Health Care Versus Energy Within the S&P500

The chart below shows the performance of different sectors of the equity market so far this year. Of course, there are always sectors that are outperforming, so nothing much new there. However, if in general as an investor you don’t commit much to health care and you are overweight energy, recent months have likely given you reason to examine comparative performance rather more closely, as we have. If in addition you’ve had a couple of small positions in smaller energy names, you’ve also experienced first hand the relative underperformance of small cap stocks versus the market. Suffice it to say that the results of owning a handful of large health care stocks and being short a smattering of small energy stocks would have been about as perfect a position to hold over the last three months.

"EnergyThe chart tells the story, but to put numbers on it, while the S&P500 is +14% this year, Healthcare (defined as XLV, the sector ETF) has returned almost double at +27% while Energy is -19%. A good portion of the Health Care/Energy relative performance has occurred just in the past three months (28%). Interestingly, the daily returns of MLPs have been most highly correlated with Energy (64%), even though MLPs have outperformed Energy by a whopping 19.5%. In fact, at +11% for the year the performance of MLPs is not far short of the S&P500.  What’s happened is that bigger than typical daily falls in Energy spill over to MLPs even though midstream energy infrastructure (what most MLPs are engaged in) has a very different risk profile from Exploration and Production. So on days when XLE fell 1%, the correlation with MLPs was higher than normal, at 76%. MLPs react to sudden moves, but on the days when Energy is not down 1% or more (84% of the time this year) they react to their own economics.

So what does one conclude? The surprise of the past 2-3 years has been that ACA (The Affordable Care Act, or “Obamacare”) has been very good for the health care sector. I doubt many architects of that legislation expected to create such wealth for health care providers. However, the major news story of 2014 is clearly Oil. Small energy sector servicers have been extremely weak, while the economics for many energy infrastructure businesses have remained sound notwithstanding big drops in some of their customers’ stock prices. Friday was such a day. with the Energy sector -6.3% and MLPs -5.3%. There are substantial crosscurrents beneath the simply headline result of the S&P500.


Another Activist Exposes a Weak Board with a Lousy CEO

It’s an odd phenomenon that, although capitalism as a philosophy is built around the meritocracy of free markets, in the area of corporate governance the power of profit maximization has often failed to dump ineffective boards of directors and/or management in favor of more competent people.

Boards are usually made up of invited friends, and sometimes their supervision of senior management resembles that of golf partners where it’s good manners to ignore others’ poor shots while offering congratulations on the good ones. The pressure to avoid rocking the boat is felt by everyone.

Hence the Economist this weekend noted an innovative solution to the issue of weak, sometimes unqualified board members. Why not outsource the function to companies whose business it is to provide such services? This currently happens with audit and legal work. Board members are hardly engaged full-time by any one corporation. Why not develop specialists who are truly independent and full-time?

It struck me as quite a clever suggestion. It ought not to be necessary, but the many failings we see week after week highlight that capitalism is often coming up woefully short in this important area of corporate governance, or how the very stewards of capital are managed and evaluated. Even Warren Buffett punted when a few months ago he was asked about the egregious compensation plan recommended by Coke’s (KO) management.

Although Berkshire (BRK) is KO’s biggest shareholder and Buffett about as vocal on investor rights as anybody, the great man meekly abstained rather than vote against a plan he freely admitted was needlessly generous.  “If you keep belching at the dinner table, you’ll be eating in the kitchen,” was his typically folksy and non-combative explanation. He understands as well as anybody the duty of board members to be only occasionally critical and then in the nicest possible way.

Other examples include ADT, which as I’ve written before is busy demonstrating the ham sandwich test (invest in a company that could be run by a ham sandwich, because one day it will), as shown by their buyback of Corvex’s position in ADT stock last year at $44 just before disappointing earnings took its price eventually below $30. Activists are often a force for good as they seek to expose management failings, but Keith Meister’s Corvex is a negative since he’ll readily throw other investors under the bus for a quick profit. We own ADT in spite of its leadership since we think anybody could run it as badly as current management and many could do better. It’s an option on executive suite change.

