Devil’s Advocate: It Is Not Too Late to Buy Stocks

August 5, 2009 No comments »

I saw a report yesterday by James Paulson (PDF), a Wells Capital strategist, wherein he argues that stocks are cheaply priced at current levels for a number of reasons.  I thought, given my last post speculating that we will see the S&P 500 at 666 again, it was only fair to present a counter-argument.  It is a well-reasoned argument, once you get past his obsession with question marks and exclamation points!?!?!? He has six main points:

  1. The rally from March was just returning prices to October 2008 levels following an overreaction to economic conditions.  The new bull market has yet to begin.
  2. When adjusted for inflation and the interest rate environment, stocks are at their lowest in terms of price/earnings since 1950, and in the lowest quartile going back to 1870.
  3. Extreme inventory and cost-cutting have made U.S. companies more potentially profitable (”profit leverage”) than in a long time.
  4. Rally despite “excessive and persistent doubt” about the market and economy suggest that there is not much downside to the market.
  5. There is truckloads of liquidity out there.
  6. Don’t fight the Fed — with the Fed using unprecedented powers, the market will not be allowed to fall.

I think this is the best thought-out “bull” argument I have seen.  Paulson tempers his argument by saying that there will almost certainly be downtrends and corrections along the way, but now is as good a time as any for a long-term investor to enter the market.

My time to Speculate. I do not disagree with Paulson.  In fact, there are a number of great buying opportunities at today’s levels from a value perspective.  I recently picked up Dun & Bradstreet (DNB) (I will post on this this weekend), for example.  Nevertheless, given the overall continuing economic decline, I believe that we will continue to see plenty of — better priced — buying opportunities for some time to come.

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Why We Will See S&P 500 666 Again

August 3, 2009 5 comments »

Warning: This post takes a stab at the future, and as such is speculative.

From a buyers perspective, I like this economy.  I am confident that there will be fantastic stock buying opportunities now and for many months to come.  Bear markets are like black Friday for value investors.

Nevertheless, I do not think current market prices are sustainable.  Over the short term, markets can get wildly out of shape — so I will not make any predicitions as to where the market is going on the upside.  We may stop where we stopped today at a little over S&P 500 1000, or may continue to 1,100, 1,200 or 1,500.  There is a lot of money to be made by talented (read: lucky) speculators on the swing up (and down), but for investors the short-term prospects are negative.  Historically, bear markets have always had dramatic rallies off of their lows as resurgent bull market optimism takes a step or two ahead of reality.  They have also retested their lows.

Many people think this time is different — the news media certainly does.  The argument goes that this time is unique because the Fed and Treasury have never bolstered an economy to such extremes before.  Nevertheless, a quick look through the fog reveals the following realities:

  • Home prices are still falling.
  • GDP is still shrinking.
  • The economy is still shedding jobs rapidly.
  • Consumers are not spending, and are saving at increasingly high levels.
  • Business revenues are not increasing — remaining flat or declining, and nearly all of the reported profits have been through cost cutting.

So if people’s houses are worth less (no equity), our overall economy is still shrinking, people are losing or are afraid to lose their jobs, are therefore not spending, and companies are in turn not making more money — how is the recession over, or even “bottoming out”?

I’m particularly troubled by the GDP numbers released last week that were hyped as being “better-than-expected” with the economy losing 1% in the 2nd quarter vice 1.5%.  First, things are still shrinking.  Second, there was also a historical revision for the first quarter numbers, which means things were overall worse than we thought they were.  As Karl Denninger points out at market-ticker.org, the adjusted GDP decline was really 1.9% when accounted for the historical changes, and when looking at only the private sector — the non-government portion of the economy declined at a higher rate than the 1st quarter at an adjusted 6.46%.  That’s right; negative 6.46% GDP for the portion of the economy that matters.

Reality will eventually catch up with Wall Street, and when it does, it will be very painful for most investors.  There are also several potential crises on the horizon that could trigger the reality-check:

  • Commercial real estate and credit card defaults have been largely ignored, but they are likely to start showing up in a big way on most banks’ balance sheets in the third quarter.  There is a growing body of evidence that this is an enormous problem.
  • A recent New York Times article suggested that AIG’s core insurance business could be very unhealthy, another collapse here could cause a full repeat of last year.
  • There is growing talk about how ill-advised China’s stimulus efforts have been.  While the Chinese economy is growing as if nothing had ever happened and partly masking our own problems at home, the growth does not seem sustainable.  China is essentially giving away money to anyone willing to take it, and China’s large state banks — already overburdened by hundreds of billions in bad loans — will probably not be able to take the inevitable defaults.
  • Oil speculation could drive prices high enough (already at $71/barrel with record high inventories and low demand) to convince Wall Street that consumers will continue cutting back to make room for gas (probably to look for jobs, not to go to work).

However the reality-check comes, it will probably come fast.  I wish it were not so, but we will likely see S&P 666 again unless people start spending by the bucket.  The good news is, there will be even more fantastic opportunities for value investors when that time comes.

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Get a Garmin

July 30, 2009 1 comment »

An article today, over at MSN’s Top Stocks Blog, claiming to reflect a Buffet-like stock picking model, suggests Garmin (ticker: GRMN) as a strong buy.  I had actually been considering an article on Garmin for awhile, so I thought now would be a good time to discuss.

I have not had a chance to do thorough financial research on Garmin, so I can’t fully recommend it.  I have not done the research to find out of it is doing anything funny in its financial statements, or if its leadership seems open, honest, and capable.  With that caveat, my sense is that Garmin is likely a smart buy.

