2009 2nd Quarter Report

(Download printable .pdf version here.)

The second quarter is now behind us as markets celebrated a vision that the world no longer was looking down a gun barrel of depression. Once the overriding concerns about survival were pushed aside, investors scrambled to participate in the rally driving the S & P 500 ahead by 15.9% and the broader Russell 3000 by 16.8%. Treasury yields were driven up along all parts of the curve resulting in a drop in bond values for government bonds. Even the 1-3 year bond index produced a negative return of -0.7% as compared to the 10-20 year index that declined 6.3%. Corporate spreads tapered in higher quality issues and collapsed in below investment grade bonds. The slightest whiff of stabilization and the briefest flash of a “green shoot” triggered the enthusiasm for equities and the cold shoulder for bonds.

We share the prevailing view that government bonds are unattractive at this point, in fact, we would argue that ten year bonds under 3% (actually at 2.68%) at the beginning of the quarter represent "reward-less risk." However, we would also note that if the market’s aversion to bonds relates to inflation fears or runaway growth, it is way too early to sanction that premise.

We also wish to make our belief clear that corporate bonds and especially preferred stocks offer much more attractive risk/reward profiles. Preferred shares have guaranteed priority over common shares when it comes to dividend payments and a higher claim on the assets of a company in the event of bankruptcy (though not as high as the claim held by bondholders). Since the great bulk of preferred share issuance comes from the banking industry, especially under what is called a “trust preferred” structure, in many ways holdings of preferred shares represent a participation in the health of the banking industry. No wonder that the last two years have provided so much volatility in this instrument!

As we go through the last stages of this recession, as I believe we are, the banking industry will continue to face loan losses and recognition of non-performing assets, more so from the commercial real estate side than the residential portfolio side. It’s still early in the recovery period for the large banks' capital markets businesses, and obviously the recovery is still fragile and subject to disruption based on macroeconomic surprises. But there has been considerable evidence of a turn, visible in credit spreads, equity market indices, declining volatility, and improved underwriting and trading volumes. We are encouraged by the significant and successful capital raises that the industry has achieved during the second quarter, thus stabilizing their balance sheets with more of an equity "cushion" and in many cases, paying down TARP loans.

The terrifying experience that banks have gone through in the last two years has taught them some very important lessons:

1. The Importance of Diversification- Overconcentration will kill you. Banks are being very vigilant to avoid too much exposure to one area whether it is alt-A mortgages, CDO’s, or credit derivatives, etc.
2. Avoiding Business that Doesn’t Pay an Adequate Return- Many mortgage assets that seemed to be low risk yet ultimately proved destructive were fairly low return instruments from the onset. As has always been the case, the industry will rescue itself through fee increases to consumers primarily and wider spreads on interest charged versus paid.
3. Having the Strength of your own Convictions- Not playing “follow the leader” and involving bank assets in businesses that are only barely understood.
4. Risk Management Technology- Systems depending on historical norms do not provide real-time solutions.

Chastened by this trial by fire, banks are a repentant lot. Regulatory changes will force more prudent use of capital. Like the boy caught with his hand in the cookie jar, better behavior is cultivated, at least for a while! As to the threat of new regulation, let me reiterate a quote from the last quarterly:

"A brilliant player wants a referee, for only when the game has appropriate rules can he really show his talents."

The absence of rules or referees resulted in a widespread outbreak of rough play if not idiocy. The survivors in this industry will ultimately thrive in what is becoming a decidedly more concentrated industry in a post-Lehman world and one where leverage will be much more judiciously employed.

As we had also pointed out in earlier commentary, securitization and asset-backed markets remain largely frozen. The good news here is that the US Treasury is planning a sweeping overhaul of these markets with tough new rules designed to restore confidence by reducing the incentive for lenders to originate bad loans and foist them off to investors. The new plan forces lenders to retain part of the credit risk to the loans that are being bundled into securities and to end the gain-on-sale accounting rules that spurred many lenders (notably mortgage lenders such as Countrywide) to create synthetic profits that led to a general erosion of lending standards and deepened the housing bust. Securitized markets financed more than half of all credit in the US in the years immediately preceding the housing crisis. Newfound prudence will reap long term rewards in our opinion.