Currently the role of using capital to improve management is taken by activists such as Carl Icahn. He just provided a stark reminder of how shareholders often need activists to correct some of their self-seeking behavior. Family Dollar (FDO) just the other day agreed to sell itself to Dollar Tree (DLTR), an unlikely partnership since they operate different business models and would continue to do so afterwards.

FDO CEO Howard Levine noted that no discussions had taken place with the more obvious and bigger merger partner Dollar General (DG), to whose steadily improving operating metrics FDO eternally aspired but never reached. DG’s CEO Rick Dreiling flatly contradicted this by noting that DG had expressed interest in a combination multiple times in recent years. Carl Icahn backed this up, recounting a dinner with Levine at which the subject of a combination with DG was discussed. With DG, Howard Levine will lose his job to the superior operator, whereas with DLTR he’d keep it. As Icahn memorably noted, Levine thinks that because his father founded the company the son owns it. But he doesn’t. FDO’s stock has consistently underperformed DG’s in recent years as has its business. As close competitors it’s been helpful for investors as well as the companies themselves to compare their relative operating performance which has invariably favored the larger, better run DG (we are currently invested in DG, and were until very recently invested in FDO).

DLTR was a better merger partner for a CEO putting his own job ahead of his fiduciary obligation to his shareholders, and the FDO board passively acquiesced. Levine even agreed to a $300 million break-up fee in the DLTR transaction, a final slap in the face to those stockholders who thought he had their interests at heart.

Investors though should be far more assertive. If well-run boards with good corporate governance were more highly valued, they’d arrive more quickly. The more a poorly run company’s stock is shunned the quicker activists or competitors can buy a stake and fix it. The best solution to poor corporate governance is to invest with competent management and avoid the poorly run, at least until they’re cheap enough to draw in an activist. FDO had at least met this test in the last couple of years. Even institutional investors don’t have to own every publicly listed large cap company. Until investors become even more discriminating in their allocation of capital, activists will continue to correct perhaps the biggest weakness in contemporary capitalism – the management of the executive suite.

The Trading Risk Confronting Some MLPs

Barron’s has one of their by now regular articles on MLPs this weekend as they interview their “MLP Roundtable”. These write-ups are invariably constructive, and the most recent one is no exception. As well as noting the many opportunities offered to build out infrastructure in support of America’s shale boom, General Partners (GPs) received a mention. Roundtable member Douglas Rachlin of Neuberger Berman pointed out that, “GPs are not required to contribute capital to the organic-growth projects or acquisitions their MLPs make; yet they benefit in a disproportionate manner through their ownership of distribution rights.”

Becca Followill of U.S. Capital Advisors added, “Some MLPs don’t have a general partner, which makes them easier to take out and can make a deal more accretive more quickly.”

These are both features of MLPs that we’ve long identified and reflected in our own MLP strategy.

Quite a few names reported quarterly earnings last week. The numbers were generally good and MLPs are overwhelmingly reporting increases in future capital investment which for GPs at a minimum assures continued growth in distributed cashflow received and therefore in dividends paid. But not everything was good. Buckeye Partners (BPL) issued a surprisingly disappointing report which included losses in their Merchant Services division. We’re investors in BPL and have been for years.

The most attractive businesses for MLPs are fee-based whereby they earn recurring income from storage and pipeline assets. BPL largely does this, but like a handful of other MLPs they also have a marketing division which incurs basis risk on its underlying products on behalf of customers, often in exchange for quite narrow margins.

These activities can be quite tricky to manage. MLPs face a principal-agent problem here, in that their desire is to generate a return through using their inside knowledge and control of product to charge more than the cost of the basis risk incurred. However, there is inevitably judgment involved, and while the MLP wants to exploit an additional element of its franchise, if not properly managed the traders involved will seek to make money from the risk taking side of this. In fact, risk-averse basis trading maximizes the firm’s franchise value and minimizes the value added of the trader. The trader’s incentive can therefore be to minimize the apparent value of the franchise so as to maximize the apparent value of his skill-based activities. It can lead to excessive risk-taking, since profits from properly exploiting the MLP’s position in the middle of all kinds of information about supply and demand can appear to value the trader less than trading profits generated through his own skill/judgment.