Financials

I will not go through all of the ratios that I usually do, because the article does a decent job of that.  In short, Garmin makes a lot of money, and does so very efficiently.  The stock is also valued very cheaply.  Why?

The Smart Phone Threat – A Fallacy

Apple’s iPhone, Palm’s Pre, and RIM’s Blackberry are all seen as potential Garmin killers.  As a result, investors have panicked from Garmin’s shares expecting its long-term demise.  This is a classic example of the market’s extreme short-term stupidity.

The GPS market is growing.  There are billions of people who have not yet touched a GPS device or benefited from its substantial society-changing effects.  It is true that the smart phone makers stand to profit enormously from this growth, but so does Garmin.  Not everyone will get a smart phone, and even if they do, Garmin’s devices are far more powerful than a smart phone GPS.  GPS devices are also not just used by regular joe’s.  GPS devices are integral to aviation, and all forms of commercial and freight transport.  These applications require specialty devices with robust capabilities that Garmin makes.

Garmin stands to benefit enormously over the long-term from this trend, and Garmin is the name in GPS.

Ignore Panicky Idiots

The idiotic punishment of stocks in favor of hot companies is nothing new.  Recall 1999 when insurers and other traditional companies lagged and even declined behind dot-com and tech stocks rising to meteoric heights.  The old economy was dead, remember?  The dot coms tanked the following year, and the traditional companies rallied.  This situation is slightly different in that Apple et all are profitable and sustainable companies, but it is the same in that Garmin has been unfairly punished by the markets because of a false threat.

Do your research–I know I plan to–and consider buying Garmin while the market is stupidly planning its never-to-come demise.

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How to Protect from Inflation

July 27, 2009 1 comment »

inflation_wheel_barrelSpecter of Inflation

Only six months ago, inflation was the last thing on anyone’s mind.  Deflation threatened as prices — especially energy prices — plunged to record lows.  Following massive Fed and government intervention, focus has shifted.  While deflation is still a possibility, it is now unlikely given the enormous amounts of money being injected into the economy.

With massive sums of money being injected into the economy — a table in a recent Fed report indicated that the potential support to the economy could reach 21 trillion dollars — inflation is the more likely scenario.  Only a small fraction of the money being used to support the economy is coming from the existing money supply.  Most of the money being injected into the economy — through TARP, the Commercial Paper program, treasury buying, etc — comes from newly minted money.  The Fed is doing what the Fed does best; it prints dollars.

I agree with most of what the Fed is doing.  The economy needed massive stimulus to avert a complete meltdown, and continues to need a lot of stimulus.  The problem is with balance.  Forecasting the economy — or even measuring its current state — is a job best done by palm readers and astrologers.  Even a slight over stimulation of the economy — say $200 billion — can cause substantial inflation.  With the Fed throwing around trillions of dollars, getting the right balance of stimulus becomes nearly impossible.  Higher-than-normal inflation is almost a certainty.

A little bit of inflation is a good thing.  In the United States, we seem to like it where it does not approach threatening proportions in the 2-4% range.  In reality, inflation rates anywhere between 2-8% are considered healthy.  Many countries comfortably handle 8% inflation rates without any negative economic impact.  Nevertheless, with the amount of stimulus in the economy, the possibility of inflation higher than 8% is significant, and whereas hyperinflation was previously an impossibility, it is now possible, albeit unlikely.

Forget about Gold

Whenever inflation comes up, so does gold.  I honestly cannot explain to you what gold has to do with inflation, since the world is no longer using gold as a currency standard.  Gold does make some sense on the level that it is a commodity, and all commodities tend to rise in price with inflation since they tend to be priced in dollars.  I personally suggest avoiding gold. Gold is the first refuge of panicky idiots, and as such suffers from wild speculatory swings.  Instead, consider buying into a no-load commodity mutual fund — diversifying among commodities, including agricultural products, metals, oil and natural gas, will protect you from speculators and inflation alike.  From a value perspective, I’m not convinced that now is the best time to buy into commodities, but buying into any significant dips may be beneficial in the long-term.

Stocks

Stocks have natural inflation protection.  So long as the inflation is not at the panic-inducing level, stocks will benefit.  Stock prices tend to rise with inflation because of both the inflationary effects buying the actual shares and the higher nominal revenues/earnings associated with inflation.

To double-up the effect, buying stocks that are strongly connected to a commodity is a way to avoid dealing with the commodities market.  I recently recommended natural gas company, EnCana.

Bonds

Bonds and cash are typically thought of as the enemy to an investor in inflationary times.  This is not necessarily true.  Treasuries can be a drag on a portfolio when inflation is high, but not all bonds are treasuries.  Investors preparing for an inflationary environment may consider weighting their bond portfolio more heavily towards higher-yield bonds, such as investment-grade corporate bonds or a high yield bond mutual fund.  While returns may or may not outpace inflation, they will certainly be less of a drag than treasuries.  Nevertheless:

keep in mind that an inflationary environment can be an excellent time to buy good bonds at cut-rate prices.

The exception is with TIPS.  TIPS, or Treasury Inflation-Protected Securities, are a new type of treasuries that track inflation.  One can buy them directly, or through a TIPs mutual fund.

Most Importantly, Go Global

I cannot understate the importance of having a global portfolio.  The world of investment opportunities does not exist within the boundaries of the United States.  By diversifying assets globally, one mitigates issues that affect only the United States, especially inflation.  By investing in stocks, bonds, and even CD’s internationally, one can reduce inflation and currency risk in the aggregate.

That Being Said…Don’t Overdo It

A good portfolio shouldn’t need tremendous tweaking.  Good stocks and good bonds will generally be good stocks and bonds over the long term.  Severe inflation is not likely to last longer than a few years before the fed can launch an effective counter-attack, so there is not much sense in shifting one’s entire portfolio to fight its ugly face.  Focus on value and don’t get sidetracked by speed bumps like inflation.

