Shaping a Portfolio for 2012: mid-year review

2012 strategy

The year is half over.  It’s time to look at the basic portfolio strategy put in place on January 1st, see how well it did and make mid-course corrections.

The relevant Strategy posts are:  Shaping a Portfolio for 2012:  general, and putting the pieces together.

In brief, I thought:

–plus 10% for the year would be a good performance for the S&P 500

–volatility would be high, caused by the evolution of the EU financial/identity crisis, with Europe possibly following Japan down the road to ultimate economic and stock market irrelevance

–emphasis should be on the US, where broadening and deepening of economic recovery would make it important to emphasize technology, domestically-oriented companies and WMT customers rather than TIF clients.

results?

How has that worked out so far?

Overall the strategy has been a reasonable guide.  Through July 3rd, the S&P is up 9%, making it a star among world equity markets.  WMT is up 18%; TIF is down 19%.

where I was wrong

Volatility has been greater than I’d expected.  I would have preferred daily fluctuations around a more or less steadily rising trend.  Whe we got instead was a sharp advance through March, an equally sharp fall through early June, and then a bounceback.

The EU may not be such a lost cause as I had expected.  In January I thought that the EU-as-the-new-Japan was both the most prudent course to plan for and the most likely outcome, given the immense power of the status quo.  I now think there’s hope for a better future for the EU, although decline-into-irrelevance is probably still the most prudent planning stance.  The difference?  I’m tempted to add one or two more EU-listed stocks to complement the IHG I already own.  I haven’t started looking yet, so I have no idea which names.  The general idea, however, would be to have companies domiciled in the EU but with much of their business elsewhere.

Emerging markets in general, and China in particular, have been weaker than I’d expected. Emerging markets are normally boom or bust affairs.  This time around, it’s taking these economies longer than I’d thought to reach an even keel after the boom of a couple of years ago.  Their next day in the sun may not dawn until 2013.  The result may be weaker commodities prices until then.  Another plus for consumers worldwide.

The effects of GDP weakness elsewhere has taken a greater toll on US industrial growth than I had figured.  The current slowdown in the US has to be the most important development I didn’t anticipate.

where to from here?

My thoughts are more in the category of fine-tuning rather than a complete overhaul.

–the S&P 500 has already achieved my admittedly conservative objective for the full year.  I think this means it’s time to become somewhat more defensive.  To move significantly higher from here, investors have to be able to envision reasonable earnings growth coming in 2013.

For now, the election (no one in Washing ton seem to me to be up for the task of addressing the current economic challenges the US faces–but this is usually the case) and the “fiscal cliff”  (the idea that currently-mandated spending cuts and tax increases will clip 4% from next year’s GDP, sending the country back into recession) stand in the way of imagining a happy outcome.

–This means that beneficiaries of innovation and structural change–traditional growth stocks–will likely be the second-half winners.  I’ve begun to think that the major cellular operators in the US, especially VZ, are particularly interesting.

–dividend-paying stocks continue to look attractive to me, despite their being expensive relative to recent history.  High current yield isn’t enough, however.  Dividend growth is an increasingly important issue, since simple bond-like high yielders have long ago been picked over.

–I’ve also begun to look at REITS that concentrate on major cities in the US, as a supplement to the hotels I’ve been advocating for some time.  The idea is that cities like New York and San Francisco are hubs of tech innovation.  They also draw considerable buying interest from foreigners  And their own economies are on the rise again.  I own SLG.  It has some warts, though–mainly its dependence on the finance industry tenants–so this one has a handle-with-care label on it.

quantitative easing in Japan: implications

quantitative easing in Japan

With all eyes on Greece, one of the less noticed developments in global securities markets is the recent decline of the ¥ versus the US$.  As I’m writing this on Thursday morning, the ¥ has weakened from a high of ¥76 = US$1 reached on February 2nd to the current ¥80 = US$1.

This is not just the result of one of Japan’s periodic, ultimately fruitless, attempts to intervene in currency markets to temporarily weaken the ¥.  Instead, it’s the currency markets reaction to what appears to me to be a substantial shift toward monetary easing by the Bank of Japan.

Why do so?