It’s not only banks that can get themselves into trouble with risk. And in BPL’s case, it appears that a poorly constructed hedging strategy went wrong during the 2Q, causing the Merchant Services unit to swing to an operating loss.

Positions were liquidated, people fired and a more modest business model adopted. But it shows that unwelcome surprises can come from units that appear to offer steady if unspectacular returns, if the principal-agent conflict described isn’t carefully managed.

IBM, The Stock That Gets No Respect

IBM must be one of the least liked large cap stocks around. The criticisms are easy and familiar: they haven’t grown revenues in years, they are involved in financial engineering to prop up earnings, they are taking on lots of debt to support cashflows. Recently, Barron’s Roundtable noted that Fred Hickey had IBM as a short recommendation.

It’s true IBM has been a poor performer against the S&P500 over the past year. However, it has less volatility than the market with a trailing Beta of 0.66 so all other things being equal you would expect it to lag somewhat when prices are rising. And it’s true that revenue growth for years has been non-existent, hovering frustratingly around the $100BN annual level. However, earnings have grown nicely over the past ten years aided by improving margins and a reduced share count. So although revenues are flat since 2004, over that time EPS has more than tripled from $4.93 to an estimated $17.90 consensus forecast. The sharecount has dropped from 1.7 billion to around 1 billion as they relentlessly return cash to shareholders through buybacks.

As for debt, it’s true that it’s risen although IBM is hardly a leveraged company. They’re expected to finish the year with $48BN of long term obligations less Cash of $17BN for $31 BN of net debt, supporting pre-tax operating income of $21BN. This hardly seems like reckless leverage. Meanwhile, they still look to be on track to hit their target of $20 in operating EPS next year. At $194 a share it just doesn’t seem ridiculously expensive.

As for innovation, in 2013 IBM inventors received 6,809 patents, the 21st consecutive year of being the most prolific recipient of such awards.

So IBM isn’t that exciting on a daily basis, but it does look like a fairly compelling place to invest some of your money if you’re not one of those people who requires daily gratification on your stock picks. Fred Hickey’s price objective on his short IBM was $150 in the abovementioned article. At the time of his interview it was trading at $182 but has since risen $12, over a third of Hickey’s sought after gain. Shorting isn’t easy, and don’t imagine we’re claiming victory because we still own IBM and anything can happen. But there must be better ways to make money than trying to short IBM. They just keep generating cash, $18.1 BN in Cash from Operations (less change in Financing receivables) over the past 12 months, or about $18 per share.

For excitement, watch Amazon (AMZN) as they continue to break records for the most inefficient converter of revenues into profits. In ten years sales have increased sevenfold while EPS has halved. In their most recent quarter over $19BN in revenues, up 23% year on year, generated a small operating loss. The best investment you can make in Amazon is to sign up for Amazon Prime. Being a customer is far more likely to be satisfying than being an owner.





The Shifting Regulatory Landscape for Bond Investors

In my new book, Bonds Are Not Forever; The Crisis Facing Fixed Income Investors, I make the case that some big trends in the U.S. economy and Finance began shifting following the financial crisis of 2008, the consequences of which will include interest rates insufficient to compensate bond investors for inflation and taxes (hence the Crisis). The last few days have produced two news items of note which illustrate the altered economic and political landscape.

On Thursday, the Wall Street Journal reported that “Embattled J.P. Morgan” would be bulking up its oversight by spending an additional $4 billion and adding 5,000 employees to clean up risk and compliance problems. No doubt the company has been hit by a succession of issues from the huge loss in the office of the CIO to problems with mortgage underwriting standards and commodities trading. They’ve responded by deploying substantial amounts of money and people to resolve these problems and reduce the odds of new ones in the future.