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How Wall Street Steals: High Frequency Trading

July 24, 2009 4 comments »
tie_servers

High Frequency Traders Go to Work

Occasionally I like to take time from discussions of value investing, to call out shenanigans when I see them.  I had been considering a discussion of High Frequency Trading (HFT) for a few days, driven by the recent gravity-defying run-up in the markets.  I couldn’t wait any longer, given that the New York Times blew the lid off of this sadistic genie in a bottle in this article.

What is High Frequency Trading?

HFT is a type of trading that utilizes supercomputers and proprietary trading algorithms to automatically and intelligently make trades within microseconds.  HFT systems sometimes sit in the actual stock exchange in the server rooms that run the exchanges themselves, which allows for even faster trading.  The concept itself is fairly benign, but — like most things on Wall Street — the devil is in the details.

What’s the Big Deal?

The main problem with these systems is that they enjoy privledged information.  The major investment firms that use these supercomputers for internal trading and reserve them for their best customers, pay an extra fee to the exchanges that allows their supercomputers to have access to real-time market information before it reaches the trading public.  By being able to see trades before anyone or anything else, and executing bids and transactions in microseconds, these supercomputers are able to predict very short-term market trends and be the favored buyer and seller for any momentum on any stock. These systems make money by getting a slightly better price — on the scale of pennies or fractions of a penny per share — on millions of trades.

It is just a Penny, who cares?

While making only small sums on trades, HFT systems do this at such high frequency that the net-effect is massive market manipulation.  More than half of all trades are conducted by HFT systems these days, and according to the article, it is estimated that Wall Street pocketed $21 billion off of HFT last year.

HFT systems drive up the costs of investing for everyone else.  By using privileged information, HFT systems get the best price possible for most trades, effectively raising the cost of investing for all investors.  This is essentially a $21 billion money transfer from funds — mutual, pension, and other wise, and average investors like you and me directly to the pockets of Wall Street firms. In turn, there is no value added.  These computers are not investing in companies, they’re manipulating ticker symbols on a microsecond scale.  Outside of Wall Street, no one is better off because of HFT systems.

Conspiracy Theory

While I can’t prove it, I suspect that the problem is much deeper than this.  Given the enormous amount of control that HFT has over the markets in the form of volume, I fear that there is enormous potential, and incentive to manipulate markets on a broader scale.  While HFT is legal, if firms were to illegally collude, then they can have almost complete control over the direction of a market given the dominance of these systems.  Given the profits at stake with market domination, and the need for the major firms to generate capital to pad their poor balance sheets, the incentives are ripe for such a scenario.

I believe that this may be happening.  Lately, the markets seem to be defying all reason and gravity.  Despite lackluster earnings reports, the markets have surged for 11 days straight — this is unheard of.  These swings seem to hide behind less-bad news and completely ignore bad news.  I think that someone is manipulating these markets — pushing them higher and higher so as to profit more when they fall.

I know I’m the same person who says to ignore the day-to-day, week-to-week, and month-to-month swings of the market.  I know I say that a value is a value.  This is all true, but the fact is that we — as a world of investors — are losers in a world dominated by HFT.  HFT makes value plays a little bit less valuable, and if manipulation is at work, may be setting up millions of people for major disappointments on their 401k statements.

Heads they win, tails we lose.

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Forget the Stock Craze: Asset Allocation for Intelligent Investors

July 21, 2009 5 comments »

stock-chart-downWhat is a good asset mix?
I have heard a lot of talk on this topic, and there are a lot of simple rules that are ran through the media and personal finance circles.  They tend to vary on the theme that you should be heavier in stocks the younger you are.  One popular rule of thumb is to subtract your age from 100 to get the correct allocation of stocks for your portfolio.  These recommendations tend to get inflated towards a stock-heavy bias the more stratospheric the stock market gets, often at the investor’s detriment when things come crashing down.

I won’t rely on my own advice in this department as a mere peon, but will refer to the Abraham of value investing, Benjamin Graham,  who offered a different perspective in his book The Intelligent Investor.  First, he suggests that a portfolio strategy depends primarily on two things:

  1. What is the goal for the investment? With this question, Graham suggests that age is not important, but investment time line.  A woman who is 90, but has a solid pension that she lives on completely, can invest her remaining portfolio completely in stocks with no real risk to her well-being.  A 25 year old, on the other hand, saving for a home in the next five years, has a very different goal and should invest more conservatively.  To this end, Graham encourages considering goals in the formulation of an asset plan.
  2. What is cheap? Here is where Graham diverges heavily from the mainstream.  Graham, like most value investors, considers stocks and bonds — when purchased below fair value — risk neutral.  He suggests only that an investor, given equal value in both, favor bonds because of their higher standing in bankruptcy proceedings.

The practical application of this is that Graham suggests that an investor should shift to a higher bond allocation as stock prices increase, as measured by market price to earnings ratios (I discussed one way of doing this in an earlier post).  Such an approach would have saved millions of investors their 401K’s in the last year — as stocks increased to absurd highs in 2007, an intelligent value investor would have been almost completely allocated in bonds.

Graham Recognizes that We Are Dumb

As a hedge against our natural tendency to get great and seek higher returns, Graham suggests that an investor should — regardless of age — have at least 25 to 75 percent of his/her portfolio in treasuries, and investment-grade bonds.  In suggesting this, Graham points out — writing in 1949 — that there are significant periods of time when bonds outperform stocks and vice versa.  By maintaining a large bond portfolio, and investor does not get tempted into chasing stock returns when stocks are overbought, or when bonds are actually outperforming stocks over time.

