Monthly Archives: March 2014

dividend-paying stocks

March 17, 2014 By in Constructing a Portfolio, Current Market Thoughts, Industry Analysis, Recent Market Action, Securities regulation, Utilities Tags: , , , , , , 1 Comment

Robert Rhodes of Rhodes Holdings LLC made one of his usual astute comments about my post last Thursday on utility stocks.  In this post, I’m going to elaborate on my view of buying stocks for their income.

Financial planning guides often mention that when selecting a stock because of its dividend, one should consider not only its current yield but also the potential for the payout to grow.  My impression is that the authors don’t just want to steer us away from too-good-to-be-true extremely high current yields, which are most often a sign that the market thinks the dividend is likely to be cut sharply or even eliminated.  I think they also believe it’s better for investors to pick a stock with, say a 3% current yield and the possibility of 8% annual growth in the payout vs. a stock with a relatively secure 6% yield and no dividend growth potential.

For a Millennial, who arguably has no business getting involved with income stocks, the expert advice is probably correct.  In contrast, for a senior citizen looking for income-generating investments to support retirement, the 3% yield + the promise of growth is certainly better than Treasuries.  But for a seventy-something a good argument can be made that the 6% current yield is the better choice.   At least, that’s what I’ve thought until very recently.

my reasoning?

The handy-dandy rule of 72 tells us that a 3% yield growing at 8% per year doubles in nine years (72/8).  It takes that long for the payout to equal the 6% dividend of the non-grower.  This also means someone who buys $100 worth of the 3% yielder collects $40.50 over the nine-year period, assuming the payout increases at a uniform rate.  The person who chooses the 6% yielder collects $54.  It takes the former another two years+ to draw even in terms of total income received.

Put a different way, the superiority of the 3% yielder with growth doesn’t come into bloom until over a decade after purchase.  That’s a long time.  It hasn’t been clear to me that financial planners fully appreciate how large/long the shift in income is away from the period a senior citizen may be young and healthy enough to enjoy the money.

Capital gains?  In theory, the steady-state 6% yielder has significantly less capital gains potential than the 3%er.  But who knows?  Arguably the senior citizen is more concerned with preservation of income than in making capital gains.  It’s also possible that the sprier utility won’t be able to sustain profit expansion for such a long time.

my change of heart

As I wrote last week, the negative effects of years of downward regulatory pressure on utility rates in mature areas, and the consequent corporate response of cutting maintenance/replacement are starting to become apparent.  It’s no longer clear to me that the dividend payments of no-growth utilities are as rock solid as I’ve been assuming.  So, yes, there’s a chance that the fast grower will slow down in short order.  But I now think there’s also a good chance that mature utilities will be forced to divert large amounts of cash flow away from shareholders in order to shore up creaky infrastructure.  So the mature utilities may be much riskier than they appear.

 

Tesla (TSLA) bids adieu to the Garden State

March 14, 2014 By in Autos, Industry Analysis, Stock ideas Tags: , , , , , Leave a comment

Tesla (TSLA) is an interesting, multi-dimensional company.  It took a gigantic step forward, in my view, a short while ago when it raised $2 billion+ to help fund the “gigafactory” it plans to build to make to build batteries that will feed the needs of the Elon Musk empire.  The money came through a convertible bond issue whose buyers accepted ultra-low coupons in return for the right to buy TSLA stock at around $350 a share.

direct to consumer

One of the firm’s key profit strategies is to sell its electric cars direct to the consumer, bypassing third-party auto dealers.  This is potentially very important.

The typical traditional car company has an operating margin of around 12%.  Publicly traded car dealers mark the vehicles they purchase from manufacturers by another 10%-15% in selling them to the end-user.  If TSLA is able to achieve the performance metrics of the typical auto manufacturer (it may be aiming higher), capturing the wholesale-to-retail markup would potentially double TSLA’s per unit profit.  In addition, the current sales volumes for TSLA are extremely low–TSLA’s goal of selling 35,000 cars in 2014 would give it 0.2% of the domestic car market if it sold them all in the US.  So it makes no sense for TSLA to set up its own dealerships.  And what terms would a third party demand for a dealership that might initially sell only 100 cars a year?

traditional car dealer opposition

The biggest stumbling block for TSLA in direct sales is the obvious one:  the auto dealers don’t like this, and they form an immensely powerful lobby in local politics.

