Big Blue: singing the blues?

IBM has seen better days. Lately, it’s been the poster-child for old technology: not growing, seemingly threatened by technological obsolescence, and failing in the cloud and mobile. (full disclosure: my clients and I own shares of IBM)

I think this view misses a few things. IBM has very deep relationships with its customers, who tend to be large organizations that need or want IBM’s help with information technology. IBM also dominates mainframes, and has a very strong position in middleware. IBM is a very high return on investment business, with lots of opportunities to reinvest for future high returns.

I believe IBM’s key strength is its relationship with customers. IBM is deeply embedded with large organizations who use its hardware, software and services. These customers prefer to “not get fired” because they buy from IBM, but they also have legacy systems that are very difficult to replace. IBM is there to hold their hand when it comes to information technology, and that is why many, if not most of them, will continue working with IBM. They trust IBM to help them with their information technology decisions and implementations.

Part of the reason IBM is so embedded is that many large organizations still use IBM’s mainframes: 92 of the top 100 banks, 10 of the 10 largest insurers, 6 of the 10 largest retailers, 23 of the 25 largest airlines. Most of these organizations started using mainframes decades ago, and have legacy code that would be very expensive and difficult to move off IBM’s mainframes. Feature-wise, mainframes are very reliable (reboot time in years, not weeks), high security, and extremely fast (especially for the type of processing such organizations do). IBM is dominant in mainframes (~90% market share) and that’s unlikely to change soon.

IBM has the highest market share in middleware at present, too. This is the software that links software components or enterprise applications with each other. IBM’s middleware allows other programs to work together, and that connection is extremely important to IBM’s customers. Gartner’s most recent report showed IBM with 29% market share, far ahead of Oracle’s 14%. This position is likely sustainable because of how integral middleware is to large organizations. Software is 28% of IBM’s revenue, but 48% of their pre-tax profits. Software really matters for IBM and its customers.

IBM generates very high returns on its investments. It doesn’t take a lot of capital to provide IBM’s hardware design, services or software. By my calculations, IBM generates 35% returns on net assets, 42% returns on capital, and 84% on net tangible assets. Although these numbers have been trending down recently, the decline is not precipitous and they demonstrate the high return nature of IBM’s business. I believe these opportunities will continue into the future because the nature of IBM’s business and its underlying stability hasn’t fundamentally changed (many disagree with me on this–seeing tech obsolescence as IBM’s key problem; I have more to say on this below).

And, that’s an important key to understanding IBM: the nature of its business. IBM is first and foremost an enterprise information technology company. It is not trying to dominate all markets, just the markets where IBM has value to add and the returns are high. Much of IBM’s business is service-oriented. That work is usually based on long term contracts that allow for predictable allocation of assets and returns on investment.

Importantly, IBM seems to have institutionalized high productivity innovation and financial discipline. IBM has led the world in patents for 20 years, which just shows how important innovation is at IBM. Not all of those patents are productive or successful returns-wise, but it does show how even a large organization can put innovation at the center of its culture. This culture does not make it omnipotent, but it does lead to high value products and services–in other words, many high return, future investments.

When IBM does miss a technological change it views as important to enterprise information technology, it doesn’t tend to suffer from not-invented-here. Instead, it acquires the technology it lacks, and does it with financial discipline. By this, I mean IBM doesn’t pay a price it can’t get a good return on. It prefers to buy smaller companies that haven’t expanded internationally, such that IBM can recoup its investment by putting its global sales force to work selling the technology just acquired.

IBM’s financial discipline is on display with its returns on capital and acquisitions, but also with its capital allocation between reinvesting in the business, paying dividends, issuing/repaying debt, and buying back stock. IBM has been justly criticized for buying back stock up to 43% above its current price level, but I think this misses IBM’s attitude toward reinvesting in the business that focuses on investment returns (I judge the organization on their process and discipline as well as their successful implementation–no one gets it right 100% of the time). That focus and discipline is rare, especially for a technology company.

The cloud is where IBM has felt the most criticism, recently. The story is that IBM missed the transition to the cloud, and that it can’t catch up to new businesses native to the cloud, or further ahead in cloud implementation. But, I think this misses the nature of IBM’s business and its customers. I don’t think a top 10 bank will jump to a cloud database solution any time soon. They want IBM’s legacy mainframe system paired with the cloud in a hybrid configuration (as much to maintain security and regulatory requirements as to prevent having to recode their systems of record). Many or most of IBM’s current customers are in similar situations with similar concerns. IBM is very likely to be a trusted partner showing them the way.

