inflation on the rise?

Regular readers know that I like the economic work done by Jim Paulsen of Wells Capital, the Wells Fargo investment management arm.  His May 1st “Economic and Market Perspective” piece argues that the US has turned the corner on inflation, which will –contrary to consensus beliefs–be on the rise from now on.

His argument:

–the first signs of upward wage pressure in the US are now becoming visible (in developed economies, inflation is all about wages)

–recently, a rising dollar has kept the price of imported goods from rising (in some cases, they’ve been falling) and suppressed demand for US goods abroad.  That’s changing, turning the currency from a deflationary force into in inflationary one

–productivity is low, meaning that companies will have no way of offsetting higher wages other than to raise prices

–in past economic cycles, the Fed has somehow invariably remained too loose for too long.


I’m not 100% convinced that Paulsen is correct, and to be clear, he expects only mild inflation, but I’ll add another point to the list:

–although it doesn’t talk much about this any more, the Fed has clearly in mind the lost quarter-century in Japan, where on three separate occasions the government cut off a budding recovery by being too tight too soon.  In other words, there’s little to gain–and a lot to lose–by being aggressive on the money tightening trigger.


Suppose Jim is right.  What are the implications for stocks?  This is something we should at least be tossing around in our heads , so we can have a plan in mind for how to adjust our portfolios for a more inflationary environment.

My thoughts:

–inflation is really bad for bonds.  As an asset class, stocks benefit by default.  But bond-like stocks–that is, those with little growth and whose main attraction is their dividend yield–will be hurt by this resemblance.

–if the dollar is at or past its peak, it’s time to look for domestic-oriented stocks in the EU and euro earners in the US (the basic rule here is that we want to have revenues in the strong currency and costs in the weak).

–companies that can raise their prices, firms whose labor costs are a small percentage of the total, and consumer-oriented firms that are able to expand unit volumes without much capital investment should all do well.

–I think that average workers, not the affluent, are the main beneficiaries of a general rise in wages.  So firms that cater to them may be the best performers.




a Fall stock market swoon?

Over the past thirty years, the US stock market has tended to sell off from late September through mid-October, before recovering in November.  That historical pattern has some brokerage strategists predicting a similar outcome for this fall.

Why the annual selloff?

It has to do with the legal structure of mutual funds/ETFs and the fact that virtually all mutual funds and ETFs end their tax year in October.

1.  Mutual funds are a special type of corporation.  They’re exempt from income tax on any profits they may achieve.  In return for this tax benefit, they are required to limit their activities to portfolio investing and to distribute any investment gains as dividends to shareholders (so the IRS can collect income tax from shareholders on the distributions).

2.  All the mutual funds and ETFs I know of end their fiscal years in October.  This gives their accountants time to get the books in order and to make required distributions before the end of the calendar year.

3.  For some reason that escapes me, shareholders seem to want an annual distribution–even though they have to pay tax on it–and regard the payout as a sign of investment success.  Normally management companies target a distribution level at, say, 3% of assets.  (Just about everyone elects to have the distribution automatically reinvested in the fund/ETF, so this is all about symbolism.)

4.  The result of all this is that:

a.  if realized gains in a given year are very large, the fund manager sells positions with losses to reduce the distribution size.

b.  If realized gains are small, the manager sells winners to make the distribution larger.

c.  Because it’s yearend, managers typically take a hard look at their portfolios and sell clunkers they don’t want to take into the following year.

In sum, the approach of the yearend on Halloween triggers a lot of selling, most of it tax-related.

not so much recently

That’s because large-scale panicky selling at the bottom of the market in early 2009 (of positions built up at much higher prices in 2007-07) created mammoth tax losses for most mutual funds/ETFs continue to carry on the books.  At some point, these losses will either be used up as offsets to realized gains, or they’ll expire.

Until then, their presence will prevent funds/STFs from making distributions.  Therefore, all the usual seasonal selling won’t happen.

how do we stand in 2014?

I’m not sure.  My sense, though, is that the fund industry still has plenty of accumulated losses to work off.  As a general rule, no-load funds have bigger accumulated unrealized losses than load funds;  ETFs have more than mutual funds, because of their shorter history.

