It looks to me as if this “testing” process is going on now.

Fundamental analysts like me usually regard technical analysis as being something like fortune-telling, a dubious enterprise at best.   So, on the one hand, it shows how bad sentiment has become that our thoughts turn to the charts at all.  On the other, a market bottom is by and large a psychological phenomenon.  So it probably makes some sense to try to figure out what the mindset of the market is.  And, as I just mentioned above, for whatever reason, market bottoms seem to follow a clear pattern.  Here goes:

 

NUTS AND BOLTS OF A MARKET LOW

The index to watch in the US is the S&P 500.

Use daily charts.  The low to look for can be an intraday low, not necessarily a closing low, so use a chart form that shows daily high, low and close.

The rate of market decline usually accelerates as the low is being reached.  Many times, stocks that have been the star performers of the down market–that is, relatively resistant to decline–underperform during this period.  (Market veterans have traditionally talked about three phases of a bear market:  hope (or denial), boredom (steady drip, drip, drip of decline), and despair.  During this final phase, investors give up hope and lose control over the fears that have been plaguing them during the down market and discard even the crown jewels of their portfolios.

Volume may not matter.  Technicians ofter talk about a selling climax, which occurs on high volume.  This may be corroborating evidence, but I don’t think it’s necessary.

During the “test,”  the market may fall below the low previously established.  This is scary, because it suggests that the previous low won’t hold.  In the US, if the market rebounds, I’ve always thought of this as a good sign (in Asia, where investors “read” charts differently, breaking below the old low, even for a few seconds, is almost always a bad thing.)  

HOW DOES THE CURRENT MARKET STACK UP?

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Banks and Book Value

Financials are either the hardest kind of companies to analyze or the easiest.

* They’re hard because they’re in a lot of different lending businesses–mortgages, credit cards, personal loans, business loans–for all kinds of customers, from blue chip to sub-prime.

*The assets they hold, that is, the loans on their books, can have long lives.  Some loans will doubtless go bad, so there’s always the question of how quickly the bank catches them and how accurately it marks them down to realizable value.

*In addition, since the repeal of Glass-Steagall, the banks have been able to do extensive proprietary trading and other investment banking activities, which present more complicated management control and reporting issues.

 

 For smaller financials, limiting themselves either to only a few products, or dealing with a small range of customers, or operating in a limited geographical area, a generalist analyst can probably get his arms around the main issues.  For the largest, multi-line, multi-customer, maybe multi-national firms, even a financial company specialist may have his hands full.

 

 

The structural opacity of financial companies has always bothered me and has generally kept me away from investing in financials, except for in emerging markets, where the institutions tend to be simpler and much less mature than their counterparts in the OECD.  These companies present their own set of issues, but that’s not what I want to write about today.   

 

Suppose you want to buy US-listed financials.  An institutional money manager can do his own reading and  then call in a specialist analyst from a brokerage house to explain the ins and outs of the major firms in the industry.   But everyone believes (correctly, I think) that industry analysts form strong biases in favor of the areas they cover.  So at the very least you’ve got to give a sanity check to what they say.  But not everyone is big enough to have in-house analytic help to guide them.  And, of course, not everyone is able to get a sell-side analyst to come to visit.

 

 So what can you do?  –what portfolio managers always do.  Simplify.  Try to describe in the most general terms what the companies do and find a variable that, conceptually, should correlate well with stock price.  In this case, use book value.  Why?

Financials are middlemen in the purchase and sale of a commodity, namely, money.  Money is money.  It stays money.  It doesn’t get old, or wear out or become obsolete, like a machine or a building can.  So, assuming–and this may be a big “if”–the company, assisted by its auditors, accounts roughly correctly for unrealized gains and losses, then the value stored up in the firm should be the money it originally started with, plus profits not paid out in dividends, plus any new equity raised along the way.  In other words, shareholders equity or book value.   As a further support for this view, one might remember that this is (or at least is supposed to be) a heavily regulated industry.  So even if the managements and the auditors don’t keep good records, the regulators will find this out and fix the problem.

Book value, then, could serve the same function that a PE ratio would in another industry. One could compare the profits of companies in the industry as a percentage of book and award higher or lower multiples of book value to the better or weaker competitors.

 I think that this is actually the way non-specialist portfolio managers look at financials.  One refinement:  we should use tangible book value, i.e.,  exclude brand names or other “intangible” things that find their way onto the company’s balance sheet as a result of acquisitions.  We’ll factor in these sources of value through the multiple of book value we decide to pay for the stock.

 

What do we get if we do this?

 

This chart lists a a number of big financial companies and compares their stock prices with book value, as taken from the company’s latest filings:

 

                                recent price            recent book value                price/book         

Goldman                   80.00                        108.00                                    74%                         

Morgan Stanley      18.82                            30.25                                    62%                         

Wells Fargo              11.50                            12.70                                    91%                       

JP Morgan                19.51                            38.00                                   51%                         

Citigroup                    2.14                             12.50                                   17%                           

Bank of Amer. 1       3.91                             11.40                                   34%                          

Bank of Amer. 2       3.91                              9.00                                    43%                           

 

(I’ve shown Bank of America in two ways:  the BofA1 book value is the company’s reported tangible book at 12/31/08, shortly after the Merrill acquisition was announced.  BV has no impact from Merrill in it.  BofA2 book value assumes BofA issues 1.25 billion new shares, but that the value of Merrill ends up being precisely zero.   This isn’t a forecast.  I have no reason to believe that this will be the outcome of the acquisition.  Positive value to Merrill would make BofA2’s book value higher and its price/book lower than I’ve shown above.)