What if I Am Lazy?

I don’t blame you if you don’t want to be constantly watching the markets and determining where the values are.  I enjoy it, but many don’t.  Graham also understood the need for people to have a worry-free portfolio.

For the lazy investor, Graham suggested an equal balance of stocks and bonds.  To best achieve this, the modern investor would invest half of their money in an S&P 500 index mutual fund, and half in a treasury and investment-grade bond index mutual fund.  I don’t like Exchange Traded Funds (ETFs), so I will ignore those, but they are an option that would achieve the same effect (even if I don’t recommend it).  The funds should be low-cost and no-load, and it is further advised that the investor have an international stock fund and an international bond fund (as much as 25% of the portfolio for each would not be too much), which will protect the investor from currency risk and an underperforming U.S. economy scenario.

Yeah, 50% in bonds, really. Think about that for a minute.  Not when you are fifty or seventy.  When you are 10, or 25.  I think most people today understand the wisdom in this suggestion, while I probably would have been booed off of the internet two years ago for suggesting it was a good idea.  People, just as they did in Graham’s day, fall in love with the adrenaline, thrill, and sky’s-the-limit prospects of the stock market.  The reality is that over any random period of time, your odds are roughly 50-50 in besting the bond market or not.  Repeat this to yourself:  bond is not a dirty word.

Update for Today

Things were a bit different in Graham’s time.  There were very few choices for investors.  Stocks or bonds.  That was it.

Today there are a lot more avenues for investment.  A good portoflio should include a fair mix of assets from other markets — including real estate (REIT funds), and commodities (oil, natural gas, agriculture, minerals — there are several broad commodity index funds to chose from).  Graham also discusse the potential value in a diverse portfolio of junk bonds, also known as high yield bonds.  Graham concluded that the average investor could not diversify enough in this market to minimize risk sufficiently, but today’s investor has access to hundreds of high yield bond funds that spread risk over thousands of bonds, and should definitely be in any portfolio.

So next time you read an article emphasizing the you-must-be-an-idiot-if-you-are-not-xy-percent-in-the-stock-market-or-you-will-die-poor-and-alone, think about the market today, and remember Graham’s advice.

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Value Pick: EnCana

July 19, 2009 2 comments »

ECA_logoEnCana is a Great Value

After comprehensive research, I’d like to recommend EnCana (ticker: ECA on both New York and Toronto Exchanges) as an excellent value prospect.  While I can’t guarantee market success, EnCana has all of the elements of a great company and great value stock that should make this a profitable choice for a long-term purchase.

Detailed analysis follows:

Company Overview

EnCana, based in Calgary,  Alberta, Canada, is the largest producer of natural gas in North America, producing 3.8 billion cubic feet per day in 2008.  While the company also has some oil and shale oil operations, natural gas accounts for more than 80% of production.  With a current market capitalization of 38 billion based on today’s share price of 50.81 (US), EnCana is one of the largest natural gas companies in the world.  EnCana also enjoys considerable dormant potential with a land portfolio of 23 million acres and proven reserves of 19.7 trillion cubic feet. To understand the enormous swaths of land that the company controls, it is best to see a map of EnCana’s land holdings (PDF).

Value

EnCana is currently an excellent value.  Everywhere one looks there are good things to be found with EnCana, so I will just list them:

Measures of Value

  • EnCana is currently trading at a very cheap Price-to-Earnings (P/E) ratio of 5.6 and a price/book ratio of 1.63.  Taken together, this provides a P/E and price/book multiple (I call this a PEB) of 9.13.  Value-investing founding father Benjamin Graham believed that any PEB under 22.5 provided a margin of safety — in this case, the margin of safety is very large.
  • EnCana is also trading at a low price/sales ratio of 1.30.
  • The company is trading at an ultra-low P/E to growth (PEG) of 0.27 when dividends are included in the calculation (P/E divided by earnings-per-share growth plus current dividend yield).  Current dividend yield is 3.15%.
  • Current price/cash flow is a low 3.50, or about 31% less than the industry average of 5.10.

High Growth and Superb Margins

  • EnCana boasts a superb 16.2% return on invested capital (ROIC), a measure of management’s savvy at wisely putting assets to their best use.  Management has been consistent in keeping this figure above their target of 15% for the last several years.
  • Other measurements of return are equally glowing — with a return on equity (ROE) of 31.5%, a five-year average ROE of 22.1%, and a return on assets of 14.3%.
  • EnCana also enjoys the excellent margins necessary to profit considerably from its excellent returns — with a net profit margin of 23.23%, pre-tax margin of 32.20% and impressive gross margin of 64.84%.

Low Debt

  • EnCana enjoys a low debt-to-equity ratio of 0.40 and debt-to-earnings-before-interest-tax-depreciation-and-amortization (EBITDA) of 0.70.  This means that if the company dedicated its after-operations cash flow towards debt repayment, it could repay all of its debts in just eight months.

So Why is it So Cheap?

I know most people are cautious about the central premise of value investing — if I can buy a dollar for forty cents, then what is wrong with the dollar?  I think this is a healthy question, and all value picks must be carefully analyzed to make sure that it is not a value trap – a company that is cheap for a very good reason.

EnCana is cheap because it has been punished with the rest of the natural gas producers.  Natural gas prices are currently at an inflation-adjusted all-time low.  Natural gas prices in 2009 have drifted in the $3 and $4 range, down from a high above $13.  This shift obviously has profound impact on the earnings of natural gas producers like EnCana.  EnCana, however, will be able to easily weather this storm.