After over two decades of minimal economic growth and mild deflation, citizens’ tolerance for political and bureaucratic bungling of Japan’s economic policy seems to me to have finally been exhausted.  Voters are deeply unhappy with the administration of the recently installed Democratic Party of Japan.  But no one wants the Liberal Democrats back either.  There’s serious discussion about forming a third political party–really radical thinking in a country where politics has been dominated by a single party, the LDP, for a half century.

There’s also been talk in the Diet of legislation that would take away from the Bank of Japan its Federal Reserve-like role in setting monetary policy.  This threat appears to be what’s prompted the central bank to launch the new program of quantitative easing.  The BoJ is basically saying that it will continue to inject money into the system in large amounts until inflation reappears.  In other words, the new stance is the Fed’s approach, but on steroids.

implications

In the near term, this policy will likely continue to weaken the ¥, removing one source of pressure on the profits of Japanese export-oriented companies.  It’s already prompting investors in the Tokyo stock market to re-orient their portfolios toward export-oriented stocks.  I don’t think this policy move, by itself, has the slightest chance of removing Japan from the morass in which it has been trapped for many years, however.  And substantial negative consequences may lie down the road.

As anyone who has read me on Japan before knows, I think the fundamental issue for that economy is the ground-level social decision made twenty years ago not to adapt to a changing world, but to preserve the traditional social order even if that meant slower economic growth.  After all, the country did hide its banking problems for a decade.  Despite a shrinking workforce, it doesn’t allow immigration.  Its laws cement the management practices of twenty year ago–and most times the actual managers–in place and defends them from virtually all attempts at change. Iconoclasts risk social censure, or worse.

Sounds a lot like the Eurozone, doesn’t it–one currency, but keep the local power brokers in place?

risks

Without substantial structural pro-growth reforms, what’s likely to happen?

For a while, nothing much.  The character of the stock market will continue to change, as investors shift away from smaller, counter-culture secular growth stocks to larger, older exporters.  But for foreign investors, a large part of any local currency gains will be erased by currency losses.  So it will be even harder to make money in Tokyo than before.

The strategy, however, seems to me to be playing with longer-term fire.  The central government has piled up a huge amount of debt, which it can continue to service both because interest rates are extremely low and because–lacking other investment alternatives–Japanese citizens continue to buy tons of government bonds.  Reemergence of inflation will mean, at the very least, rising nominal interest rates, and therefore rising debt service for the government.  In addition, in an all too rigid economy, inflation may spread relatively quickly and begin to have negative effects on the value of Japanese assets.  If so, Japanese investors may shift their money away from government bonds and toward inflation-protection vehicles, like real assets or foreign securities.  That might lead to further currency weakness and compound the government’s funding problem.  So a sovereign debt crisis, while not imminent, may be ultimately waiting in the wings.

what I’m doing in response

I own two Japanese stocks, DeNA and Gree.  I like them both, although each has taken its lumps as the market orients toward exporters.  I’m certainly not going to add new money to Japan.  And I’ve got to consider whether I lessen my exposure.  If DeNA and Gree didn’t have substantial businesses outside their domestic market, I’d be doing that already.

 

 

hotel stocks: why I think they’re attractive now

not hotels themselves

It’s not that I think owning a hotel is a great investment.  Generally it isn’t.

Like most real estate, hotels can be (and almost always are) leveraged financially using non-recourse debt–meaning that if you can’t repay, the lender can only seize the property, and has no claim on your other assets.  That’s a definite plus.  But office buildings have the same deal and sport much higher and more stable ROIs.

As far as I can see, the typical hotel developer/buyer is an individual or family that views them as symbols of status, signs that they’re “arrived.”

a mature industry in the US

I began covering the hotel industry in the US 30 years ago.  Even then it was a mature industry whose major firms were beginning to develop by:

–segmenting the market by not only offering generic “hotels,” but also resort, luxury, boutique, low-end, extended stay, suites–all the varieties that we have today, and

–selling their hotel properties, while retaining the hotel management contracts that deliver them the bulk of the cash flow the properties generate.

The rest of the developed world has since begun to follow suit.

today’s hotel stocks

The result is that today’s hotel stocks are by and large multi-brand property management companies that control brands and distribution networks (reservation systems and loyalty programs).  Yes, they may own some hotels directly.  But, through their management agreements, their profits are tied to those of all the hotels they manage, even though they don’t have the capital burden of building or maintaining them.

why today?