Given these underpinnings, we have been careful in our preferred stock selections for balanced accounts with considerable attention being paid to not only financial strength but also the underlying legal covenants which can vary widely from issue to issue. In terms of our common stock selections in this industry, we appreciate the loan underwriting discipline of US Bancorp as well as its significant exposure to fee income. Similarly, we believe that the Bank of New York Mellon, with almost $21 Trillion in assets under custody is a formidable global financial services company operating in 34 countries and serving more than 100 markets.

In the letter we circulated in mid March, "we essentially drew a line in the sand...sentiment had become utterly despondent, and valuations had become fire-sales. Extreme volatility in markets also creates extreme opportunities." Given the high level of enthusiasm that investors have expressed in the most recent quarter, do stocks continue to reflect opportunity?

General structural concerns abound in the US and world economy. Though we are nearing the end to the longest and deepest recession since the Second World War, the sheer depth of this recession means most people won’t feel the recovery for some time. The collapse in household wealth, for most people, expressed largely in real estate value, and the weak state of the labor market will weigh on growth for some years. Internationally, the Europeans are relying on the US to generate growth; the Americans are relying on the Chinese, who in turn are waiting for the rest of the world. China may be one of the fastest growing economies in the world, but it is only about half as large as the Eurozone in dollar terms. With the tailwind of bank lending that has accelerated Chinese investment by 30% year-over-year, imports there are down by 25% Both Chinese exports and imports are falling but unfortunately imports are falling faster. It is painfully obvious that North American consumers have no overwhelming desire to resume their free-spending ways, even if they have the credit card capacity to do so. This includes vast numbers of once thoroughly "dependable" people in their comfortable middle years whose remarkable shopping habits formed the foundation of Western prosperity and Third World growth prospects.

In a survey by McKinsey, 90% of Americans said their households were spending lessmore than half of them by choice- rather than need. A majority indicated that they would stick to their cheaper ways when the economy recovered. The newly frugal consumer is performing a task unfamiliar in two decades - saving disposable income.

There is an incredible yin/yang feel to this economy. At one extreme stands Fed/Treasury/Government sponsored reflationary efforts. Unprecedented is the only characterization we believe applies. At the other extreme lies US households. Never in a half century have households actually paid down debt at a rate that is now occurring. Couple this with increased savings; the worst decade for payroll employment gains since the Depression; year over year retail sales at a record low in the history of the data; and continued pressure on wages, and we have the prescription for households now being a meaningful source of deflationary pressure in the US economy. The tension created by these two extremes bearing down on the economy naturally has investors guessing at the ultimate longer term thematic outcome.

Recent equity market enthusiasm has focused on the “beat the numbers” game. Wall Street analysts had set the bar very low as the recessionary backdrop had drained them and corporate managements of any enthusiasm. Though this earnings season has provided largely positive earnings surprises, a conspicuous concordant element that has been broadly disregarded is the weak character of top line revenues. In our view, it seems that the key drivers of short-term investor behavior are momentum and fear (of not being fully invested), not necessarily fundamentally based concerns.

Here is a case in point, Intel, a fine company that surprised the street with much better than expected earnings. However, focus on the blue bar in the following chart:

Quarterly revenues have meandered for the last five years, the five year growth rate at just over 4%. Despite a commanding market share that Intel enjoys, quarterly revenues have been in a range of $8-$11 Billion for years…pricing power appears to be virtually nonexistent. Careful examination of the elements that led to the positive earnings surprise also causes me to scratch my head… Intel’s year over year R&D fell $165 million. Its S, G&A expenses fell $180 million and capital spending dropped $170 million compared to 2Q 2008. Is the road to a successful long-term franchise especially in technology built on contracting R&D, marketing and G&A, and shrinking cap-ex? Because this is exactly what investors paid up for and apparently saw as a major positive. Adding to the Intel "story", the company has also announced Intel their intent to issue $1.5B in new debt and use the proceeds to buy back their stock. Not to increase hiring, not to increase R&D, not to increase cap-ex or upgrade plant and equipment in any way. It intends to issue the debt to engage in financial engineering, returning capital rather than employing capital. Is this a sign of operating strength or weakness? Does this strengthen its franchise?