The company’s conservative financial management has put it in a stronger position than its competitors.  With its low-debt and strong cash flow ($2.3 billion net cash flow last year), EnCana has a substantially stronger balance sheet than its competitors.  EnCana has wisely engaged in heavy price hedging — two-thirds of its 2009 production is hedged at contract prices above $9 for natural gas, despite current prices below $4, and over half of 2010 production is hedged at prices above $6.  With contract prices more than twice current market price, EnCana is not feeling the pain of low gas prices that is crushing many of its debt-laden competitors.  In fact, EnCana’s guidance predicts 2009 net cash flow similar to last year — between $2 and $3 billion.  Should low gas prices persist through 2011, EnCana will have the cash flow and large cash reserves to continue healthy operations for some time while out-investing its competition for when prices return to higher levels.  The company also wisely avoids guaranteed supply contracts — giving it the flexibility to shut down a majority of its operations should continued low gas prices force the need to do so.  This allows EnCana to maintain high margins when prices are down.

Innovation and Culture

A poor corporate culture can stagnate a company and drive it into uncompetitiveness.  EnCana is not one of those companies.

By all accounts I could find, EnCana seems to pride itself on a robustly innovative corporate culture.  The company spends considerable resources on enhancing collaboration, communication, and innovation within its workforce.  The best evidence for this, besides its own claims, is in its technological developments.

For well over a decade, EnCana has been the pioneer of a major technological shift in oil and gas development.  EnCana (under a different name at the time) first began pilot projects for shale oil and gas extraction in the early 90’s.  While these technologies did not become in vogue until 2008, EnCana was well ahead of the curve with large-scale projects as early as 2003.  As a result of its considerable dedication to innovative new extraction methods, EnCana holds or is in the process of obtaining patents for a number of critical technologies that it developed for cheaply extracting oil and gas from shale, as well as other technologies for minimizing the number of rigs that need to be drilled to extract a resource.

Thanks to its early investments and research, EnCana is the world leader in shale oil and gas extraction.  This is supremely important given that EnCana has managed to reduce costs to where shale extraction is economical.  It is estimated that there is up to 2.8 to 3.3 trillion barrels of shale oil globally that were previously too expensive to extract, and shale gas is expected to account for as much as half of North American natural gas production by 2020.

Financial Statements

After examing EnCana’s financial statements, I found no red flags.  In fact, I was impressed by the high level of above-and-beyond financial detail that EnCana provided.  In my mind, this is one sign of a good company that understands its duty to the shareholders by providing all possible information to make informed decisions.

Leadership

I’m a big fan of EnCana’s leadership, which is largely grown internally (yet another indicator of a strong corporate culture).  CEO Randy Eresman has been a strong leader, and has guided the company to a smart model focused on its strengths in nonconventional extraction and on its home territory in North America.  Eresman has guided the company into the sale of its overseas properties — which included fields in Qatar, Brazil, and France — in favor of Canada and U.S. development.  This is a very smart play given the politically stable, natural gas rich environment in North America, and the lower costs of operating on a single continent. Mr. Eresman is also fairly young, and is likely to remain in charge for the foreseeable future.

CFO Brian Ferguson has also shown incredible savvy in his management of EnCana’s finances.  While his very-conservative management may have made him look like a dinosaur next to free-wheeling natural gas companies like Chesapeake Energy when gas prices were high, Mr. Ferguson has the last laugh.  His fiscal conservativism has left the company in a position to substantially best its competition in this difficult credit and low-gas-price environment.

Executive compensation has also been kept to reasonable levels, which shows strong corporate governance.  Mr. Eresman’s total compensation package of salary, grants, and stock options of about $10 million is reasonable given the large size of EnCana and his successful management.  Other senior executives’ compensation is also reasonable — in the one to four million range.  I am particularly impressed with EnCana’s judicious issuance of stock options, with only 3 million options issued out of 750 million shares outstanding.  I also like that none of EnCana’s executives have sold stock recently, indicating that they, too, believe in the company’s long-term potential.

Key Future Developments

One impending development of note is a proposed split of EnCana into two companies.  The proposed split would split the company into EnCana, comprised of all of EnCana’s current natural gas assets, and Cenovus, comprised of all of EnCana’s current oil assets.  Under the plan, shareholders would get one share of each company.  The proposal was originally slated for vote in May 2009, but has been taken off the table indefinitely until stability returns to the markets (corporate speak for higher prices for the Cenovus initial public stock offering (IPO)).  I am undecided about how I feel about the proposed split — it makes sense to allow the two areas of the company to truly focus on their core businesses, but I like the flexibility, and economies of scale provided by the current structure.  I am also hesitant about the division of a winning management team — Eresman would remain head of EnCana, but CFO Ferguson would become the CEO of Cenovus.  Given EnCana’s strong culture and leadership development, any leadership changes will probably be neutral.

Natural Gas Prospects

I like natural gas’ long-term prospects.  Not only is it incredibly abundant, and cheap to extract, it offers significant advantages over oil.  Natural gas burns much cleaner than oil-based fuels, with significantly less greenhouse gas emissions.  I believe that given its abundance and competitive pricing, natural gas will continue to be a growing source of energy well into the future.  Natural gas is positioned to be a key transition fuel, with the technology in place to easily switch from oil and coal burning to natural gas burning power, and combined with low carbon output, natural gas is a logical clean alternative to oil and coal.  Continued global focus on lower greenhouse gas emissions and taxing carbon output will be greatly in natural gas’ favor.

