Saturday, February 11, 2012

When the party ends, what price will the U.S. pay for its debt binge?

A little while back, former Fed Chairman Alan Greenspan sounded the alarm about the “dire consequences” of swelling U.S. debt, as we may soon face higher borrowing costs.
Here’s another newsflash for you: The Chinese won’t always be on call when we need them!
The Chinese have provided the U.S. with short-term satisfaction. Satisfaction that felt so good that the U.S. became quite addicted to it. The reality is that we’ve been addicted to Chinese stimulus and, although we have a guilty conscience, we keep on doing it.
What we have been doing is focusing on only half the equation: The short-term satisfaction we’ve been getting. But what about the cost? Uncle Sam borrows the money from China to stimulate the economy by giving the cash to (“stimulating”) banks that are looking at mounting losses each month.
The government has become quite two-faced, even by historical standards.
Question: Why would the government be surprised that the banks aren’t willing to lend money out when the banks know what the reality of the situation is? They know they are just deferring losses, and that’s why they are hoarding cash. Duh.
Would you lend money out if you knew you had a massive margin call that you’d eventually have to pay? Imagine having a margin call (when you borrow money to pay for a stock purchase and when the stock declines the broker calls you to tell you to send in more money to “meet the call”). Then you sit there, watching that stock decline, praying that your stock advances enough in price to make that margin call go away. Some of you who’ve been there just got a chill up your spine.?
And those of you who have been in this position know the broker won’t accept that. Even if the stock advances back to where it started, you still have to send in money to meet the margin call.?
Well the banks have an asset–one ! thatR 17;s just slightly bigger than any stock position you’ve ever held–that they borrowed to buy … and it’s down BIG.?
They have nobody barking at them to come up with the funds. And guess what: They are actually sitting there hoping prices will advance enormously one day. And if you were a bank, why on Earth would you lend money out when you know you’re in the hole?
So do you believe the government when they pretend they are trying to encourage banks to lend more money to stimulate the economy?
The government, in essence, is encouraging the seemingly successful banks to “massage the numbers.”
The government obviously knows the scoop though, as they relaxed mark-to-market accounting rules for the toxic mortgage assets that banks carry on their books at inflated values. And they call that stimulation?
Stimulate away!
But how much will you have to pay for a happy ending to this financial mess?
The Chinese have always been the most reliable when it comes to relieving our stress. Gosh, they certainly get a ton of business here in the United States, and that continues to motivate the Chinese to be on call waiting to dabble dirty in our debt markets. Why not? We’re the biggest buyer, and have been the safest bet on the block!
But what happens when prices go up? (The price of money that is.) Where will the U.S. go to get that short-term satisfaction it needs when the Chinese, who dominate that market, want more? The Russians?
Alan Greenspan knows a little something about this topic. He recently wrote in The Wall Street Journal about the dangers of the complacency the government has about federal debt, saying:
“The U.S. government can create dollars at will to meet any obligation, and it will doubtless continue to do so. U.S. Treasuries are thus free of credit risk. But they are not free of interest rate risk. If Treasury net debt issuance were to double overnight, for example, newly issued Treasury secu! rities w ould continue free of credit risk, but the Treasury would have to pay much higher interest rates to market its newly issued securities.”
Although we haven’t seen a huge spike in interest rates, it’s possible to see a sharp spike in a very short period of time. As Greenspan points out, “Between early October 1979 and late February 1980, for example, the yield on the 10-year note rose almost four percentage points.”
That’s right! Four percentage points in four months!
Greenspan said:
“Federal debt to the public rose to 59% of GDP by mid-June 2010 from 38% in September 2008. How much borrowing leeway at current interest rates remains for U.S. Treasury financing is highly uncertain.”
For those who don’t understand the bond market, let me put this in simple terms: Let’s say your friend, who has a reputation of financial success, wanted to borrow money. And at the same time, you wanted to park your money somewhere. So you might lend him cash for a low rate of return (like treasuries have been paying lately–10-year Treasuries pay just over 3%.) But if you realized that your friend has been progressively borrowing more and more at an alarming rate, thus creating a higher degree of risk to your loan, you probably wouldn’t lend the friend money unless he paid a very high rate of return.
Federal debt to the public has risen during the past year and a half to $8.6 trillion from $5.5 trillion.
This is exceptionally dangerous, and Greenspan says in his WSJ article that the U.S. is feeling rather complacent about these dangers because so far we haven’t felt the pain of what, historically, have been the consequences of such behavior (rising inflation and interest rates).?
He talks about the fact that Congress has handed out hundreds of billions of dollars, and the fact that it becomes difficult for them to not give an extra couple billion here and a couple billion there. Compared to what’s ! already been handed out, a few billion doesn’t seem like a heck of a lot. In fact, it looks like a great big slap in the face when they say “NO!” So as they release the money, they shout “YES!”
The higher rates move, the less sense it makes to invest in the stock market. That’s one reason why higher interest rates are bad for stocks. When the cost of borrowing increases, it becomes harder and harder to operate profitably as a company, making stocks with lower growth potential less attractive. The more cash we print, the more likely it is that we see runaway inflation. That means we would be looking at higher cost of goods coupled with a higher cost of borrowing money.??
Sure, there is always the possibility of deflation. In fact, some of the smartest investors say that’s a more likely scenario. But if we have deflation, what happens to the value of the homes that banks are holding on to? They go down. And what happens to the banks when they don’t meet their margin calls? The FDIC–that’s what. In other words, you own them. Yes, you.?
Sorry to stress you out with this not-so happy ending. But there are two things you can do to relieve your stress.
1. Go get a massage.
2. Become completely comfortable with making bearish bets so that you can profit from falling equity prices. Because, while we can’t save the world, we sure can make sure OUR ending is a happy one.
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Wednesday, February 8, 2012