I can imagine the stultifying impact these additional legions of compliance, regulatory and legal experts will have on many aspects of business. I worked at JPMorgan for 23 years and it’s a great company. I know from first hand experience that when additional layers of oversight are added whose job is to basically say “No” to any transaction or new line of business that carries a hint of the risks that have so bedeviled them in the past couple of years, it leads to a pretty frustrating environment. If you choose to make your career protecting a large bank from the sometimes questionable instincts of its revenue-generating employees, “Yes” is a word that carries career risk and limited upside. Many potential transactions and activities will now not occur, because they won’t pass muster with an increasingly vigorous compliance culture or because the weary revenue generators will steer clear of anything that is the least bit questionable. It will certainly make it a less fun place to work, and will hurt the top line while seeking to curb the Legal Expense line. It will make banking at JPMorgan more risk averse, less interesting and presumably more aligned with the public interest. If you hit a bank with enough $500 million fines, they do get the message.

The thing is, senior management will be well aware of the potential impact on revenues of rejecting all but the most anodyne transaction and will no doubt strive to maintain a profitable balance between the competing cultures of “No” and “Yes”. They will be very sensitive to the new trade-off. And yet, they’ve still chosen to go down this road. The bank that most successfully navigated the financial crisis of 2008 has assessed the ongoing regulatory  environment which must increasingly look as if they’re every government lawyer’s favorite target, and have adjusted their posture accordingly. The political mood has shifted against big banks and Big Finance after thirty years during which financial services grew its share of U.S. GDP. This is one manifestation of the altered landscape.

A second story of note is Larry Summers’ withdrawal of consideration for the position of next Fed chairman. Interestingly, it was the lukewarm support from Democrats on the Senate Finance Committee that led to the calculation that Republican votes would be needed even to get the President’s nominee to the full Senate for consideration. Summers is regarded by some as less enthusiastic about increased regulation than they might like, further reflecting the mood for a more tightly controlled banking sector. Listening to Senator Elizabeth Warren discuss the urgent need for ever more banking oversight may not  reflect a balanced view, but it does once again reflect the new reality Finance faces.

Financial markets have this morning provided their input – bond yields are down and stocks are up, reflecting the view that a Fed Chairman Yellen will continue Quantitative Easing and low interest rates for longer than would a Chairman Summers.

Whether or not this is good public policy isn’t really the point – others may debate that. However, what both stories highlight is that a shift towards more banking regulation and dovish monetary policy pushes back the time when bond investors might expect to earn a decent yield on their savings. The market expects a Yellen Fed to continue to promote the interests of borrowers at the expense of savers through very low rates. The JPMorgan story illustrates that what’s good for Finance is clearly less important in Washington than what’s good for everyone else. So bond investors should conduct their affairs accordingly. Current interest rates are unattractive, and it will likely be a long time before bonds are a good deal.


Bridgewater Reassesses Flight to Quality

If you stop to think about it there are several analogies for the Fed’s “tapering”, under which they gradually relax the support which has been underpinning the bond market. Maybe it’s the parent who creeps out of the young child’s bedroom at night believing they’re finally asleep, only to be halted by renewed cries from the little one. Maybe it’s Jenga, a game played with wooden blocks where players alternate turns of removing one without causing the structure to collapse. Or perhaps the magician who dramatically whips the tablecloth smartly off the table while leaving the place settings unmoved.

Whatever imagery does it for you, somewhere within the investment horizon of most people the Fed will make their move. Which is why a Bloomberg article on Bridgewater’s $80BN All Weather fund caught my attention earlier today. It seems that in recent weeks Ray Dalio substantially reduced their exposure to Fixed Income. Apparently not in reaction to the weak bond market of the second quarter, but instead as a result of many months of analysis which concluded bonds were no longer as attractive in a portfolio that’s expected to generate positive, uncorrelated returns most of the time.

The classic justification for holding bonds is the diversification they provide to a heavy weighting in equities. It’s worked more often than not, but we may just be heading into a period of time that will test conventional wisdom. To start with, yields on high grade and government bonds are unattractive on a buy and hold basis. It’ll be hard to finish ahead of taxes and inflation with yields of 2-3%. The idea that bonds will rally during times of equity market stress, thus mitigating the inevitable mark to market swings of a conventionally allocated portfolio only seems to justify bonds if you’d actually sell them when they’re bid up through a flight to quality. Few investors do, and the ownership of bonds for the temporary sugar high that turmoil may bring seems less interesting when the long term prospects are poor. Watch for creative explanations from financial advisors to defend clients’ bond holdings in the future.

