two more years of emergency-low interest rates!

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.


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.

lessons from the Eastman Kodak bankruptcy

A bankruptcy is never fun.  But studying what happens as a company approaches a financial crisis is an important and useful exercise in securities analysis.  Eastman Kodak’s Chapter 11 filing illustrates many general characteristics, as well as one or two novel twists.  Here’s what I see:

a close-in look

–bankruptcy fears feed on themselves.  One day a senior analyst at my first job told me about a research report he wrote on a small magazine publishing company.  He pointed out gently deteriorating subscriber trends and opined that–unless they were reversed within a year or eighteen months–the company could be out of business.  He called the publisher two months later and found out the company was closing its doors for good.  Why?  The CEO told my colleague that advertisers had read his report, concluded it made no sense doing business with a dying firm and stopped placing ads.  Cash flows dried up, the company began to bleed red ink and was forced to cease publication.

Maybe my former colleague’s report was that influential, maybe not.  But something did happen to accelerate the magazine company’s decline–a loss of market confidence.

On paper, a firm might appear to have plenty of time to fix current financial problems, but the situation can change dramatically and very quickly if business partners decide to defend themselves against a possible Chapter 11 filing.

What can happen?

working capital issues 

End users will likely worry that bankruptcy will mean the end to a product line, or at least a cessation of operating supplies, repair parts and service.  Warranties, too.  So they’ll hesitate to buy.  Anticipating a falloff in demand, wholesalers and retailers may no longer want to carry the products.  And they certainly won’t be in any rush to pay the manufacturers for units they have in stock–no matter what terms they’ve agreed to.

Suppliers, knowing that trade creditors have little clout in bankruptcy proceedings, may ask for payment in advance before they’ll ship raw materials.

In theory, these supplier and customer actions should show up on the balance sheet in expanding receivables and shrinking payables, or maybe a buildup in finished goods inventory.  In practice, however, my experience is that they’re almost impossible to detect.

drawing down a bank credit line.  Contrary to what people commonly believe, a bank’s commitment to offer long-term finance can be very fragile thing.  For money already borrowed, restrictive clauses (covenants) in the loan agreements can easily mandate that if the borrower’s financial condition falls below specified levels, bad stuff will happen–say, the entire principal becomes due immediately, or the borrower has to devote all of its cash flow to repayment.

The same thing applies to unborrowed money, except that the line can be reduced or cancelled outright if the bank sees deterioration in the financials a company periodically submits as a condition of keeping the credit line open.  When Kodak suddenly borrowed its entire $160 million credit line (see my post), it signaled to Wall Street that it was worried about this possibility.

–fraudulent conveyance.  This is a new one for me.  Kodak had been supporting its turnaround efforts in recent years despite by selling patents.  According to newspaper reports, lawyers for potential buyers warned of a legal risk were Kodak to enter Chapter 11 soon after a purchase.  In that event, lawyers for the creditors could sue to reclaim the patents, arguing the sales price was too low (the fraudulent conveyance).  If this tactic were successful, the pre-bankruptcy buyer would have to give up the patents.   But it wouldn’t get its money back.  It would become an unsecured creditor of Kodak–at the end of the line of those hoping to be paid by the bankruptcy court.  If bankruptcy is imminent, why take the risk?

–foot-dragging in litigation.  Kodak has also been suing tech companies for violating its intellectual property rights.  After its Chapter 11 filing, Kodak complained that the other parties had been dragging out settlement talks, ostensibly in hopes of getting better terms from the bankruptcy court.   Maybe so, but what’s so surprising about that?

–resigning directors.  Shortly before Kodak’s bankruptcy filing, three independent (that is, not company employees) directors resigned.  This isn’t an everyday occurrence.  It’s almost never a good sign.  In this case, it signaled to me that Kodak had made a very important decision that these directors not only disagreed with but wanted to forcefully distance themselves from.

stepping back a bit

From the Kodak case, I think an analyst can develop a useful checklist of possible bankruptcy symptoms.  I have one further, Kodak-specific comment though:

why printers?

I’ve followed printer companies in the US and Asia off and on for the better part of twenty years.  My take is that printers, both corporate and personal, are a very mature, brutally competitive, commodity business, whose heyday was three decades ago.  Corporate customers play one supplier off against another to get discount services.  Retail customers buy machines for well below the cost of making them, while the printer companies hope to eventually earn a profit through ink sales (I understand this may not exactly be the Kodak model, but that in itself is another potential worry).

In my view, this is an industry to get out of, not get into.  My questions about Kodak’s strategic direction would make me less willing to back the company, not more–and I suspect I’m not alone in this view.  That alone would make business partners quicker to adopt defensive measures than they ordinarily would.

why do pension plans choose hedge fund and private equity managers?

private equity

Mitt Romney’s presidential candidacy has created a new wave of interest in the mechanics of private equity.