This would imply that there won’t be an October selloff in 2014.

Even if I’m wrong, the important tactical point to remember is that the selling dries up by October 15 -20.  Buying begins again in the new fical year in November.






why I don’t like stock buybacks

buyback theory

James Tobin won the Nobel Prize for, among other things, commenting that company managements–who know the true value of their firms better than anyone else–should buy back shares when their stock is trading at less than intrinsic value.  They should also sell new shares when the stock is trading at higher than intrinsic value.  Both actions benefit shareholders and add to the firm’s worth.

True, but not, in my view, a motivator for most actual stock buybacks.

Managements sometimes say, or imply, that share buybacks are a tax-efficient way of “returning” cash to shareholders, since they would have to pay income tax on any dividends received.  I don’t think this has much to do with buybacks, either.  It also doesn’t make a lot of sense, since a majority of shares are held in tax-free or tax-deferred accounts like pension funds and IRAs/401ks.

the real reason

Why buybacks, then?

Years ago I met with the CEO of a small cellphone semiconductor manufacturer.  We had a surprisingly frank discussion of his business plan (the stock went up 20x  before I sold it,  which was an added plus).  He said that his engineers were the heart and soul of his company and that portfolio investors like me were just along for the ride.  He intended to compensate key employees in part by transferring ownership of the company through stock options from outsiders to engineers at the rate of 8% per year!!

Yes, the 8% is pretty extreme. In no time, there would be nothing left for the you and mes.

Still, whether the number is 4% or 1%, the managements of growth companies generally have something like this in mind.  They believe, probably correctly, that they won’t be able to attract/keep the best talent otherwise.

The practical stock option question has two sides:

–how to keep the portfolio investors from becoming outraged at the extent of the ownership transfer and

–how to keep the share count from blowing out as stock options are exercised.  A steadily rising number of shares outstanding will dilute eps growth; more important, it will alert portfolio investors to the fact of their shrinking ownership share.

The solution?   …stock buybacks, in precisely the amount needed to offset stock option exercise.

is there a better way?

What I don’t like is the deception that this involves.

However, would I really prefer to have companies allow share count bloat and have high dividend yields?  What would that do to PE multiples?   …nothing good, and probably something pretty bad.

So, odi et amo, as Ovid said (in a different context).



spinoffs: sometimes toxic, sometimes hidden gold

The March 12th edition of the New York Times’ excellent Dealbook section has an article written by Buckeye professor Steven Davidoff, titled “In Spinoffs, a Chance to Jettison Liabilities.”  It’s well worth reading.


In it, Mr. Davidoff documents how in a spinoff ( which is when publicly listed companies separate out a chunk of themselves into a separate legal entity, whose shares they then distribute to existing shareholders) the parent companies sometimes have ulterior motives.  (…shocking!)

being left behind on an ice floe

Many times, such “spinoffs” are businesses the parent wants to sell but can’t find buyers for.  They often are loaded up with a disproportionately large amount of the company’s debt.  Sometimes the spinoff is even forced to take out new loans and turn the proceeds over to the parent before it’s launched.  Davidoff gives lots of examples.

One of my favorites is the case of Monsanto, which spun off its industrial chemicals and fiber operations as Solutia, to get rid of liabilities relating to its production of PCBs.  It later spun off its agricultural businesses as the “new” Monsanto, retaining its pharmaceutical businesses in the parent, which was renamed Pharmacia.  Spinoff Monsanto was forced to agree to compensate Pharmacia for any losses it might suffer from Solutia-related litigation.  Sort of like a belt and suspenders.

three points

–None of this spinoff-unfriendly activity takes place completely in secret.  Somewhere in the SEC filings all of the potential bad stuff is disclosed.  Don’t expect it to be to be highlighted in LARGE print and a bold typeface.

There is a quick and dirty way to help focus your attention, though.  See where the current CEO is going end up.  There’ll never be potentially toxic liabilities there.  Look at the other parts of the deal.