For the dealers, TSLA itself isn’t that important. They  see TSLA as the thin edge of the wedge–that if TSLA is able to sell direct to the consumer, sooner or later Toyota, Ford and GM will be doing the same.  After all, their profits potentially double.  There goes the traditional car dealership business.

In many states, there are already laws on the books that enshrine car dealers.  They compel auto purchases to be made through traditional dealers and prohibit car manufacturers from obtaining dealer licenses.

That hasn’t quite been the case in New Jersey, where the Motor Vehicle Commission has allowed TSLA to operate   …until this week.   On Wednesday, the MVC revoked the previous permission it had granted TSLA and ruled that it can’t sell cars itself in the Garden State.  TSLA must establish a third-party franchisee network to sell in the state.

The decision has been unpopular with both conservatives and liberals.  The press is pointing out that the NJ change or heart follows very large political contributions to Governor Christie by car dealers.  The result remains, however:  no more TSLA sales in New Jersey, effective April 1.

This story is still evolving.  The next chapter will be written in Ohio, where TSLA is fighting a similar battle against auto dealers.  The lost sales in each state where TSLA is forced out will likely be negligible, although whether they amount to something in the aggregate is another question.

I’m not sure many holders of the stock believe the direct sales effort was anything more than tilting against windmills, given how deeply politically connected traditional car dealers are.  I suspect the most lasting damage done may be in TSLA’s image.  Its outlets in high-profile retail space help identify it as the choice for potential buyers of electric cars.  If they gradually go away, does the cachet that gives TSLA one of its current sales advantages gradually fade away?

 

yesterday’s gas explosion in Harlem and the economic structure of utilities

March 13, 2014 By in Current Market Thoughts, Portfolio management, Recent Market Action, Stock ideas, Utilities Tags: , , , , , , , 1 Comment

Yesterday morning a leaking 125-year old cast iron gas main in East Harlem, just east of Park Avenue in Manhattan, exploded.  The blast killed six (an equal number are still missing) and injured 60.  The two five-story buildings the main served were pulverized.  Debris even covered the nearby elevated train tracks, disrupting commuter train service to Connecticut and upstate New York.

I have a generator in my backyard because the electric power outages in my neighborhood ars so frequent.

After Superstorm Sandy, it was a month before the first Comcast trucks appeared on our street to restore internet and cable (Verizon was on the scene a day or two after the storm, causing virtually everyone to switch).

Why do things like this happen?    .

..welcome to the world of mature utility operation, one where, in the Northeast US at least,  “business as usual” is facing increasing citizen discontent.

background

Governments grant monopolies to electric, gas and water companies in a given service area.  They do so to avoid expensive and disruptive duplication in the buildout of infrastructure.  In return for their exclusive status, utility companies are subject to rate regulation by the local utility commission.  No matter what formula is officially used, the rate-setting ultimately comes down to the utility receiving a specified return on its net (that is, after subtracting accumulated depreciation) plant.

When the service area population is growing, the utility has smooth sailing.  Its net plant is continually increasing as it hooks up new customers.  The utility commission also grants a generous return on that plant, in order that the utility has no trouble getting money, by issuing stock or bonds or borrowing from banks, to pay for the new plant and equipment it needs.

When the service are matures, however, this favorable dynamic changes.  Because there are no/few new customers, the utility’s net plant growth slows to a halt.  Net plant may even begin to shrink, meaning so too does operating income.  In addition, the utility commission no longer sees any reason to keep the allowable return as high as it did in the past.  More than that, the utility is now “trapped” like any other highly capital-intensive business with a lot of sunk costs (think: a cement plant, or a supertanker).  It can’t rip up the lines and leave.  So it’s a price taker, meaning the utility commission can easily bow to pressure to keep utility rates low by reducing the return it allows.

So high returns on a rising base morphs into falling returns on a shrinking base.