What makes them interesting to me as investments today is that they’re already comfortably profitable because of the post-recession resumption of business travel.  But they’re also very sensitive to the recovery in leisure travel that I expect will follow the pickup in hiring we’re now seeing in the Bureau of Labor Statistics reports.  (Meetings and conventions are the third big source of income for hotel stocks.  I’m not counting on that getting any better this year.  But it might.  On the other hand, it can’t get any worse, so it’s at least a neutral influence.)

I think the return of leisure travelers (which we’re already beginning to see in results from DIS) will have three aspects:

–a shift from staycation to vacation,

–a move of current Motel 6 stayers to, say, Marriott, and

–gently rising room rates.

According to HotelNewsNow.com, US hotels raised occupancy rates (the percentage of available rooms actually rented) to 60.1% and average daily room rates by 3.7% (to $101.64) last year.  HNN predicts that the combination of rising occupancy and room rates will lift industry revenues by 4.3% in 2012.  I think this is too low.

operating leverage

The key to my positive case for hotel companies is that they have immense operating leverage.  An example:  MAR has achieved an operating margin above 10% only once (in 2007) during the past decade, according to Value Line. 

Consider what happens if room rates rise.  The hotel has almost exactly the same costs if it sells a room at $102.64 as does at $1 lower.  So the margin on that extra dollar is close to 100%, not 10%.  Similarly, if the hotel rents an extra room for one night, its out-of-pocket expense is basically the cost of cleaning it post-stay and putting in new little soaps and shampoos.  That’s about $15.  So the margin on having an extra guest is around 85%.

Let’s say the overall margin on an incremental dollar in revenue is 90%.  If we figure a hypothetical $100 in revenue for a hotel firm at an operating margin of 10% last year, operating profit was $10.  If the extra $4.30 that HNN predicts for 2012 comes in and has a margin of 90%, then it yields operating profit of $3.87.  That’s a 38.7% year on year increase in profit from a 4.3% in revenue.

In reality, no company is going to show that much extra profit.  There’ll always be room refurbishment or other maintenance projects to pay for.  Employees will get raises, new staff will be hired, executives will get bonuses.  But that’s the general idea.

Another, non-fundamental, aspect to the story is that the US stock market has begun to shift its focus from investment ideas that depend only on continuing consumption by the affluent (the major theme since early 2009) to those that are keyed more to recovery of the average consumer.  So the market response to any signs of positive operating leverage of the type I’ve just described may be unusually enthusiastic.

I should point out that this isn’t analysis; it’s the germ of an idea.  That hasn’t stopped me from taking a small position in MAR while I do my homework.  I’ll write more when I finish my work.

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.

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.

I’ve just updated Current Market Tactics

I’ve just updated Current Market Tactics.  If you’re on the blog, you can also reach the CMT page by clicking the tab at the top of the page.

prospects for fixed income in 2012 (III): conclusions

This is the final installment of three that contain a bond market analysis by money manager Strategy Asset Management, LLC.  (Installment I, Installment II)

Risk and Return

Bond investors will face some difficult choices in the months ahead.  Our base case for 2012 includes a modest acceleration of GDP growth accompanied by an improvement in employment and personal income.  US housing prices will finally stabilize and inflation, as measured by the Consumer Price Index less food and energy costs, will continue to rise.  (This inflation measure bottomed at 0.6% year over year in October and now stands at 2.2%.)  The Federal Reserve, however, is likely to keep short term interest rates at virtually zero.  All this points to a significant rise in government bond yields.

The current yield curve for government bonds looks strikingly similar to that which prevailed at the close of 2008.  Based on the improving domestic economy and our assumption that the European debt problems will be contained (admittedly, not a universally held point of view), we think the changes in bond market yields will be very similar to those which occurred in 2009.  If so, it implies interest rate increases in excess of 150 basis points for US Treasury securities with maturities of five years or more.  That translates into a near 12% price decline for ten year government securities.  To avoid these possible losses, investors would need to shrink the average maturity of their portfolios to two years or less and accept current returns of 0.25% versus the 2%-plus yields now available on longer dated investments.