Summary and Additional Information

In short, EnCana’s stock is currently very cheap and offers excellent prospects.  Given that the company is Canadian, it also offers some diversification from US dollars and the US economy, which I would encourage all investors to strive for.  I intend to open a position, and intend to continue buying and renvesting dividends as the stock remains cheap.  I will also be proud to own such a fine company.

Additional Information:

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Reader Response: Value in Microsoft?

July 15, 2009 6 comments »

steve-ballmerReader John B. asked in the comments to my last post, Goldman at the Gates, whether or not I thought Microsoft (ticker: MSFT) was a good investment.  So, let us take a look.

I have not done a serious deep dive into Microsoft’s financials, so let me preface this discussion with a caution that anyone choosing to invest in Microsoft should do further research before making a long-term buying decision.  With that said, let us take a quick look at what is on the surface:

What I like at first glance:

  • Microsoft is one of the few major technology companies that pays a dividend – currently weighing in at 2.25%.  This is a major positive in my mind because of how few technology firms do this.  Microsoft finally realized a few years ago that massive piles of cash were not in its shareholders’ interest – I wish Google and a few others would take this lesson to heart.
  • Microsoft is in excellent financial condition with almost no debt — 5% of equity — and plenty of cash flow to weather any storm.
  • It has a long history of positive earnings growth, though growth rates have understandably slowed a bit in the downturn.
  • With a return on invested capital (ROIC) of 35.7% (anything over 10% is excellent) — a measure of management’s effectiveness at leveraging its capital in profitable ventures– Microsoft is outstanding at putting its assets to good use.  This also holds true for all of Microsoft’s margins – 42.47% return on equity, 25.86% net profit margin, and so on.

Honestly, none of this is surprising for a large tech firm these days.  From a sector-blind viewpoint, it is incredible that Microsoft has managed to mantain high, if declining, growth rates as such a massive company.  More surprising is another measure of potential value:

  • One method of looking at whether a high growth company such as Microsoft is a decent value is to look at its PEG ratio, or price-to-earnings to growth ratio.
  • This ratio measures whether a stock is undervalued relative to its growth (PEG less than 1) or overvalued (PEG more than 1).  I prefer to use a modified version that accounts for dividends so: P/E/(EPS Growth + Current Dividend Yield). 
    Microsoft’s dividend-modified PEG is currently a respectably low 0.64.

What I don’t like:

  • Using traditional measures of value, P/E and price/book ratios, Microsoft is very expensive.  While Microsoft’s P/E ratio of 13.37 is reasonable, especially for a technology firm, its price/book is not at 5.57.  This makes Microsoft’s so-called PEB ratio (my term – P/E times price/book) a stratospheric 74.47.  That is more than three times higher than my target of less-than 22.5.
  • Microsoft price/sales ratio is high at 3.36, but not outlandish.

Summary of Fundamentals

Based on the financials above, I would say that Microsoft looks like a moderate value for a high growth firm.  I am a bit hesitant to say it’s a substantial value given its very high PEB.  Alernately, high price/book ratios are no stranger to technology firms given that they have very little physical capital (such as manufacturing facilities), and this explains the very high PEB.  At the same time, I am always hesitant to make exceptions to good rules when there are plenty of stocks that have all of the glowing characteristics above and have low PEBs.  After all, some of the same arguments were once used to explain the dot-coms in the 1990’s, and airline stocks in the 1950’s – of course, unlike dot-coms or airlines, Microsoft makes money.

Corporate Culture

I believe that corporate culture is important, especially in a highly competitive industry like software.  It is a company’s key asset in retaining good talent, encouraging and monetizing ingenuity, and staying competitive.  This is one area where I am questionable of Microsoft’s competitive position.  Relative to its major competitors (albeit smaller) – Google, Oracle, Apple – Microsoft is downright stodgy.  Its overgrown, bureaucratic largesse is legendary in the technology arena — something that notably affected profits with the poor showing in Vista.  I recall reading an article about how something absurd like 30 committees were responsible for different elements of the shutdown/restart menu.

The verdict remains out though.  Bing suggests considerable marketing and development savvy, even though it is not likely to dent Google’s armor, but may hurt Yahoo and Ask.com.  Windows 7 looks like it is going to be what Windows Vista should have been, and in a fraction of the time.  These developments suggest that perhaps Microsoft’s management has shifted gears, injected energy, and streamlined the bureaucracy.

Behind the Curve?

Nevertheless, Microsoft remains behind the curve in many areas.  Its overwhelming revenue generators are Windows and Office — the same two products that were its major sources of revenue ten years ago.  In meantime, Microsoft has developed no major innovation, developed an advantage in any new market where someone else had not already beaten them to the punch or stolen any major profit potential from under their noses.  Examples abound — Apple with the mp3 player, Google with search, Apple with the smart phone, Google and Salesforce with cloud computing, and so on.  While Microsoft has profitable products in some of these areas, it has not provided any major innovation with its products that has led it to dominate any new market segments.

As a result of this continued behind-the-curve-ness, along with problems with Windows Vista, Microsoft’s brand image has suffered mightily.  Google can walk into a crowd of developers, especially on college campuses, anywhere in the world and get people on board to develop applications for its initiatives.  Microsoft on the other hand has a negative association among many young developers, and long-term, it is developers that make or break a software firm.

Leadership

Like culture, the verdict is still out on Microsoft’s leadership.  My read on Steve Ballmer is that he has taken the notion of injecting energy into the company literally — manifested by his unnervingly flamboyant and eccentric developer conference speeches.  I may be a bit unfair here, but I don’t think running around like a mad man on stage inspires anything but discomfort for those watching.  The proof of effective leadership will be when Microsoft shows that it can identify a potential market, create a truly great product, and set the tone for that new market.