Why I'm Not Buying Berkshire Hathaway

I get it. We all love Warren Buffett. He's the financial world's favorite rich uncle. His company, Berkshire Hathaway (NYSE: BRK-B ) is a mighty juggernaut that's seen its stock price soar nearly 500,000% since its genesis. It's made many millionaires, and it made him a billionaire many times over. But it's not going to make me rich. It might not even make me market-beating returns going forward.

I don't want to bash Buffett. I really like the guy, and would love to talk shop with him for a few hours. I just won't invest in his company, and here's why.

Invest like a rock star

Let's face it, Buffett isn't just one of the greatest living investors. He's also one of the greatest financial celebrities of the past century. The ascent to fame wasn't an overnight process, although many financial pros and savvy investors were aware of his talents long before the media caught on. With fame comes attention, and therein lies the rub. How easy is it to thrash the market when the whole market pays attention to your every move?

If your goal is to beat the Dow (INDEX: ^DJI ) , Buffett's had your back in spite of the spotlight, at least since 2002. In the past decade, Berkshire's doubled the anemic growth of the index, which just happens to track several of Buffett's key holdings.


Berkshire Hathaway Total Return Price Chart by YCharts

Blinded by the light

But what if you jumped in later? The closer you get to the present, the worse Berkshire does relative to the Dow, and the more Buffett starts popping up in pop culture. Over the past five years the index is down 1%, but Buffett is only up 8%. The post-recession bounce wasn't as high for Buffett as it was for nearly everyone else -- the Dow turned ! the tabl es on Berkshire after 2009 and has grown double the rate of Omaha's finest. The past year hasn't been kind either, as Berkshire is down 8% relative to the index. Maybe he was too busy guest-starring in The Office finale.

None of this accounts for reinvested dividends from individual Dow companies, which would skew the numbers even more to Buffett's detriment. And speaking of dividends...

The dividend free pass

I hear quite often that Berkshire doesn't need to pay dividends. The argument often runs along similar lines to those given by my colleague Morgan Housel, who says that the company invests more efficiently than its shareholders and should have free reign to do so. This worked very well as it grew explosively through the '60s, '70s, '80s, and '90s. But now that Berkshire's a lumbering conglomerate with a $190 billion market cap, there's not quite as much room to run as there used to be.

Buffett loves dividends from other companies, however, and has made much use of them to grow Berkshire's cash hoard. Coca-Cola (NYSE: KO ) , one of his favorite holdings, paid out about $376 million to Berkshire last year, according to Buffett's most recent shareholder letter. He boasts that the annual Coke dividends are likely to become greater than Berkshire's initial cost basis over the next decade.

Not quite so efficient

That's great for Berkshire, but what about its shareholders? It turns out that holding some of Buffett's favorite companies and reinvesting the dividends would have done better than just holding Buffett's company over the past decade and having him do the investing for you.


Berkshire Hathaway Total Return Price Chart by YCharts

Coke, American Express (NYSE: AXP ) ! , and Wells Fargo (NYSE: WFC ) were three of Berkshire's largest holdings 10 years ago. Reinvested dividends helped all three trounce Buffett since then -- without that boost, none would have beaten Berkshire's 59% return. I can't give Buffett a free pass when the proof is staring me right in the face.

Core businesses in danger
Berkshire still generates a substantial amount of revenue from its insurance businesses. As with most any insurance business, Berkshire does better if there aren't any major catastrophes. Note the "if" -- predicting such things is notoriously difficult. But recent research has shown an uptick in extreme weather damage. 1996 to 2005 was the second-worst decade for hurricane damages since the 1930s, and the worst ever for sheer number of billion-dollar-plus hurricane-related losses.

The years since have continued that trend. Hurricane Irene tipped 2011 into the record books as the 10th natural disaster to cause over a billion dollars in damage, edging out 2008's nine 10-figure-plus calamities. Berkshire's been very good at hedging insurance risk, but not even Buffett can stop an earthquake, unless he can somehow figure out how to fly around the Earth fast enough to turn back time.