–Not all spinoffs are disasters waiting to happen.  There’s a legitimate case to be made against conglomerates.  If a company has, say, two unrelated businesses, one which generates tons of cash flow but has few growth prospects, and a second that has huge growth opportunities, it may make sense to separate the two.  Income investors will bid up the price of the first, growth investors the second.  The sum of the two parts can be worth much more than the original conglomerate.

Sometimes, too, a small growth business can be lost in a much larger entity and starved of capital.  Spinoff will allow it to flower.

Two things to look for:  in my experience, it’s a good sign if the spinoff is relatively small and doesn’t “fit” with the rest of  the firm (think:  Sara Lee and Coach).  Also, it’s a plus if the parent retains an interest in the spinoff.

–There’s a perverse, human nature aspect to the spinoff game.

A captain, dying to get his own ship–even if it is rapidly taking on water–may be unduly optimistic in talking about his new command.

On the other hand, if you’re a shrewd businessman, once you learn your division is going to be spun off–usually at least a year, maybe two, in advance–you know there’s no sense in shining up the business any more until it’s its own public entity.  Improving your business pre-spinoff only makes your post-spinoff job harder!!  Best just to go on vacation for a while.  The result:  a “good” spinoff can be shockingly good in the first few years.

returns: capital changes vs. total return

Happy New Year!!

Like a stock that’s gone ex-dividend, my mind has gone ex-thoughts on the final day of the year.  My family might contend that this is not as unusual as I want to make it out to be.  Whatever the case, I can always hope that, like dividends, my absent thoughts will show up in my account as credits in a day or two.

Anyway, this is the best I can come up with on a sleepy New Year’s Eve.

Through last Friday, the S&P 500 was up 14.07% for 2012, year to date, on a total return basis.  The index was up 12.52% on a capital changes basis.

The difference?

Total return includes dividend payments as part of the return.  Capital changes doesn’t.

In figuring out your performance against the index, the total return figure is the one to use.  Looking at standard reference sources, like your broker’s website or the financial news, however, the figure that gets the most prominence is the capital changes one.

There are two historical reasons for this:

–from the mid-1980s until very recently, US Baby Boomers, who have been a major force in the domestic stock market, have been pretty much exclusively interested in capital gains, not in dividend income. So they paid the highest prices for growth companies.   Firms risked being typecast as dowdy and unimaginative if they paid large dividends, so they didn’t.  The result is that the dividend yield on the S&P has been small, and easily ignored.  No longer, though.

–keeping track on a daily basis of inflows and outflows of funds, account by account, is necessary for an accurate total return performance calculation.  This was beyond the computer capabilities of the custodian banks I knew for a considerable portion of my professional career.  Easier to ignore than to spend the time and money to upgrade staff and computer systems–especially when the calculation didn’t make that much difference.

2012 (and beyond): a different story

Dividends are again a significant component of the total return on US stocks.

2012 has seen a significant number of companies declare large special dividends, making the difference between their stocks’ capital changes and total returns especially large.  Take WYNN, which I own, as an example:

Through last Friday, WYNN is just about unchanged, year to date, meaning a capital changes return of 0.  The company has paid out dividends of $10, an $8 special dividend + four quarterly $.50 dividends.  On a total return basis, then, the stock is up a bit over 9%.  Yes, still an underperformer–but not by the margin that just looking at the figures Yahoo or Google offer would suggest.

I’m not sure that 2013 will be a year to write home about as far as capital change in the S&P 500 is concerned (more about this when I post my strategy for 2013).  Despite the absence of a spate of special payouts, I think dividends will be at least as important to next year’s total returns as they have been in 2012.

See you next year!


special dividends and (in)efficient markets

As I’ve already blogged about, many US companies are paying large special dividends to shareholders before December 31st. Either that or they’ve accelerated payouts planned for 2013, distributing them this year instead.  The idea is to avoid the presumably much higher taxes the IRS will be levying on dividends next year.  Some companies, like COST, appear even to be borrowing money to fund distributions.

The after-tax value of a dividend payment in 2012 to a taxable shareholder is likely greater than one made in 2013.  In addition, it may be possible to manufacture a tax loss from the transaction as well–something that would add another bit of extra value.  So it’s not surprising that stocks paying special dividends should be strong performers in advance of the day they start trading ex dividend.