But the other side of things is that stocks and bonds may at times be highly correlated on the downside. If the Fed’s attempts to at least slow the growth of its $3.5 trillion balance sheet awake the sleeping child, or perhaps even result in a smashed dinner set all over the floor, weaker stocks may be accompanied if not even caused by weaker bonds. The flight to quality may not work.

We believe the most likely outcome is one of very measured, non-threatening reductions in Quantitative Easing and a further very long interval until short term rates rise. This is what the Fed has told us to expect. But that’s just a forecast, and we could be wrong. However, if we do find ourselves in a substantially weaker equity market caused by the Fed’s lack of manual dexterity, we at least won’t have compounded the error by owning bonds as well.

Skating Where the Puck Was

This is the title of a “mini-book” by William Bernstein. I just came across a review of it by Larry Swedroe. I haven’t yet read Mr. Bernstein’s book (I just ordered it this morning) but Swedroe’s review caught my attention. It looks as if a three factor analysis of hedge fund returns has arrived at the same conclusion I did in my book – that hedge funds used to be great, that early investors did well, and that the industry today is overcapitalized.

David Hsieh, Professor of Finance at Duke’s Fuqua School of Business suggested that alpha is finite, and that’s why today’s hedge fund investors will continue to be disappointed. Makes perfect sense to me. So now we have some real academics weighing in on the debate, as opposed to the pseudo-variety hired and paid for by AIMA in London.  Mediocre returns delivered at great expense continue, providing additional support for the critics.

Hewlett Packard Shoots Their Other Foot

Hewlett Packard (HPQ), a company that is earning records for large and expensive strategic errors, plummeted to new depths of incompetence today with their $8.8 BN write down of Autonomy, a software company they acquired in 2011. The list of enormous acquisitions about which nothing much positive subsequently emerged is shockingly long: Compaq in May 2002 for $25 BN; P&G IT in 2003 for $3BN; Mercury Interactive in 2006 for $4.5BN; Opsware in 2007 for $1.6BN; Electronic Data Systems in 2008 for $13.9BN; 3Com  for $2.7BN, Palm for $1.2BN, 3PAR for $2.35BN and ArcSight for $1.5BN all in 2010; Autonomy for $11BN in 2011. And these are just the $1Bn or greater deals. $66.75BN in acquisitions over the past ten years and the company’s market cap is less than half of that. None of today’s board members have served since 2002, but several joined in 2009 since when HPQ has spent $18.75BN including on the ill-fated Autonomy deal. Among those board members who have been around long enough to be responsible are G Kennedy Thompson and John Hammergren (both since 2005), and Marc Andreessen and Rajiv Gupta (both since 2009). There are only eleven board members including CEO Meg Whitman, and she was on the Board when they bought Autonomy prior to becoming CEO.

When you write a check for $11BN and subsequently find you were ripped off, you can’t seriously blame anyone but yourselves. Pointing the finger at the former management of Autonomy or the auditor just further confirms that none of these people should be managing anybody’s money but their own. For our part, while we’re thankful to have never been investors, we’re going to add the HPQ Rule to our investment process that rejects any investment in a company with one of these value destroyers on its board of directors.

How We’ll Painlessly Avoid The Fiscal Cliff

The Fiscal Cliff is forecast to represent 2.9% of GDP drag in 2013 if nothing is done, according to the Congressional Budget Office (CBO). Although it was originally intended as a mechanism to force Congressional compromise around bringing the Federal budget under control, with less than seven weeks until the automatic tax hikes and  spending cuts take effect the focus is now clearly on simply avoiding the blunt instrument of fiscal policy that it represents.

The CBO’s analysis breaks down the different pieces of the Cliff and calculates the impact of each on GDP. Assessing the likelihood of compromise on each one provides an interesting perspective on the likely resolution.