Mortgages, normally a refuge for investors in a rising rate environment, pprobably won’t be a good port of call in 2012.  The market prices of high coupon mortgage securities are astronomical–GNMA pass-thru mortgages with coupons between 5% and 7% are being valued at 110% to 115% of par value.  These premiums are much higher than during previous low yield episodes; for example, GNMA 7% coupons never traded above 106 until mid 2010.  The current mortgage market bubble has occurred because mortgage refinance activity in these premium coupon mortgages has been exceptionally low, limiting prepayment losses for investors.  Borrowers have been unable to refinance because they are underwater on their existing mortgages and lack the equity to meet requirements on new mortgages.  That could all change with the stroke of a pen.

It is rumored that President Obama wants to replace the acting Federal Housing Finance Agency head with a more activist chairman and push for a multi-trillion dollar refinancing plan.  It would permit current borrowers in the government agency guaranteed programs to refinance into lower coupon mortgages with no requirements other than being current on the existing mortgage.  No appraisals, no income verification, no upfront payments.  This is actually a great idea.  It would save consumers tens of billions of dollars a year, increase housing demand and lift home prices, and boost economic growth–in an election year no less.  The losers under the plan would be holders of high coupon mortgage securities who would probably see the market value of their investments drop at least 5%.

While a change in the rules could hurt high coupon mortgages, their lower coupon cousins–the mortgage pass through securities with 3.5% to 4.5% coupons–would be crushed if interest rates rise.  Given the already inflated prices of even these securities, their upside appreciation potential, even in a declining interest rate environment is very limited.  (And we could see that further reduced if government actions unleash a flood of new low coupon securities.)  Meanwhile, they would suffer sizeable price declines and negative total returns if interest rates rise.

Making choices

As we begin 2012, most of our accounts are 20% to 30% below their benchmark maturity targets.  This is at the outer end of our usual duration bands and represents a significant call on the direction of interest rates.  During the fourth quarter of 2011, we added to our holdings of short term US Treasury notes.  We are generally overweight US Treasury securities compared with mortgages.  Nonetheless, a large rise in market yields would result in losses for most of our portfolios.  Accordingly, it is possible in the months ahead we may adopt an even more defensive maturity stance if the economic and political scenario we envision begins to materialize.

In closing, we thank you, our clients, for your support during 2011 and we will continue to work to merit your loyalty in the year ahead.  We wish you a healthy and prosperous New Year.

Note:  The Market Environment reflects the vies of the Investment Advisor only through the date of this report.  The Investment Advisor’s views are subject to change at any time based on market and other conditions.  December 31, 2011.

Thanks again to Strategy Asset Managers for allowing PSI to publish “Bond Market Environment, Fourth Quarter 2011.”

prospects for fixed income in 2012 (II)

This is the second of three installments of a yearend analysis of the bond market by Strategy Asset Managers, LLC.

Follow the money

The Federal Reserve recently released its quarterly flow of funds study for the period ending September 30th.  Despite a brisk pace of federal government borrowing, aggregate credit demands remained weak.  Total non-financial debt grew at about a 4% pace as households shrank their borrowings.  This provided plenty of space for federal government debt to expand.  Meanwhile, the Federal Reserve was dumping huge amounts of money into the economy.  A broad measure of money supply–so-called M2–increased 9.8% over the last year.  Lots of money and little credit demand resulted in very low interest rates.  This could change quickly, however.

The US consumer has been tightening his/her belt since 2007.  The bursting of the housing bubble resulted in lower home prices, lower turnover and a decline in mortgage debt outstanding–from $14.8 trillion in June 2008 to $13.6 trillion in September 2011.  Faced with a troubling job market, consumers reduced non-mortgage debt as well.  This peaked at $2.6 trillion in 2008 and now stands at $2.47 trillion.  This borrowing metric seems to have stabilized recently as consumer confidence in future economic prospects has improved.

While the household sector of the economy has been paring back debt, the financial sector–commercial banks and savings & loans–has been reducing debt and balance sheet leverage.  This explains why few are worried about the leakage of European banking problems into our financial system.  So, once folks are ready to buy a new car or upgrade to a bigger house, banks will be able to provide them credit.  Despite the massive (+300%)  growth in federal government borrowings over the last decade, households remain the largest sector of the credit market with $13.2 trillion of debt outstanding versus $10.1 trillion of federal government debt.  If household borrowings increase by just 5%–less than half the rate experienced in the first half of the last decade–aggregate credit demand could rise by 7%.  This rate of expansion is not compatible with the current low level of interest rates.

That’s it for today.  SAM, LLC’s conclusions tomorrow.

Here’s yesterday’s initial post in this series.