The debate has so far primarily been about whether what private equity does–take control of companies that are not making much money, reorganize them and sell them on–is socially useful.  The answer is generally “Yes.”

A secondary question is whether investors in private equity funds, primarily pension plans and university endowments, are getting a good deal. The answer here is generally “No.”  In a recently conducted study for the Financial Times, for example, professors at Yale (whose endowment has been a bastion of such “alternative” investments) and Maastricht University conclude that the vast majority of profits go to the organizers and promoters of private equity schemes, not to the investors who bear almost all the risks.

hedge funds

The same is true of hedge funds, which incidentally are putting the finishing touches on a decade of underperformance versus an S&P 500 index portfolio.  And that conclusion is based on the data the funds themselves voluntarily report.  There’s lots of evidence that some hedge funds routinely overstate their: investment performance, assets under management, and the size and qualifications of their professional staffs.

these are illiquid investments

…oh, and in addition to less-than-stellar profits, these vehicles can be highly illiquid.  In the Great Recession, investors in hedge funds learned to their dismay that the contracts they signed (which they apparently hadn’t read) allowed their managers to refuse requests for redemptions–even for years.  Recently, stories have also been circulating about failed private equity projects that refuse to liquidate, presumably because that would put an end to the management fees the organizers are collecting.

but they’re in high demand

That such a P.T. Barnum-esque situation should have developed with exotic investment vehicles isn’t that strange.  What is, however, is that despite a long period of lackluster performance, institutional investors want to put more of their money into hedge funds and private equity, not less.

Why is this?


The standard answer that institutions will give is that these “alternative” investments aren’t correlated with the movements of stocks and bonds.  Therefore, they’re a diversification.   That lowers the risk of the overall institutional portfolio.

This, of course, is not true.

Generally speaking, the fact that the returns on two assets aren’t correlated doesn’t mean that the risks of one partially offset those of the other.  It just means that you’re exposed to two different sets of risks.  The fact that in bad weather you speed in a racing car and pilot a small plane doesn’t mean you’re safer than if you just did one of the two.

Also, in the case of alternative investments, there’s no public market and holders have no independently verified information about their returns.  So they have no way of determining if risks are correlated or not.

political pressure

A second, less talked-about reason is that hedge and private equity funds hire powerful, politically connected, salesmen who wield influence over the pension plan managers.  There have been scandals about payments to such sales agents in California and New York.

damned if they don’t

To my mind, the main reason institutional investors are attracted to alternative investments is simple arithmetic.  Traditional pension plans don’t have all the money on hand today that will be needed to pay their future obligations to present and potential retirees.  They assume that they can invest the funds they do have to earn a specified return, usually around 7%, so that today’s assets can grow enough to meet future obligations.  If they can’t do this, the plan is underfunded and the employer has to eventually kick in enough to make up the difference.

Is 7% a reasonable annual rate of return in today’s world?  Not if you’re limited to publicly traded stocks and bonds.

Let’s say that you have a 50/50 mix of the two asset categories.

–Stocks can probably have a nominal return of 8% a year (inflation +6%).  History says that in the aggregate the managers you hire will deliver somewhat less than that.

–The 30-year Treasury is yielding about 3%; the 10-year yields about 2%; the return on cash is practically zero.  Interest rates are now at emergency-low levels.  This means chances of a capital gain from holding bonds are slim; chances of a capital loss on your bonds as the economy recovers and rates rise are high.  Let’s be super-optimistic and say you can collect a 3% coupon and make no losses.

With a 50/50 mix of stocks and bonds, then, a pension plan can achieve a return of about 5% annually.  That’s nowhere near enough to meet the 7% goal.  Even if the plan went to an allocation of 100% stocks,  it might not achieve a 7% return.  And doing so would give up all protection against the possibility that another year like 2008 rolls around–as one sooner or later will.

How does the executive in charge of the pension plan deal with this problem?

Does he go to his boss and say he needs an extra $10 billion or so to fund the plan–taking the risk that the boss will shoot the messenger?   …or does he take the chance that, against the testimony of experience, alternative investments will deliver what they promise–big enough returns to get to the 7% goal?

The latter is certainly the path of least resistance.  And this fact also probably makes the political pressure from the hedge fund/private equity salesman that much harder to resist.

AAPL’s awesome 1Q12

the report

After the close of New York trading on Tuesday January 24th, AAPL announced results for 1Q12 (AAPL’s fiscal year ends in October).