IBM’s numbers have looked weak or even terrible over the last couple of years. Part of the reason is due to currency: much of IBM’s top line comes from outside the U.S. (66%) and the U.S. dollar has appreciated over 20% over the last year. IBM has also been aggressively selling off lower return on capital businesses: retail store solutions in 2012, customer care, showcase reporting, ACG and Cognos ADT in 2013, and microelectronics, industry standard servers, solidDB, Cognos Finance, IMS Tools Suite, Sterling Transportation Management Systems, ILOG JViews, Ilixir Visualization, Focal Point and Purify Plus in 2014. These divestitures have hurt both the top and bottom line, but have also raised profit margins. Adjusted for these divestitures and currency moves, IBM’s numbers look much better, though not wonderful, either.

And, I think this is the heart of the investment argument for IBM. There is little doubt that revenues haven’t been growing, but is that already factored into the price? It seems to me that it is.

IBM’s last 4 quarter sales per share were around $87. The adjusted net margin (adjusted for discontinued operations and a few other small items) over the last 12 months were around 17.5%.

My base case assumptions are 0% sales growth, 1.5% net margin growth, and 2.5% share buybacks. Hanging a 12.5x multiple on that (4% earnings per share growth) I come up with a price of around $190.

My below base case scenario sees -2% sales growth, 1% margin growth and 2% share buybacks (the low end of management’s expected range). Hanging a 9x multiple on that (1% earnings per share growth) looks like a $137 price.

My above base case scenario envisions 2% sales growth (the low single digit number management claims they can achieve), 2% margin growth (going from 17.5% net margin to 18.5% over the next 3 years based on moves to higher margin hardware/software and services) and 3% buybacks (the top end of management’s expected range). Hanging a 16x multiple (7% earnings per share growth) gives a $244 price.

If I give a 25% chance to the poor outcome, a 50% chance to the base case, and a 25% chance to the better outcome, that looks like a mid-teen return (I assume dividends grow at the same rate as earnings per share). That looks pretty interesting considering that the S&P 500 looks like a mid-single digit return from here. IBM’s price seems to factor in the key issues a bit too harshly.

Looking at Wall Street’s estimates, other analysts seem to be in the same ballpark with my assessment for earnings, which seems to indicate that the multiple and growth are where our opinions differ. I think a 10x multiple is too low for a business like IBM, but Wall Street seems to think it will stay there. If IBM executes as I believe it will, mostly because of its relationships with customers and embedded products and services, I think other investors will end up agreeing with me and rewarding IBM with a higher multiple.

As for growth, I don’t think IBM needs top line growth to grow value per share. Growing margins and executing buybacks at smarter prices–two things IBM has done well in the past (although not every time)– should lead to low to mid-single digit growth in earnings per share. That, too, would indicate a higher multiple.

I have deliberately stayed away from describing IBM’s upside. Watson could prove a solid money maker and revolutionize computing. So could IBM’s specialization in analytics, growth in hybrid cloud, or efforts in security and engagement. I don’t think IBM needs these things to go right to win, but if it does, it provides more upside.

What could go wrong for IBM? Technological obsolescence: the cloud could evolve to provide the same level of speed, reliability and security as mainframes but at lower cost or with greater convenience. Or, IBM’s relationships with customers could be sundered by competitors or substitutes able to best IBM’s services. I don’t think either threat is imminent or very likely, but either could make inroads over time that could build into bigger competitive difficulties for IBM. I am watching IBM’s numbers closely to see if this has or is happening.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Big Blue: singing the blues?

No Joy for Joy Global

Because the coal market is tanking, it’s an interesting place to look for investments.

I must admit, I’m not very interested in the coal producers themselves because I see no sustainable competitive advantages. The businesses that serve the coal market, however, do interest me, because I can find companies that possess such advantages. I believe Joy Global (JOY) might be one of them (neither my clients nor I own any shares of Joy Global at present, although this could change at any time).

Joy Global makes some of the huge equipment used for mining. This includes both surface and underground mining equipment, like conveyors, breakers, long wall shearers, roof supports, drills, shovels, draglines, loaders, etc. Joy’s website gives all the fascinating details.

