Saturday, January 24, 2009

Looking Up for Energy and Resource Stocks

Swiss investor, Marc Faber, still hates America, but he has a good track record for market prediction. So, I paid attention when I read this in Barrons today, in the Investor Roundtable Part 3:

Faber: When volatility diminishes (in the next few months), you want to be in cyclical industries. Among the most cyclical stocks are resource producers. They were driven up by incremental demand from China, and then collapsed. In the next six months they could have significant upside. I like Rio Tinto, BHP Billiton and CVRD [Companhia Vale do Rio Doce].

The financial crisis and collapse in commodities will keep supplies out of the market. Nobody is exploring now. There is no money, and projects are being postponed. Whenever the recovery comes, in five or 10 years, resources stocks will go ballistic from today's low levels. If you're optimistic about the next six months, too, when the news may be slightly better than today, you should own them. Freeport McMoRan Copper & Gold fell from 127 to 15 and is now 26. Xstrata, in Switzerland, is another one. A lot of these stocks are more attractive than gold, because gold is at a 20-year high relative to industrial commodities.

Scott Black: Rio Tinto's balance sheet isn't in good shape. They have a refinancing issue.

Faber: Worst-case, the Chinese government could buy them out. China has taken a big stake in the company. Meryl recommended Kaiser Aluminum [KALU] earlier today. I would add Alcoa.

Felix Zulauf: You're not saying this is the beginning of a big bull market, but of a base-building process from low levels.

Faber: Correct, but when stocks decline by the magnitude seen in resources shares, or the Nasdaq after 2000, a base-building period follows that can extend for several years. When you print money, you can get an artificial bull market (in cyclical and resource stocks) that exceeds everyone's expectations.


And this is a quote from Scott Black, another on the Barrons Roundtable of great investors (and a disciple of Benjamin Graham and value investing). He makes the case for XTO. But the arguments and metrics can be applied just as well to the Canroys (though it appears XTO did a much better job of hedging than PWE or PGH):


BLACK : My next pick is an old favorite, XTO Energy, in Fort Worth. The stock is 37.58, there are 577 million fully diluted shares, and the market cap is $21.6 billion. The company did a smart thing by hedging approximately 77% of its natural-gas production in 2009. They have locked in 1.6 Bcf [billion cubic feet] of gas at $8.94 per Mcf [thousand cubic feet], and 62,500 barrels a day at $118.85 per barrel. Production has been growing dramatically, and should average about 2.67 Bcf per day in 2009, up 18% year over year. About half the increase is from drill-bit growth, the rest from acquisitions. XTO bought Hunt Petroleum last year for $4.2 billion, figuring it could triple reserves, which are now 80% gas, 20% oil. It has 12 Tcfe [trillion cubic feet-equivalent] of gas and 500 million barrels of oil.

BARRONS: What are you pricing reserves at?

Black: I value the gas reserves at $3 per Mcf and the oil at $8 per barrel. Breakup value is about $44 a share, so the stock is selling at 85% of breakup value. My 2009 revenue estimate is $9.86 billion -- slightly higher than the Street's -- which converts to $4.50 a share in earnings. Return on equity is 15.5%, return on total capital 10.3%. Free cash flow is $2.28 billion. XTO has cut its capital-spending budget this year, to $3.8 billion from more than $5.3 billion. They are wed to the notion of knocking $1 billion to $2 billion of debt off the balance sheet.

Their finding and development costs were $1.45 to $1.50 per Mcfe in 2007, and $1.65 in 2008. This year they could fall to $1.50. XTO is one of the few energy companies with rising earnings, because of hedging. They will earn about $3.75 to $3.80 a share for 2008, and $4.50 for '09. The stock sells for 8.3 times earnings and 3.6 times discretionary cash flow. It is extremely cheap. You've got asset and earnings protection. And they are in every major field in the U.S. -- the Barnett Shale, Fayetteville and so forth. Energy is a controversial investment today, but XTO is the cream of the crop.

Schafer: If they hedged this year, does that mean next year's earnings will be down?

Black: No, because they hedged 2010, too.

Friday, January 23, 2009

Goodbye, President Bush; We Will Miss You

I do not name this post sarcastically. I know I am in the minority, but I will miss President Bush. Yes, he was hard to watch and listen to at times, with his less than perfect execution of the English language (and won't the liberal comedians miss him for this?!). And yes, he was bullheaded and stubborn and overly loyal to his friends; and he could stick too long to his conservative principles when pragmatism suggested otherwise. But that is also why I liked President Bush. Like every human, he was fallible. But unlike most politicians, he was humble and able to laugh at himself. He knew he was not very polished and he reveled in his imperfections.

I just read a great piece on President Bush's retirement from the Presidency by Karl Rove. Yes, it is biased as Rove was Bush's right hand man for many years. But it is also honest and true. Read the article below. I think regardless of your political orientation, you will appreciate the great human being that is George W. Bush. And note his accomplishments. Did anyone besides me and Karl Rove get the irony of President Barak Obama warning terrorists that "you cannot outlast us"? This statement was only made possible by the unpopular policies of President George W. Bush. In the unvarnished re-examination of historians, he will be remembered for protecting us at one of our darkest times.