The problem of revenue growth and pricing is fairly ubiquitous. Here is a look at data from the National Federation of Independent Business, the largest small business advocacy group in the country (chart courtesy of Contrary Investor.) As you can see, the outlook for pricing power for most of these businessmen is as bad as it has been in a decade.

Absent pricing power, sales growth and the quality of top line revenues, in very large part, the headline corporate earnings gains we are seeing as of late are being driven by cost cutting and lack of meaningful corporate capital expenditures.

Further reinforcing our view that inflationary concerns may be over-played is a look at capacity utilization (chart courtesy of Contrary Investor)

Historically, inflation has been triggered when capacity utilization breaks above 82%. With capacity utilization at multi-decade lows, we dismiss most arguments supporting reflation.

The need for corporate earnings growth, cost cutting and productivity enhancement has been with us in every economic cycle on record. But the current cycle is being accompanied by a generational credit bust. This has not been present in any cycle really since the 1930’s. So we are currently dealing with a different animal. This reinforces our fundamental skepticism regarding investors rewarding corporation valuations for cost cutting on a short-term basis. In the absence of credit cycle expansion, we believe current corporate cost cutting is simply planting the seeds of tomorrow’s corporate top line pressure.

We have added some new securities to the portfolio. Carbo Ceramics is in an attractive niche of the energy services industry, an industry that is suffering from a significant decline in the demand for rigs as energy prices have fallen. Carbo’s particular niche is production of a ceramic material (proppant) that increases the production of oil and gas, particularly from shale based reserves. The company’s economics are outperforming that of the industry. In the most recent quarter, the sales volume in the U.S. decreased 17% year-over-year, but grew 1% sequentially in spite of drilling rig count decreases of 50% year-on-year and 30% sequentially. We believe that the company, with its 53% market share and logistic advantages should demonstrate pricing power as shale based projects in the States and internationally develop.

E-Bay, as well provided us with an attractive entry point. EBay, the online-commerce specialist, has promised a turnaround in its core on-line auction business for some years. Investors have focused on the problems of turning around this business and the impact of Amazon’s competitive efforts and have largely ignored E-Bay’s other operating subsidiaries, namely PayPal and Skype. Given its excellent balance sheet and long history of stable and growing free cash flow, we were able to acquire E-Bay at a very attractive valuation with a high free-cash flow yield.

We will continue to maintain our valuation discipline in a market that seems, at least in many cases to be ignoring fundamentals. In many ways, the market’s recovery from its March lows has followed a historical institutional investing playbook. Big-money investors frequently gravitate toward high-beta, volatile and low-priced stocks to capture a turn in the market’s fate, so the market’s leadership in high tech, basic materials, and consumer discretionary names is not surprising. We recognize the knee-jerk out of the starting blocks institutional playbook leadership of these definitively high beta sectors, but the key here is not to get caught up in linear thinking over time. There is no guarantee that what has occurred so far will continue ahead. Moreover, the question looms large as to whether investors are truly discounting the reality of fundamental outcomes that lie ahead, or are simply and blindly following the historical playbook script. We continue to believe in a global economic recovery and continue to find interesting securities in our worldwide pursuit. The key, as always, is not to get carried away with the valuations that the market may demand, or the feel-good momentum that buoys enthusiasm, but rather to buy stocks at a rational price. We are definitely not bearish, but vigilant and treading carefully in a market that seems somewhat unguarded and rash.

We appreciate your confidence and trust and invite your questions and comments.

Richard H Konrad