Joy’s equipment is highly specialized, and that means it is highly integrated into mining production companies. Joy’s equipment is also highly productive, which means that mining businesses focused on costs and long run efficiency can benefit from owning Joy’s products.

Most importantly, Joy’s mining equipment is difficult to optimally operate and maintain over the long run without support from Joy, which means that one of Joy’s most important businesses is parts and service. To keep this type of equipment is good working condition, it is beneficial to engage the services of Joy Global.

Joy gets almost 55% of its business from coal miners. That is because Joy has specialized in the type of equipment used for mining coal, both underground and surface. Everyone knows that the coal industry is severely depressed right now with low coal prices due to too much supply and low demand. Coal suffers, too, from competition from alternatives like natural gas at very low prices, as well as oil, nuclear, wind and solar. Significantly, coal is also facing severe political pressure because it is considered such a dirty energy source. Many of the governments of the world, particularly in the U.S. and Europe, are working hard to eliminate coal as a source of energy.

What may not be as well understood is how fundamental coal is both as an energy source (thermal coal) and as an input to making steel (met-coal). Even if everyone agreed that coal is a terrible energy source, it would take decades to completely switch from coal to other energy sources (even here in the U.S.). Coal is also a major energy source in places like China, India and Indonesia (the 1st, 2nd and 4th most populous countries). In China, switching from coal will take a very long time, even assuming the Chinese government agrees to curtail its use. India and Indonesia, in contrast, are trying to figure out how to produce more coal to meet their growing energy needs. Coal may be hated, but it’s not going away any time soon, and perhaps not ever.

In addition to coal, Joy does business with mining companies focused mostly on iron ore and copper, but also gold, oil sands, and potash/salt. None of these businesses are doing that well now, either, because of too much supply and not enough demand. In other words, it is not just the coal market that has Joy down.

Although down, I don’t think Joy is out. Even in it’s depressed state, it is still generating over $3 billion a year in revenue, 75% of which is the more consistent service business I referred to above. And, Joy is still quite profitable. Profit margins are down from a high of over 14% (trailing twelve months) in 2011 to 8% now, but that is still quite respectable. Over the last 4 quarters, Joy still earned $2.69 per share. Not bad.

As investors know, it is the future, not the past that determines a security’s price. For Joy, the short to intermediate term looks pretty unclear. I think it is prudent to assume that the commodities boom of the last 15 years is over. That means looking at Joy’s past 15 years of financials doesn’t necessarily help a lot in figuring out the nearer term future.

I do believe that Joy’s service business is a good place to start in assessing value, though. Joy’s service business has generated an average of $565 million in revenue a quarter over the last three quarters. As a base, that is a bit over $2.2 billion a year in revenue. Unfortunately for Joy, that service business has been declining, too, as miners have been putting off maintenance and overhauls to try to make ends meet.

Assuming Joy’s service business continues to decline, I still think that Joy will remain profitable and able to pay interest payments and dividends. I think Joy’s service business, even without any original equipment sales, could see a further decline of around 25% and still be able to pay interest and dividends. The service business could decline 25% from here, or more, but maintaining a level that low seems unlikely. I believe creditors and bankruptcy judges will agree that maintaining equipment in good working order at the mining companies is in everyone’s long term interests.

As a base case, I’m assuming Joy can do $500 million in revenue a quarter just from service (down 11.5% from the last 3 quarters). Using a 6.5% net margin (lower due to continued fixed costs) on that gives you around $1.28 in earnings per share.  Hang an 8x multiple (which assumes 0% growth), and you get a $10.24 price. I think that is a pretty negative scenario: assuming service declines 11.5%, and no original equipment sales.

Could things be worse? Of course. Assuming services declines 25% and gets only a 5% net margin (even bigger hit from fixed costs), you end up with $0.74 in e.p.s., which would be below Joy’s dividend rate of $0.80 per year. Hang my no-growth multiple of 8x on that and you get a $5.90 price. I think that is an extremely negative scenario, but one that must be considered.

Assuming the coal market eventually stabilizes and Joy gets back to its current level and mix of services and original equipment (75%/25%), then you get back up to $3 billion of sales, an 8% net margin, so $2.37 in e.p.s., and an 11.5x multiple (3% growth), and Joy would be back up to $25 to $30 in price. That would be a nice return from here.