 

 

What does looking at book suggest the market is saying about these stocks?

 

Starting with the most straightforward comment,

 

*The price to book numbers are very low, across the board, relative to patterns of the last ten years.  Good banks have traded in the past at more than 2x book.  The “value line” for Goldman used by the Value Line Investment Survey is 1.3x book.  Less than six months ago, BofA and its investment bankers thought Merrill Lynch, a second-tier franchise in my opinion, was worth buying at 1.8x book.

*The market thinks brokers are more valuable than banks, which is a reversal of traditional form.

*They all look like closed end funds, trading a discount to net asset value.

*Extending the closed end fund analogy, most would in theory get a price boost if they announced they were going to liquidate and return assets to shareholders.   Taxable investors would be better off in all cases, except maybe Goldman and Wells Fargo, but tax exempt investors, like pension funds, would clearly benefit in all instances.  

*The numbers are all over the map.  Some figures, like those for Morgan Stanley, are audited; most are not, since their reporting year ends in December.  It may be that price to book will rise, once the annual audit results are known.

*Information may be in the “bad” numbers, not the “good” ones.  Citigroup really stands out.  If you could wave a magic wand and liquidate the company right away and get the balance sheet value for the assets, you’d get almost 6x your money.  It seems to me that if the balance sheet is a picture of the company, the market is saying Citi’s is a Dali or a Pollock, not a photo.

*A weird thought–Citigroup might be cheap, not necessarily on the value of tangible assets, but on “intangibles,” the value of its brand name and retail distribution network.  For this to be so, however, you’d have to believe that the tangibles have a value as high as zero and that the firm would be held in management hands that  know how to exploit the brand.    Irrelevant but interesting, I think–Let’s say tangible assets are worth minus $1/share.  If the government takes a 40% stake in a firm at a price of, say, $1/share, then the existing shareholders are better off, in that they’re only underwater on the tangibles by 25 cents.  But the government now owns 40% of the brand name.

Disclaimer

I’m writing this blog to help organize my own thoughts about investing in stocks, as well as in the hope of getting constructive criticism and advice about my views from readers.  As long experience has taught me, investing in stocks is often a humbling experience.  Even the most seasoned investors will make serious mistakes from time to time.  The most meticulously crafted research can be factually incorrect or incomplete, resulting in faulty investment conslusions.  In addtion, new, sometimes poorly understood, economic developments can emerge, both in the markets where a given firm competes and in the wider national or global macroeconomic sphere, that can later economic prospects significanly in one direction or another.  Even if research is perfect, it is often difficult to assess whether the conclusions are new and potentially valuable, or are already well-known and factored into prevailing stock prices.  The cliche that the markets tend to make the greatest fools out of the largest number pf people sums up the situation neatly.

 

I have close to thirty years of experience as a professional securities analyst and equity portfolio manager, involved in both the US and non-US stock markets, so my opinions may have some value.  Nevertheless, you should not use these opinions as the basis for your investment decisions.  Before making any investment decision, you must conduct a thorough personal financial analysis to determine what investments may be suitable for you.  This analysis should include, at the minimum, an assessment of your total financial circumstances, investment goals, tolerance for risk (especially for the possibility of loss), and the time, effort, and skill you are able and willing to bring to the investment process.  You must also decide whether you have the skill to perform this analysis yourself, or whether you should seek the help of a financial planner or other professional who specializes in this endeavor.

 

 

 

For the reasons set forth above, you should understand that I am not making any representation or warranty, express or implied, as to the accuracy, completeness or correctness of my research.  I am making no guarantee or promise about any results that may be obtained by use of my research or opinions.  Nor should anything I write be taken as a recommendation that any security, portfolio of securities, or investment strategy is suitable for the reader or for anyone you may share this information with.

 

I do not intend my blog to provide what are known as “maintenance” research services.  That is to say, I cannot make any promise that I will provide updated analysis or opinions on any subject about which I may write.  Although it may be clear from what I write in my blog that I no longer consider a particular security or investment theme to be viable, I assume no obligation to inform you specifically about my change in assessment.

 

This same disclaimer applies to any tax, legal, or insurance matter that one may interpret as advice.  I cannot emphasize strongly enough that you must consult a qualified tax professional, attorney, or insurance advisor with respect to such matters.

 

If I write about a security, I will disclose to you whether on not I have a position in that security and, if not, whether I plan to take a position.  You must not interpret the fact that I have acquired a position in a given security, or intend to acquire a position, as being a recommendation of that security, which would carry with it the requirement that I follow up and disclose to you when I may buy or sell that security in the future.

How to use brokerage research reports

The Business section of yesterday’s New York Times had an interesting article in it, pointing out that during the current stock market downturn the typical Wall Street analyst recommendation has been “buy” not “sell.”   A similar study of any other downturn would likely produce the same results.  Why is this?

There are lots of pragmatic, institutional reasons why it’s so difficult for an analyst to write “sell” (more about this below).  Also, as investor sentiment indicators–which are invariably most bullish near the top and most bearish at the bottom–illustrate, it’s psychologically much harder than it might seem to either buy low or to sell high. Ff there may not be much information in the analyst recommendation, then, what are the really useful parts of an analyst’s research report? Continue reading