As a quick aside, I also do not like the massive amount of stock options that Microsoft, most tech firms, and many other companies today issues its employees.  I will write about this at greater length in the future, but I fail to see the value added for the shareholder.

Crystal Ball

Very long-term, Microsoft may be in trouble if it cannot learn to reinvent stale product lines and develop effective new products early enough to matter.  Any continued image degradation will cannibalize Microsoft’s future developer pool and further reduce its competitiveness.  Microsoft may have also missed the boat entirely in some tectonic shifts in technology — principally smart phones and possibly cloud computing.  If these two technologies truly start replacing the Microsoft PC as we know it today, that could be the end for the company’s glory without new significant revenue streams.

I could be wrong.  Microsoft has been a successful firm for sometime, and all odds are in its favor for it continuing to be successful.

Invest or Not

Based on this look, I would say that it is worth considering investing in Microsoft.  I personally would prefer a more traditional value play (that high PEB really does unnerve me), but by most measures, Microsoft is an excellent buy at current valuations.  While there are several things I don’t like about how the company has been run in the recent past, there are signs of improvement, and buying in now could be incredibly profitable.

Assuming its financial statements do not reflect any major sources of concern, I would be confident buying a stake in Microsoft — reassessed annually — for up to five years.  Beyond that, I would have to have seen some major improvements in management and product development to continue my investment further in the future.

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Goldman at the Gates

July 14, 2009 3 comments »

orcsIt seems like yesterday that the government was bailing out Goldman Sachs (ticker: GS) along with a number of the largest banks.  A doomsday scenario was about to unfold, and everyone was in panic after Lehman Brothers unexpectedly collapsed.

Today the situation seems quite different.  Goldman Sachs is dominating its competition in terms of profitability, posting obnoxiously high earnings given its uncertain future not-so-long ago.  Goldman also recently repaid its $10 billion in TARP funds to the government, and its stock price is up 78% this year.  On the surface, it seems that any investor would be a fool not to fall in love with Goldman as assumed heir to the Wall Street throne.

It is not a secret that Goldman Sachs is controversial.  Its traders are widely known among the broader financial community as the “bandits of Broad Street.”  There is an entire blog dedicated to the “evil” of Goldman Sachs – goldmansachs666.com.  According to the New York Times article, “For Goldman, A Swift Return to Lofty Profits,” an unnamed rival executive called Goldman traders “orcs,” and an opinion piece in the guardian asked the question “Is Goldman Sachs A Blood-Sucking Vampire Squid?”  An article which itself is a reference to a damning Rolling Stone article that begins as follows:

The first thing you need to know about Goldman Sachs is that it’s everywhere. The world’s most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.

So — is it really a vampire squid?

Probably.

One thing is apparent regardless of whether or not Goldman is going to be successful in the future – Goldman’s management has decided that nothing needs to change within its corporate culture.  One must respect a company that can so clearly shake off near-collapse and return to its former glory.  Despite the financial crisis, Goldman believes that its bet-the-house-and-the-kids approach to the world is still the best avenue for its continued success.  The New York Times article points to a mind-boggling manifestation of this fact:

While others are shying away from risks, Goldman is courting them. A common measure of risk-taking at Goldman and other banks is known as value at risk, which estimates how much money a firm might lose on a single day. At Goldman, that figure rose by more than 20 percent in the first quarter. Analysts predict Goldman’s V.A.R. ran high in the second quarter as well.

With mergers and acquisitions almost unheard of, Goldman’s profits are riding on trading — mostly behind the scenes swaps and derivatives.  If one is to believe the Rolling Stone article, Goldman is probably doing this without much concern because it is manipulating the markets.

Goldman Sachs, less than a year after the heart of the financial crisis, seems to look a whole lot like Wall Street did before the financial crisis.

The likelihood that Goldman will be successful forever is low.  Speculating on the scale that Goldman is may eventually destroy it – as such behavior killed Lehman Brothers, and nearly killed Goldman itself a year ago.  That does not mean that Goldman will not be the next great Wall Street bank – its demise could take a few months or fifteen years.  Of course, in many ways, Goldman is betting on that, too.

Given its risk stance, it seems obvious that Goldman’s leadership understands that it is “too big to fail,” and is therefore banking on the implicit backing of the U.S. Treasury in its high-risk gambling (or maybe low risk manipulating).  There is little that those of us who do not work at the Treasury, Fed or SEC can do about this.  What we can do is vote with our money.

I believe that when buying a stock, one should always think about the consequences of stock ownership.  That means company ownership (however small).  More importantly, one should ask “would I feel comfortable sleeping at night if I was running this company.”  While Goldman’s executives may be able to answer this question comfortably, I am not.

Even if Goldman were instead a company selling the cure for cancer below cost, I would still have an ethical disagreement with their current management structure.  Goldman pays 49% of its earnings in bonuses to employees — with average packages cited between $600,000 to $900,000 a year depending on the source.  A company handing out money to its executives at such excessive rates does not have the best interests of its shareholders at heart  — Goldman, in its cold, technical look at the numbers and tickers of the stock market, expects its shareholders to treat it with the short-term indifference that it treats its own trades.

Goldman Sachs – evil or not – is one stock that I intend to avoid at all costs until it changes its ways.  Like Goldman, the world may also get lucky – with Goldman surviving unsupported until a new management team with a long-term, shareholder value focus comes in and shakes things up.

For a start-to-finish account of Goldman Sach’s fall and resurgence, Glenn Greenwald did a nice job of piecing it together at Salon.com.

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Are Stocks Cheap?