If I assume a 25% chance of my worse case price, $5.90, 50% chance of my base case, $10.24, and 25% chance of my stabilization case, $27.28, I come up with an assessed value of $13.42. With that, you can see why I haven’t bought, yet, but I am getting close to doing so.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

No Joy for Joy Global

The stock market wakes up to global risk

Surprisingly–to me, at least–the market has finally woken up to global economic risks.

The signs were there before: commodity prices tanking, emerging markets in heavy decline, state interventions in Greece and China, accusations of broad corruption in places like Brazil.

The question investors will be asking themselves over the weekend is: is this the beginning of a bear market or just a brief pullback to be bought into?

I’ll spoil the suspense: no one knows. Only in hindsight is it clear when bear markets begin versus temporary pullbacks.

What I do know is that a significant pullback or a bigger bear market are both opportunities for investors. During such times, psychology takes over as some people panic, and that means something is being sold too cheaply.

To benefit from such situations, the goal is not to pick the absolute bottom in the stock market or a particular stock, but to know what specific securities are worth–after arduous research–and then to buy accordingly.

When people ask me if such pullbacks scare me, I always say “No!”  Such times are great opportunities to benefit from the panic of others.

In other words, I’m excited to go shopping.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The stock market wakes up to global risk

You choose: short term "reward" and long term risk, or short term "risk" and long term reward


Whether they want to or not, investors face a basic choice: some options will allow you to achieve your goals, and others won’t. To reach your financial destination, you can either:

  • get lower returns and save more money over time (thus having less to spend )
  • get higher returns and save less money over time (thus having more to spend)

There’s no option to save less and get low returns–that won’t work.

The difficulty investors face is that they want to take little or no “risk”–avoiding anything unpopular or seemingly scary. But, what if the avoidance of supposed risk prevents you from reaching your goals?

A beautiful drive in the country can be pleasant, but if it doesn’t your destination, then it’s the wrong route. You can make valid choices among routes that will get you where you want to go, but you can’t successfully ignore whether the route will get you there.

With investing, you need to clearly understand your options, you must flesh-out the pro’s and con’s of each, and then you must choose your path.

Right now, investors face a fundamental choice between risk and reward. On the one hand, you can choose options that will likely do well in the short run and terribly in the long run. On the other hand, you can choose options that will will likely look unrewarding in the short run, but ultimately be much more rewarding in the long run. The choice is between: 

  • cash (including checking, savings, CDs, etc.)
  • bonds
  • commodities
  • stocks
  • real estate

Cash and bonds will likely do well in the short run and be an unmitigated disaster over the long run. Cash and bonds have done well over the last 30 years as inflation and interest rates have gone from mid-double-digits in the early 1980’s to low-single-digits now. This process simply cannot repeat (going from 2% inflation to -11% inflation?). This means cash and bonds may look good in the short term, but will almost certainly provide terrible returns over the long run. To choose cash and bonds, you must either be able to perfectly time the point when inflation and interest rates change direction, or you will not reach your financial goals.

Commodities are likely to do well in the short to intermediate term, but then drop like a rock at some indeterminate point in the future. Commodities have done very well over the last 12 years and are likely to continue to do so over the next 5 to 10 years. In the not-too-distant future, though, they will fall off a cliff and provide investors with very poor long term returns. Any observation of long term (inflation adjusted) commodity prices will make this abundantly clear. Like with bonds, commodities will go from great to terrible very quickly, and unless you can time that switch perfectly, you will not reach your financial goals.

Another option is stocks. Stocks have done poorly over the last 12 years, and are likely to provide unexciting returns over the next 5 to 10 years. The outlook beyond that, though, is bright indeed, with 10%+ average returns. The problem is that very few investors are willing to look beyond the short term–or their wished-for ability to time the market–to reap the much better long term results from stocks.  

The last option is real estate. Real estate has had a dreadful 6 years, and is obviously an unpopular place to invest right now. The returns from real estate are likely to be much better than cash, bonds and commodities over the long term, but the short term looks unenticing. Real estate is another choice with little short term upside, but good long term reward.  

To me, the choices seem clear. Cash, bonds and commodities provide short term “reward” with significant long term risk, and stocks and real estate provide short term “risk” with real long term reward. If you want to reach your goals, and don’t suffer from the delusion you can time the market, then stocks and real estate are clearly the best options.