The company reported its best single quarter ever, with diluted earnings per share of $13.87 on revenue of $46.3 billion.  Sales were up by 73% year on year for the three months; eps were up by 116%.  Wall Street analysts had been anticipating earnings of $10.16 per share.  AAPL not only handily beat that figure, but also blew through the high end of the estimate range at $11.26.

Management’s (notoriously lowball) guidance for 2Q12 is for revenue of $32.5 billion and per-share profits of $8.50.

AAPL shares rose by 6.3% in the Wednesday market.  On the surface at least, this strikes me as a tepid response to the numbers.  More on this topic below.

the details

quibbles first…

–AAPL is another one of those companies that uses the week rather than the month as their basic unit of time.  This creates a problem, because a year is equal to 52 weeks plus one day for regular years, plus two days for leap year.  So companies like AAPL have to throw in an occasional quarter that has an “extra” week in it to keep their reporting year and the calendar in sync.

1Q12 was one of those adjustment quarters.  Not only that, but the extra week was the high-volume sales period between Christmas and New Year’s Day.  So AAPL’s sales for the three months were likely 10% or so higher than they would ordinarily have been.

–the introduction of the iPhone4S shifted revenue out of 4Q11 and into 1Q12, because AAPL ran down inventories of its older phones and consumers deferred iPhone purchases until the new model became available.

–don’t make the same mistake I’ve heard from Bloomberg radio commentators of saying that this quarter’s earnings were more than AAPL made in a whole year not that long ago.  This sentiment is correct, but the comparison isn’t.  AAPL changed its accounting treatment for iPhone sales a couple of years ago to recognizing all the profits from a sale (markup on the device + a share of revenue collected by the telecom company over the life of a contract) up front, rather than recognize them gradually over the (usually two-year) contract term.

…followed by stunning numbers (ex the iPod)


In 1Q12 AAPL sold 37 million iPhones, with iPhone4S leading the way.  That’s up 126% yoy, in a market that expanded by 40% over that time.  It’s also 17 million more than AAPL’s previous record for a quarter.   Sales would have been even higher except AAPL ran out of phones to sell in key areas.

iPhone 4S wasn’t available in China during 1Q12.  It went on sale there earlier in the month.  Demand has been “staggering.”


APPL sold 15.4 million iPads during the quarter, up 111% year on year.  According to CEO Tim Cook, the launch of AMZN’s new Kindle lines has had no effect, good or bad, on sales.


AAPL sold 1.48 million iMacs and 3.72 million laptops, both records, during the quarter.  Desktops were up 21% in units yoy; laptops were up 28%.  Industry growth was zero.


This declining category of devices was up 133% quarter on quarter for AAPL, but down 21% yoy.  iPod Touch remains the lion’s share of sales.  APPL retains a 70% share of the MP3 player market in the US and is the top-seller in most other markets (not that any investor is going to buy AAPL’s stock because of the iPod anymore).

other stuff

Sales at the Apple Stores, which make up almost a third of retail revenue for AAPL, were $6.1 billion during the quarter.  Average revenue per store was $1.7 million, up 43% yoy.

The iTunes store took in $1.7 billion.

Weak worldwide demand for tech components gave AAPL a lot of buying clout for NAND flash and DRAM during 1Q12.  As a result, the company’s gross margin was unusually high at 44.7%.  To give a basis for comparison, full-year 2011 gm came in at 40.5%.  This favorable development probably also boosted net income by 10%.

AAPL has $97.6 billion in cash on the balance sheet.  Of that, $64 billion is being held offshore.

the stock

Trying to “normalize” 1Q12 eps by correcting for the extra week and the elevated gross margins, I come up with a figure of $11.50 or so for the quarter.  If I had to guess, I’d peg full-year eps at least $40, even after a downward adjustment of 1Q12 results–meaning reported figures could be closer to $45 a share.

If I’m correct, AAPL shares are currently trading at, at most, 11x this year’s earnings, with 40%+ earnings growth in prospect.  That strikes me as really cheap.  Subtract AAPL’s cash from the equation and the forward multiple is 8.5x.

In contrast, WMT, which has nothing like the recent growth record or current prospects of AAPL, is trading at about 12x.

COH, a global semi-luxury company, whose stock has paralleled AAPL over the past year, and which has far better growth characteristics than WMT, trades at almost double the PE of AAPL.  But even COH probably won’t grow as fast as AAPL this year.

Why the low valuation for AAPL?

I think Wall Street views AAPL as a firm built at present on a single product, smartphones.  It perceives the global transition from feature phones to smartphones, which is at least part of what’s driving the company’s extraordinary growth, to be mostly played out.  Therefore, investors theorize, AAPL will sooner or later–and probably sooner–be reduced to depending on replacement demand.  When that happens, its earnings growth will shift into a much lower gear.