The bounce-back argument
But the stock will bounce back, won't it? After all, its price-to-book ratio is about the lowest it's ever been. But in its peer group -- if you consider insurers its peers -- Berkshire isn't unique. A number of major insurers have suffered price-to-book compression over the past decade, many worse than Berkshire's.


Berkshire Hathaway Price / Book Value Chart by YCharts

In case you think I'm cherry-picking to make Berkshire look bad, only Progressive has a higher price-to-book ratio, at 2.14. It hasn't been a ! great de cade for big banks either in price-to-book terms, but with such depressed prices, many of them look pretty attractive, and some have already grown more since 2012 started than Berkshire has since 2009.

Better opportunities elsewhere
If Berkshire had a dividend, I could see the appeal. If it was still booming, it'd be a great buy. But now, after decades of dominance, it looks like Buffett's reign as king of the market has come to an end. Thanks for all the memories, Warren, but it looks like I'm too late to ride your coattails to market-beating returns. You can see the bearish CAPScall I made on Berkshire at my CAPS player page. I plan to keep it for the long haul.

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Monday, February 6, 2012

Barnes & Noble Settles With Burkle–To What End?

Failing bookstore company Barnes & Noble (NYSE: BKS), maker of the also-ran e-reader, the Nook,? has settled with raider Ron Burkle, who bought enough shares in the company so that he could claim that he needed a board seat.
The Wall Street Journal reports that “As part of the settlement, Barnes & Noble will add two independent directors to the board, in addition to a director affiliated with Yucaipa Cos., the investment firm run by Mr. Burkle, these people said.”
Burkle believed that the founding Riggio family, which holds a controlling interest in the firm, would act in their interests and not those of other shareholders. Burkle will end his proxy fight against the company in exchange for those board seats and support the re-election of chairman Leonard Riggio. Apparently, Barnes & Noble will pay the raider’s legal costs for his challenge. It is hard to imagine why this is a good deal for shareholders who will watch Burkle pick the company’s pocket in exchange for a seat at the table.
Riggio is already acting in his best interests and those of Burkle as well by putting the book company up for sale. Riggio has indicated that he may be a buyer, probably with a private equity firm which could borrow most of the purchase price from unwitting banks which have already lost tens of billions of dollars on LBOs.
Barnes & Noble has been thrashed by which has sold books online for more than a decade and does not have the costs of maintaining store locations. Amazon has also launched its Kindle e-reader which controls that market with a share that is estimated at 70% or better.
Even with a potential private sale of the company, its shares are only up to $14.48, well below their 52-week high of $25.07 and their five-year high of $48 reached in May 2006 when selling books out of physical locations was as good a business as selling DVDs from stores. Blockbuster found out the hard way that its sales would s! uffer wh en DVD sales moved to the Internet and the same now holds true of books, both paper and digital.
It is hard to see what Burkle gains by his new-found seat at the table. Barnes & Noble can hardly be broken up. The company’s online business many be attractive, but its stores are an albatross which have very little value at all.
Burkle may regret that he got what he wanted.

Sunday, February 5, 2012

Top Analyst Upgrades & Downgrades (AKS, ALU, AWK, APA, AF, AZK, DRI, HBAN, PHG, LTD, PIR, Rl, RL, UL, URBN, VIP, WBMD, WCC)

These are some of the top analyst upgrades, downgrades, and initiations seen from Wall Street brokerage and research firms this Wednesday morning.
AK Steel Holding Corp. (NYSE: AKS) Raised to Outperform with $12 target at Credit Suisse.
Alcatel-Lucent, S.A. (NYSE: ALU) Raised to Buy at Deutsche Bank.
American Water Works Company, Inc. (NYSE: AWK) Raised to Buy at Ladenburg?Thalmann.
Apache Corporation (NYSE: APA) Started as Buy at Stifel Nicolaus.
Astoria Financial Corporation (NYSE: AF) Cut to UNderweight at JPMorgan.
Aurizon?Mines Ltd. (NYSE: AZK) named as Value Stock of the Day at Zacks.
Darden Restaurants, Inc. (NYSE: DRI) Maintained Underperform as Bear of the Day at Zacks.
Huntington Bancshares?Inc. (NASDAQ: HBAN) Cut to Hold at Stifel Nicolaus.
Koninklijke?Philips Electronics NV (NYSE: PHG) Cut to Sell at Citigroup.
Lazard Ltd. (NYSE: LTD) Cut to Neutral at Citigroup.
Pier 1 Imports Inc. (NYSE: PIR) Started as Hold at Argus.
Ralph Lauren Corporation (NYSE: RL) Cut to Market Perform at Wells Fargo.
Unilever PLC (NYSE: UL) Cut to Underperform at BofA/ML.
Urban Outfitters?Inc. (NASDAQ: URBN) Cut to Sell at Citigroup.
VimpelCom Ltd. (NYSE: VIP) Raised to Neutral at Goldman Sachs.
WebMD?Health Corporation (NASDAQ: WBMD) Cut to Market Perform at Wells Fargo.
WESCO International (NYSE: WCC) Raised to Outperform as Bull of the Day at Zacks.
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