If your financial plan permits lower returns, real estate is likely to be a less bumpy ride. If you require or desire higher returns–and the vast majority of people do–then stocks are the best option.  Choose wisely.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

You choose: short term "reward" and long term risk, or short term "risk" and long term reward

Mixed up markets

When most people think of “the market,” they think of the stock market.  But, there are other markets that are equally or more important to pay attention to.

For example, bond and currency markets are bigger than stock markets.  Commodity markets are important, too, but most people ignore them.

Why are other markets important, you may ask?  Because they frequently bring warnings of contradictory premises held by different participants in each specific market.

In a normal state of affairs, currencies and gold should move in opposite directions.  That’s what’s happening right now, especially with gold flying high and the U.S. dollar crashing.  All good there.

Normally, commodities move opposite the dollar.  Commodities have been soaring and the U.S. dollar is tanking, so everything looks as it should there, too.

Next, we come to bonds.  Bonds and commodities normally move opposite each other, and here we run into our first contradiction.  Commodities are soaring and bonds are climbing, too.  The first indicates inflation and fast economic growth and the second indicates deflation and slow or declining economic growth.  Both markets can’t be right.

Furthermore, commodities and stocks usually move opposite each other, which is just another way of saying bonds and stocks tend to move together.  Climbing commodities indicates inflation and high interest rates (lower bond prices) which both tend to be bad for stocks.

Don’t get me wrong, I’m not saying these relationships exist at all times and all places.  But, when I see markets seeming to indicate different opinions, I take notice.  It means markets are mixed up and one will turn out to be right and the other wrong.

Things are pretty mixed up right now.  The dollar is sinking, commodities are climbing, as are stocks and bonds. 

The dollar is sinking because the Fed is going to print money to try to further revive our flagging U.S. economy.  That means a lower U.S. dollar, higher inflation, and rising commodities and gold.  So far, so good.

But, a lower dollar, higher inflation and rising commodities is inconsistent with high bond and stock prices.  High inflation is bad for bonds and stocks.  That contradiction must be resolved.

To further muddy the waters, rising bond prices usually correspond with higher stock prices, but not super high bond prices.  Super high bond prices means very low bond yields, which tends to indicate low growth, deflation and economic stagnation.  And, that’s usually NOT a recipe for higher stock prices.  As illustration, Japan’s bond prices have gone up for 20 years while its stock market has lost 75% of its value. 

Bonds are indicating slow or negative growth and stocks are rallying, and that doesn’t make sense.  Bond markets are right more often that stock markets, so the on-going stock rally might be in danger. 

High gold and commodity prices and a falling U.S. dollar should mean lower bond prices and high bond yields (a.k.a. inflation).  Once again, this contradiction must be resolved.

Over time, all markets will sync back up again.  Either bonds and stocks will tank and the dollar will continue to fall; or, commodities and gold will tank, the dollar will rally, and stocks and bonds will continue to rise.  It may take time, but markets will re-achieve consistentency.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Mixed up markets

Bonds and cash just aren’t that safe

Bonds are seen as safe. So is cash. But, that’s not necessarily true.

For starters, bonds and cash are susceptible to higher tax rates than stocks. Whether anyone likes it or not, interest on bonds and cash are taxed at much higher rates than dividends and capital gains on stocks. That differential may change with new tax laws, but even then, stocks are likely to be taxed at lower rates.

Most significantly, bonds and cash are more prone to suffer from the impacts of inflation. That may not seem as dangerous as a 50% stock market plunge, but 4.14% inflation over 10 years will do the same thing (and is much more likely to be a permanent 50% loss versus a temporary one for stocks). Does anyone really want to bet that inflation won’t be above 4% over the next 10 years considering huge government debt and budget deficits?

Finally, bonds and cash can be defaulted on. This is probably the risk most people dismiss as too unlikely, but a low likelihood is not the same as no likelihood. Bonds are more likely to default than cash, and stocks are more likely to go to zero than bonds, but bonds are not without default risk. If you hold government bonds and think they can’t default, a re-reading of the history of Germany, Argentina, Russia and the Confederate States of America is in order. Think cash is default free? Check again. History has many examples including Weimar Germany, France after the South Seas Bubble, or any other example of cash not backed by specie (not yet and never aren’t the same thing).