How does the utility respond to reduction in its cash flow?  Shareholders want higher profits and higher dividends.  Management wants a higher stock price.  The only way to get higher net income  is to pare expenses.  This means replacing meter readers with machines.  It means cutting maintenance staffs and maintenance itself.  And it means trying to make aging plant last longer before replacement.

Personally, think we may be reaching a tipping point, where utilities have pushed cost-cutting too far and where business as usual becomes socially unacceptable.  Probably not good for utilities in ares that aren’t growing.

Investment significance?

There’s a long-standing dynamic in utility investing:  choosing between high dividends that are not growing and more modest payouts that have the potential to rise steadily.  To the limited degree that I buy utilities, my instinct has been to pick the higher current yield.  Why?  I’ve found the point where the growing dividend bridges the gap with the static one occurs too far in the future.  As utility service breakdowns continue to occur with come regularity in areas like the Northeast, that thinking is probably much less sound than I’ve realized.

Current Market Tactics, March 12, 2014

March 12, 2014 By in Constructing a Portfolio, Current Market Thoughts, emerging markets, Portfolio management, Recent Market Action, short selling Tags: , , , , , , , Leave a comment

I’ve just updated Current Market Tactics.

Maybe a correction isn’t in the offing.  Too bad.  On the other hand, upside momentum seem to me to be waning.

what’s going on at Pimco

March 11, 2014 By in bond market, Current Market Thoughts, Getting financial advice, Portfolio management Tags: , , , , , , Leave a comment

1.  It’s important to understand that although investment management companies can have immense revenues and profits, and may employ hundreds or thousands of people, many have management structures more like an old-fashioned corner candy store than an industrial conglomerate.

There’s a Chief Investment Officer who has a history of superior investment performance, and who is sort of like the star player on a basketball team.  He/she manages the portfolios and may (or may not) supervise other, lesser, investment professionals.  And there’s a CEO/Chief Marketing Officer, who handles the acquisition/retention of clients, administration–and everything else.

In the PIMCO case, the CIO is the bond market’s equivalent of Michael Jordan, Bill Gross.  Bonds are its main product.

2.  Mr. Gross is fast approaching 70.  Although he may still be sharp as a tack and healthy as a horse, this is ten years past the age when clients–who, after all, may be staking their own careers on Mr. Gross’s prowess–begin to worry about the management company’s succession plan.  Deutsche Bank, PIMCO’s parent, may have a concern or two as well.

3.  Until recently, interest rates in the US had been on a steady downward course for thirty years, meaning (in hindsight) a bond manager would have been most successful by setting up an aggressive portfolio and holding to it through thick and thin.  That is much harder to do in practice than the last sentence might suggest (think:  the collapse of Long Term Capital Management).  Bill Gross has done the best job over this period.

Still, it seems to me (even though I’m an equity manager) that the bond market has changed.  Mr. Gross himself has on several occasions declared the long bond bull run to be over.  Yet, as far as I can see, he has still committed himself to put up the big numbers he achieved when the rules of the game were more supportive.  The result has been big bets, greater volatility and so-so returns.

4.  All these issue have come to a head with the recent resignation of Mohamed El-Erian, the presumed successor to Mr. Gross.  Mr. El-Erian, the marketing face of PIMCO, was always a curious choice to take the reins from Mr. Gross, in my view.  The fact that he spent so much time marketing implied to me that he was not well-integrated into the portfolio management process.  And the only independent portfolio management experience Mr. El-Erian has had, that I’m aware of, was a short stint at Harvard that ended badly.  I would have pegged him as CEO/Chief Marketing Officer, not CIO.  Yet clients didn’t seem to mind.

Where to from here?

Let’s ignore the gossipy press commentary about conflict between Mr. Gross and Mr. El-Erian, or the former’s reported references to the latter’s lack of investment experience (makes you wonder how he was chosen to succeed Mr. Gross).

–PIMCO appears to have addressed the succession issue with the promotion of a number of successful in-house forty-something portfolio managers.

–That leaves the performance issue.  The prudent course of action would be to try to stabilize performance by reducing risk (read:  get close to the index) and aiming to be slightly north of middle of the pack.  Not very ego-satisfying for Mr. Gross, but the right thing to do.   But that might be like telling MJ not to shoot the basketball.   Let’s see if that can happen.