July 13, 2009 2 comments »

Are stocks cheap now?SP_PE10_large_0709
This question is probably dominating millions of investing Americans’ thoughts these days in various forms — is now the time to get back into the [stock] market?  Did I miss out on the rally?  Is the rally going to continue?

Unlike many commentators out there, I honestly cannot answer these questions.  I will however, take a stab at the broader questions and discuss the issues and potential avenues for investment today.  I will also discuss where I think things are going (speculative), but one should avoid making investment decisions on future predictions.  Hopefully, that will help you come to your own conclusions.

At right is a chart from Doug Short at dshort.com who recently took his own stab at this question.  Doug takes a common route for analyzing the overall value in the stock market — a look at stock price to earnings (P/E) ratio based on 10-year average earnings (P/E10).  The P/E10, a method developed by value investing founding father Benjamin Graham, is meant to remove distortions of P/E ratios caused in severe downturns such as the current one wherein earnings decline far faster than stock price.  The graph shows that we are roughly near the long-term cyclical P/E10 average of the S&P 500 index at a valuation near 16.

Historical trends suggest that the S&P 500 will continue down to the single-digit P/E10 realm before fully recovering.  I have one rule about history and stock prices — markets misbehave.  So while the market is likely to eventually continue down to the single-digit P/E10 realm, it may not happen.  Even if it does happen, the time frame cannot be predicted with certainty — it could be this year, two years, or ten years.  Notice from the graph that the last time we were near the median on a downtrend was in the mid-1970’s approximately coinciding with another severe downturn, yet the market did not hit its lows in terms of P/E10 until nearly ten years later.  Someone waiting for the cyclical P/E bottom may be waiting for quite a while and miss out on plenty of earnings growth and dividends.

Over the next year, I think the markets will be heading lower (speculation alert!).  The run-up is largely untenable, and historically, bear market lows are usually retested.  As previously mentioned, markets do misbehave and the market — despite all logic and reasonable assessments of valuations — could continue higher for the next 1 month or 10 years.  The situation at first glance seems hopeless.  Here is the key to breaking through this impasse:

There is Always Value

While the broader market may not look attractive, individual stocks may still be excellent investments.  The longer the investment timeline, the more attractive stocks will look at current valuations.  Staying in line with Benjamin Graham’s own recommendations, an “enterprising investor” should look for the following characteristics in a stock:

  1. Current assets at least 1.5 times greater than current liabilities.
  2. Long-term debt no more than 110% of net current assets.
  3. No earnings deficit in the last five years.
  4. Currently pays a dividend.
  5. Multiple of current P/E ratio times current price/book ratio is no greater than 22.5 (for simplicity, I will call this a PEB ratio).

Using these criteria, there are currently dozens of stocks that are undervalued relative to their long-term earnings potential.  Using my own slightly modified version of these methods (I will discuss this in detail in future posts), a few great opportunities (only a few examples of many) present themselves:

  1. EnCana Corp (ticker: ECA) the large Canadian natural gas affair with a PEB of 7.55 and current dividend yield of 3.49%.
  2. Steris Corp (ticker: STE) a medical appliance and equipment company with a PEB of 7.96 and current dividend yield of 1.77%.
  3. Snap-On Inc (ticker: SNA) is a tool company with a PEB of 9.93 and current dividend yield of 4.47%.
  4. Pfizer Inc (ticker: PFE) the drug giant with a PEB of 19.08 and current dividend yield of 4.48%.

As one can see above, there are a lot of great companies that can be bought cheaply even after the recent rally if one is willing to hold them for a long investment timeline (a minimum of one year, but preferably 5-20 years or more).  While these stocks may retreat to even lower prices in the next year or so, they are still very cheap and will likely produce great returns in the future.

Please note that the above stocks are merely examples – they are not “official” valueseeker stock picks since I have not done a thorough business and financial statement analysis of these companies. I would recommend further research before an investment decision is made, and I may do an official look at these companies in the next few weeks.

What if there really is no value to be found in the stock market or one is not yet convinced that current stock valuations are favorable?  Then forget about the stock market.  There are a dozen or so other markets in which one can invest, surely one must be cheap if stocks are not.  The most apparent and common alternative to the stock market is the bond market.  So is the bond market a safer investment?

An article in the July 13th issue of Forbes by Bernard Condon entitled “The Case for Bonds,” examined this same question.  Condon argues that because stocks are at their historical average, the better investment decision is in bonds.  Specifically, investment-grade corporate bonds and junk bonds are priced below their historical averages despite a recent rally in bonds.

Most individual investors do not have sufficiently large portfolios to properly diversify in individual corporate bonds, though I will discuss individual bonds in the future.  Instead, I suggest investors wishing to buy bonds through a no load, low fee bond fund such as RidgeWorth Total Return Bond Fund (ticker: SAMFX) as an investment-grade option or RidgeWorth Seix High Yield Bond Fund (ticker: SAMHX) for a junk bond option.  I further suggest that regardless of portfolio size, one only invest in junk bonds through a fund in order to reduce risk.  I recommend that any portfolio have at least 25% in bonds.  Graham recommended that most investors would find a balance of 50% bonds and 50% stocks favorable over the long-term – advice that looked foolish in the last cyclical bull market, but looks quite wise to anyone who has checked their portfolio balance in the last year.

So What’s the Rub?

In short, it is up to the individual investor.  Investing in well-managed, low-PEB stocks with strong long-term potential, or alternately transfering (or remaining) in a bond-heavy portfolio are both safe options with excellent growth potential.  The bond route – of course – offers slightly less risk given current valuations, as well as less overall risk from a protracted downturn or high percentage default/bankruptcy scenario.

The most important lesson is that there are always values to be found in the markets – one just has to know where to look.

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