Bonds and cash can be safer than stocks, but not always. Bonds are a promise to pay, but that promise can be broken. Cash is a note (debt) issued by the Federal Reserve as legal tender, and that promise too can be broken. Bonds and cash are much more impacted by inflation and have higher tax rates than stocks. They are not without risk.

I was reminded of this recently when I read that individual investors were generally selling stocks to buy bonds over the last year. They are rushing for a safe haven to avoid the pain of another downdraft. In the meantime, they have missed the market rally and are hoping to time the market. The history of individual investors, especially as a herd, being right on something like this is extremely poor.

The very fact that so many retail investors are racing to bonds together as a herd is enough to remind me of how badly bonds and cash can do. The next couple of years are likely to remind investors that not even bonds or cash are completely safe.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The peril of bonds

Long term bonds have beaten stocks for decades.

As reported by Rob Arnott (chairman of Research Affiliates), 20 year bonds have provided better returns than the S&P 500 starting any time from the 1979 through 2008.

That’s a startling fact to many investors who’ve been told, ad nauseam, that stocks always do better than bonds over the long run.

This out-performance by bonds has not gone unnoticed by investors, who are selling stock mutual funds and buying bond funds.

Is it time to abandon stocks and buy bonds?


You shouldn’t drive your car by looking in the rear view mirror, and you shouldn’t invest your money that way, either. The past can be a wonderful guide to the future, if and only if situations are sufficiently similar.

But, the situation over the next 30 years is highly unlikely to be the same as it was over the last 30 years.

For starters, inflation was in double digits 30 years ago. When inflation is high, bonds sell at super-cheap prices. When high inflation is tackled, as it was by Paul Volcker in the 1980’s, and continues to decline for another 20 years, as it did, then bonds have remarkable performance.

That is not the situation today. In fact, reported inflation is at an all time low, showing its first annual decline since the mid 1950’s. Bond yields reflect this low inflation with record low yields.

Bonds will not perform as they did over the last 30 years because inflation isn’t starting high and going to record lows. Count on it.

In addition, the threat of growing inflation is as high now as it was the last time bond rates were this low, in the 1960’s.

At that point in time, government spending was going through the roof to fund new social programs like Medicare and to fight an on-going war in Vietnam. If that sounds familiar to you, it should.

The U.S. government is running record high deficits as a percentage of the economy in an attempt to jump start an economic recovery, fight on-going wars in Iraq and Afghanistan, fund social programs like universal health care, and reduce carbon emissions to prevent global warming. If you think that won’t sooner or later lead to high inflation, I’ve got a few bridges I’d like to sell you.

Just because long bonds have done well in the past doesn’t mean they will do well in the future. If deflation continues for some time, as many smart people think it will, long bonds will do well. But, I believe that situation will only be temporary.

When inflation kicks up, as I think it will, long bonds will be gutted.

Stocks may not do well in the short run, but they offer excellent long term protection against inflation. Stocks are also selling at historically low prices relative to bonds. Bonds are now priced for perfection (low or declining inflation) whereas stocks are priced for a sustained recession.

Stocks may under-perform bonds over the short run, but over the long run, I don’t think its even a contest–stocks will almost certainly out-perform over the long run.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Continued ripple effects

It’s been interesting to watch how the fallout in credit markets has rippled across other markets.

The initial indication of credit market stress showed up as subprime problems during late winter and early spring of this year. At the time, many market commentators were saying it was isolated and contained.

Then, as expected, credit tightening continued to ripple across other markets as it became more difficult to raise high yield debt. This, too, was described as a short term and isolated situation.

Now, it sounds like prime home equity loans are having trouble as are auto loans. The ripples keep showing up in more and more places. And, the market commentators continue to declare that it’s contained and short term.

Is this unusual? Not at all. This is exactly the type of thing that happens every time credit markets get too loose. As the credit market gets further and further away from its most recent problems, lower quality borrowers are loaned more and more money, or money is lent to borrowers at a rates not high enough to compensate for the risk involved.

At some point in time (forecasting if it will happen is easy, forecasting when is extraordinarily difficult), credit markets tighten again as lenders realize they have made bad loans.

This usually takes several years to unfold and almost always includes a large and “unexpected” crisis such as Long Term Capital Management in 1998, the Saving and Loan Crisis in the late 80’s and early 90’s, or the corporate credit squeeze in 2002.