1) Raise Taxes on the Rich – this has received the most attention by far. The President wants to raise taxes on those single tax filers making more than $200,000 and joint filers making more than $250,000. The Republicans will likely agree to higher taxes in some form. That will be one consequence of their poor showing in the election. “Rich” may eventually be defined as income above $500,000 or even higher, but it really doesn’t matter. That’s because the CBO estimates that even if tax rates for this group were restored to their “pre-Bush” level and investment income was all taxed as ordinary income, the entire impact would be to slow GDP by 0.1%. The optics matter because the “shared sacrifice” that must ultimately include entitlement reform can only occur in conjunction with some sacrifice from the 2% or 1% (depending on the definition of “Rich”). The Republicans have already indicated some flexibility on their opposition to new taxes so while it will grab headlines, wherever they ultimately settle on this issue it won’t impact the economy much.

2) Allow the temporary reduction in the payroll tax and emergency unemployment benefits to lapse. This is probably going to happen - neither party has expressed much interest in extending these. The CBO believes this is worth 0.7% to 2013 GDP.

So now we have 0.8% of fiscal drag already imposed on the economy, as well as the effects of Hurricane Sandy (estimated to cost 0.5% during the current quarter). Let’s look at the remaining components of the Cliff as measured by the CBO.

3) Restore the pre-Bush tax rates on everybody else. This is worth 1.3%. The Republicans are against this, and the President has focused on raising taxes on the rich. How hard are the Democrats really going to push to raise taxes on the middle class under these circumstance? It’s likely both sides will agree to defer this item.

4) Automatic cuts in Defence, 0.4%. A complete non-starter.

5) Automatic cuts in non-Defence Discretionary spending, 0.4%. There’s some room for symbolic cuts to remain, by way of demonstrating resolve, but it’s unlikely to be close to this figure.

The beauty of the Cliff is Congress created it and Congress can alter it. Neither side is likely to find much benefit in causing more GDP drag than the 0.8% or so illustrated above. So having decided they’ve done enough, or made a “down payment” as John Boehner has said, the Cliff will be avoided. The announced settlement will include a commitment to a broad-based overhaul of the budget and perhaps tax reform, to be negotiated in 2013. Will they include another Fiscal Cliff by way of forcing Congressional action? Possibly, although the President will undoubtedly push back on that.

Under different circumstances during these negotiations the President and Congressional leaders would be maintaining a watchful eye on the bond market for its approval of fiscal discipline, and to a lesser degree the rating agencies. Except that, as a barometer of such things the Bond market no longer works. The Federal Reserve is by far the biggest buyer of bonds and since they’re not economically motivated interest rates won’t be allowed to respond by voting on the outcome. Perhaps the most powerful visible incentive on budget makers to negotiate difficult compromises will be silent at this time. As such, the motivating features for both sides will be contemplating the visible cost of fiscal drag through tough decisions without the benefit of lower borrowing costs for the government or the penalty of higher costs if action is insufficient.

Equity investors are enduring a difficult time right now, and that may continue through year-end. However, it seems likely that a fairly modest GDP headwind and catastrophe avoided will be where we ultimately wind up. We can all wring our hands about the long term cost of such an approach, but take the world as you find it.

We continue to own solid businesses with good prospects and strong balance sheets that will be around no matter what happens, because we’re probably going to see another can kicked down the road. We like Microsoft (MSFT) whose cashflow generation continues and is priced at an attractive less than 7X FY June 2013 EPS ex-cash; Berkshire Hathaway (BRK-B), which at under $85 is close to levels at which they could buy back stock (as much as 10% above $76.29 book value, or $83.92). We recently added to Kraft Foods Group (KRFT) which yields almost 4.5% and will comfortably cover its $2 dividend with $2.60 of EPS next year. Following a good earnings report we sold Energizer Holdings (ENR) since the battery business is shrinking by a startling 7% per annum and they’re likely to have to cut pricing to stay competitive which will hurt their margins. And we maintain an investment in the Gold Miners ETF (GDX) since reflation is where central banks are going and Europe is demonstrating the futility of too much fiscal discipline too soon.

Timing is invariably difficult, but it’s possible to see a negotiated solution that can turn out fine even if it once again delays the day of reckoning.