There’s some truth to this idea.  Look at the breakout of AAPL’s revenues during the current quarter:

iPhone     53% of sales

iPad     20%

Macs     14%

iPods     6%

Music services     4%

Other stuff     3%

Total = $46.3 billion.

After iPhone and iPad, nothing else moves the needle that much.  A half-decade ago, the iPod doubled the size of AAPL; the iPhone then doubled (a much larger) AAPL again.  Can iPad perform the same trick for AAPL a third time?  Eventually, maybe, as part of a transformation of the personal computer market over the next decade.  But I’m not sure many people would like to bet on that.

And, of course, NOK and RIMM are reminders of how fast the tech world can change.

Potential pitfalls may be Wall Street’s current focus, but it’s by no means the whole AAPL story.

As I’ve been writing for some time, AAPL shares have suffered immense PE contraction over the last four or five years, both in absolute terms and relative to the market.  According to Value Line, AAPL traded at a 40% premium to the market multiple in 2007 and a 60% premium in 2008.  By my reckoning, AAPL is now selling at a 25% discount to the market–a much lower level than firms (like WMT) with weaker business models and balance sheets.

That’s actually the good news.  The fact that a huge amount of potential future bad news seems to me to be already baked into the stock price is a powerful argument for owning the stock.  In fact, I think the market is discounting a far worse future for AAPL than is likely to develop.

Can AAPL do anything to help its own cause?  The company could begin to pay a dividend or split the stock.  Either would give the shares a short-term boost.  In the final analysis, however, all AAPL can really do is continue to post strong earnings to show that Wall Street fears are overblown.

two investor sentiment surveys: straws in the wind or contrary indicators?

investor sentiment

Investor sentiment is a funny indicator.  Outside the US, investors try to figure out what way the tide of sentiment is flowing so they can set their portfolios to benefit from the prevailing direction.  Inside the US, on the other hand, professional investors try to determine the direction of sentiment so they can bet against it.

Surveys, of course, have the limitation that they tell you what the respondents have to say.  Normally secretive professionals may simply not respond, so you may end up surveying interns rather than senior managers; or they may not give their true opinions, for fear their views will be incorporated into the consensus before they are able to exploit them to the fullest.

Once you’ve set your portfolio, whether you then seek publicity for your largest holdings is a matter of personal preference or taste.  I would prefer not to do so, although I don’t regard the practice as border-line unethical, as some do.

two surveys

Anyway, I’ve come across two peculiar investor sentiment surveys recently.

–The first comes from the Chartered Financial Analyst Institute.  The Institute conducts a series of exams on academic portfolio theory, passing all of which results in the test-taker qualifying for a CFA charter (suitable for framing) that attests to the holder’s knowledge of the concepts. Once the province solely of professional portfolio managers and securities analysts, the current 90,000+ holders of the CFA designation are much more widely distributed through the various functions of investment-related organizations and the academic world.

Conclusions from the Global Market Sentiment Survey:

–Almost two-thirds of the 58,000 respondents to the survey expect the world economy will show no growth in 2012.  34% expect economic contraction; 29% think the world will tread water this year.

–About 60% expect that equities won’t be the highest return investment asset this year.  Among the competing alternatives, precious metals gets the most votes for top-performing asset, followed by commodities, bonds and cash.  Sentiment on this topic is split geographically, as well.  Of investors in the Americas, 45% think equities will have the best returns in 2012;  elsewhere, the proportion is only about a third.

The second survey is one conducted by a popular small-cap service I recently subscribed to.   Asked what they thought the probable returns for the S&P 500 this year might be, the most frequently given answer was a loss of 20%.

the respondents

As to the second survey, I was very surprised at how negative subscriber sentiment appeared to be.  I also looked at a couple of other surveys, one of which had some respondents saying small caps were too risky to invest in–yet, as subscribers, they were paying for information about small-cap stocks.  I don’t know what to make of that.

The CFA survey had one remarkable characteristic.  Half of the respondents had either not yet passed all the exams or had held their charter for two years or less.  Another 19% had been CFAs for five years or less.  These are not portfolio managers or senior analysts actually making investment decisions.   They’re much closer to being the man in the street.

my thoughts

I think the relative inexperience of the CFA survey respondents means that they’re much more indicative of what the man in the street thinks than of what the “smart money” is doing. In a section about employment opportunities, over half the respondents from Europe said that the job situation has deteriorated.  39% of those in Asia Pacific said the same.  So it’s also possible that the respondents have been unable to distinguish between their own career outlook and prospects for world equities.  My guess is that their macroeconomic and asset market answers are contrary indicators.

The (potentially oddball) respondents to the small-cap survey?  Clearly a contrary indicator, in my opinion.

All in all,  two small reasons to want to be bullish.