I expect greater difficulties for banks (especially mortgage banks) that made bad loans, bond insurers that insured AAA tranches that were much more risky than they assumed, and mortgage insurers who looked only at recent data when pricing their insurance premiums.

At a later point in time, the market will become so disgusted that great buying opportunities will occur. I don’t think that time is here, yet, but I also assume that smart investors will start buying long before the bottom is reached. I just may be in that group, too.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Mutual fund over-diversification (the artist formerly known as di-worse-ification)

One of John Mauldin’s recent Outside the Box articles by James Montier (of Dresdner Kleinwort) highlights the fact that the average mutual fund holds around 160 stocks.

Now, this may not sound ludicrous to you, but let me walk you through why I think this is nuts.

First off, 160 is average. That means that some managers hold many more and some hold many less than 160, but let’s just work with 160 to illustrate my point.

There are around 250 workdays in a year (52 weeks minus 2 weeks for vacation gives 50 weeks, multiply that times 5 workdays per week).

Most companies report their earnings once a quarter and provide a conference call with that.

That means a mutual fund manager must monitor around 5 companies every 2 workdays (160/(250/4)x2).

Given an 12 hour work day and a 5 day workweek, that means each mutual fund manager can devote 4.8 hours per company each quarter.

Most conference calls last 1.5 hours, so that leaves only 3.3 hours to understand, model, value and evaluate each company.

Let me add that this doesn’t include time to visit companies, watch additional presentations that almost every company gives, look for new investment ideas, interact with clients, vote proxies, do administrative tasks, talk around the water cooler, etc. You get the idea.

Granted, such managers may have a herd of analysts chasing down details. But, the mutual fund manager is the one who has to make decisions, and how well can he understand a company and make decisions if he has so little time to follow and evaluate each company?

I know that when I look at a new investment, it usually takes me 3 hours just to read one 10k (annual report filed with the SEC). But then, I still need to read old 10k’s (at 3 hours a pop), plus 10q’s (quarterly reports filed with the SEC, 0.5 hour each), listen to conference calls and presentations (1.5 hours each), read current and old reports to shareholders (1.5 hours total), look up articles about the company (2 to 4 hours), read competitor’s reports (another 10 hours), etc.

In other words, just to look at a new investment idea, I have to spend around 20 to 30 hours just getting to understand the business. And then, I need to think about the business analytically, evaluate management, analyze competitive advantage, drill down into the business’s economics and business model, model the business into the future, analyze financial statements over time, etc. It takes a lot of time to thoroughly research a new investment idea.

To keep up with current investments, it usually takes about an hour to read the press release and think about and analyze the financial statements, 1.5 hours to listen to the conference call, 1.5 hours to update my model of the company, 1.5 hours to analyze the latest 10q or 10k, etc. It takes me about 6 hours per company just to stay up.

And then I still need to vote proxies and listen to annual meetings and analyst presentations!

It takes all my research time to keep up with 40 companies, have time to screen through a bunch of new ideas, and thoroughly research 10 to 20 new ideas a year.

So how can a mutual fund manager hold 160 stocks? By not doing a very thorough job of understanding the companies he owns. I think that’s an irresponsible way to invest. Perhaps that’s why 80% to 90% of mutual funds under-perform the market over the long run.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

A great source for stock research

I’d like to make a quick pitch for a new book I bought this weekend: Morningstar Stocks 500.

First off, I do not follow this guide brainlessly. I find it to be a great way to look at potential investments. It doesn’t cover every investment (only 500, hence the name). Their valuation method is not flawless, but neither is mine. Some of their recommendations and analyses are weak, but overall it’s not too bad.

So, why do I like it? I think it’s a great verification source. I like to use it to scan valuations of companies and to read their take on each business and management. Even when I disagree with them, it’s pretty easy to understand why their take is what it is.

I also think their approach is spot on. First, they look at the economics of a business, its moat. Second, they look at management, what kind of stewards are they for shareholders. Third, they look at valuation, how much is a business worth. This is the same basic approach I use, too, and so I like to read others who take that same approach.

How should this tool be used? Personally, I use it after I’ve already done an evaluation of a potential investment. After I’ve learned about the business, its competitive advantages, its management, its financial reporting, and formed a thorough opinion of all these things myself, I like to look at Morningstar’s take on the business and compare it to mine. Either I get a warm fuzzy because they did things similarly to me, or I can see how they evaluated things differently and I can question my position.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.