I’ve been noticing another feature they seem to have, however, that I hadn’t anticipated.  The stocks appear to be “carrying” a large part–and in one case I’m aware of, all–the special dividend.  Here’s what I mean:

If a company’s stock is trading at $100 a share the day before it goes ex a $10/share dividend, then in a flat market you’d expect the stock to drop to $90 when ex trading commences the next day.  But the current crop of special dividend stocks aren’t acting true to form.  They’re trading at $93 or $95 or higher instead.

What could be causing this behavior?

I haven’t seen any cases where important news breaks on the day the stock goes ex.  The only thing that I can see is that a buyer is no longer entitled to the special dividend.

I have only one explanation, and a semi-crazy one at that.  I’ve concluded that buyers don’t know that the stock has paid out a large dividend.  Buyers think instead that the stock has just made a large downward random fluctuation that makes it an attractive purchase.

I have two thoughts:

–what I’ve just described could never happen in an efficient market, which tells you something about how much attention Wall Street is currently paying to stocks; and

–I wish I’d thought of this possibility before companies started paying special dividends, rather than when they’re finishing up.

Intel (INTC)’s $6 billion bond offering

INTC has just filed a prospectus with the SEC for a proposed $6 billion bond offering.  The securities it intends to sell are as follows:

Title of Each Class of
Securities To Be Registered
Amount To Be
Proposed Maximum
Offering Price
Per Unit
Proposed Maximum
Offering Price
1.350% Notes due 2017 $3,000,000,000 99.894% $2,996,820,000
2.700% Notes due 2022 $1,500,000,000 99.573% $1,493,595,000
4.000% Notes due 2032 $750,000,000 99.115% $743,362,500
4.250% Notes due 2042 $750,000,000 99.747% $748,102,500

Several aspects of this offering are interesting:

1.  INTC says it will use the proceeds for general corporate purposes (this is the boilerplate answer to the use question) and to buy back stock.

The dividend yield on INTC shares at a price of $20 each is 4.5%.  Total interest expense for the offering, ignoring accretion of discount, will likely be $142.875 million, meaning INTC is paying a blended interest rate of 2.38% for the money it will receive.

Unlike dividends, interest payments are a deductible expense for income tax.  After tax, the interest rate is 1.55%.  So for every share of stock INTC buys it will pay out $.31 in annual interest but save $.90 in dividend payments.  So the issue makes INTC’s cash flow go up. A $1 billion buyback at current stock prices would add about $30 million to annual cash flow.

2.  Why an offering now?

A short while ago, INTC boosted its quarterly per share payout to $.225, even though the company knew its new product spending would remain very high through this year.  Companies typically don’t raise the dividend based on future earnings potential;  they do so based on the idea that they have plenty of extra cash, come what may.  In other words, INTC thought it had lots of money to spare.

What’s changed?

–for one thing, the stock price is a lot lower than I would have expected, and the dividend yield is very high.  The chance to buy INTC assets for less than management thinks they’re worth + being paid through dividend savings to do so, the opportunity may have been too good to pass up.  I think this is the main reason for the fundraising.

–INTC’s operations generated over $5 billion in cash during a (relatively weak) 3Q12 alone.  The company also has about $11 billion in cash and short-term investments on the balance sheet.  So why borrow?   …presumably because the bulk of that money is located outside the US.

3.  My initial reaction on seeing the announcement was that problems had developed with planned cash flow in the US.  I don’t think that’s correct, though.  The US has been weak for a while.  It’s emerging markets that have been surprisingly bad for INTC recently.  And those profits presumably remain overseas.

In other words, I don’t think the offering comes as a result of adverse internal cash flow developments.

4.  INTC may be figuring that current low rates won’t last very long.  To me it’s striking that the company is raising 20-year and 30-year money.  Why else do that today?

my conclusion:  I’ve written about confirmation bias recently, partly with INTC in mind.  If I’m suffering from it, INTC’s board is, too.  In any event, the company’s indicated intention to buy back a significant amount of its shares appears to be what’s behind the stock’s current strength.  My guess is that this strength will continue for a while more.