OPINION
JANUARY 21, 2009, 10:48 P.M. ET

Bush Was Right When It Mattered Most

http://online.wsj.com/article/SB123258532378704477.html

By KARL ROVE

Its call sign has always been Air Force One. But on Tuesday, it was Special Air Mission 28000, as former President George W. Bush and his wife Laura returned home to Texas on a plane full of family, friends, former staff and memories of eight years in the White House.

The former president and his wife thanked each passenger, showing the thoughtfulness and grace so characteristic of this wonderful American family.

A video tribute produced warm laughter and inevitable tears. There was no bitterness, but rather a sense of gratitude -- gratitude for the opportunity to serve, for able and loyal colleagues, and above all for our country and its people.

Yet, as Mr. Bush left Washington, in a last angry frenzy his critics again distorted his record, maligned his character and repeated untruths about his years in the Oval
Office. Nothing they wrote or said changes the essential facts.

To start with, Mr. Bush was right about Iraq. The world is safer without Saddam Hussein in power. And the former president was right to change strategy and surge more U.S. troops.

A legion of critics (including President Barack Obama) claimed it couldn't work. They were wrong. Iraq is now on the mend, the war is on the path to victory, al Qaeda has been dealt a humiliating defeat, and a democracy in the heart of the Arab world is emerging. The success of Mr. Bush's surge made it possible for President Obama to warn terrorists on Tuesday "you cannot outlast us."

Mr. Bush was right to establish a doctrine that holds those who harbor, train and support terrorists as responsible as the terrorists themselves. He was right to take the war on terror abroad instead of waiting until dangers fully materialize here at home. He was right to strengthen the military and intelligence and to create the new tools to monitor the communications of terrorists, freeze their assets, foil their plots, and kill and capture their operators.

These tough decisions -- which became unpopular in certain quarters only when memories of 9/11 began to fade -- kept America safe for seven years and made it possible for Mr. Obama to tell the terrorists on Tuesday "we will defeat you."

Mr. Bush was right to be a unilateralist when it came to combating AIDS in Africa. While world leaders dithered, his President's Emergency Plan for AIDS Relief initiative brought lifesaving antiretroviral drugs to millions of Africans.

At home, Mr. Bush cut income taxes for every American who pays taxes. He also cut taxes on capital, investment and savings. The result was 52 months of growth and the strongest economy of any developed country.

Mr. Bush was right to match tax cuts with spending restraint. This is a source of dispute, especially among conservatives, but the record is there to see. Bill Clinton's last budget increased domestic nonsecurity discretionary spending by 16%. Mr. Bush cut that to 6.2% growth in his first budget, 5.5% in his second, 4.3% in his third, 2.2% in his fourth, and then below inflation, on average, since. That isn't the sum total of the fiscal record, of course -- but it's a key part of it.

He was right to have modernized Medicare with prescription drug benefits provided through competition, not delivered by government. The program is costing 40% less than projected because market forces dominate and people -- not government -- are making the decisions.

Mr. Bush was right to pass No Child Left Behind (NCLB), requiring states to set up tough accountability systems that measure every child's progress at school. As a result, reading and math scores have risen more in the last five years since NCLB than in the prior 28 years.

He was right to stand for a culture of life. And he was right to appoint conservative judges who strictly interpret the Constitution.

Few presidents had as many challenges arise during their eight years, had as many tough calls to make in such a partisan-charged environment, or had to act in the face of such hostile media and elite opinion.

On board Special Air Mission 28000, I remembered the picture I carried in my pocket on my first Air Force One flight eight years ago. It was an old black-and-white snapshot with scalloped edges. It showed Lyndon Johnson in the Cabinet Room, head in hand, weeping over a Vietnam casualty report. George Christian, LBJ's press secretary, gave it to me as a reminder that the job could break anyone, no matter how big and tough.

But despite facing challenges and crises few others have, the job did not break George W. Bush. Though older and grayer, his brows more furrowed, he is the same man he was, a person of integrity who did what he believed was right. And he exits knowing he summoned all of his energy and talents to defend America and advance its ideals at home and abroad. He didn't get everything right -- no president does -- but he got the most important things right. And that is enough.

Mr. Rove is the former senior adviser and deputy chief of staff to President George W. Bush.

Sunday, January 04, 2009

Reflation Economics (or "The Minsky Solution")

As your resident amateur economist, I would like to offer up an article coming from one leg of the PIMCO triumvirate (Paul McCulley, the others being Bill Gross and Mohamend El-Erian) who rule the private sector bond world.

McCulley is the Central Bank expert of the group and his expertise is near Nobel Laureate in its quality and insight. The PIMCO group anticipated the current banking crisis and declared the cause well in advance of the blowup. The PIMCO team labeled the cause as the "Shadow Banking System" and saw the leverage that was being created by hedge funds and others using the tools like "carry trade" to create money through leverage.

Like the rest of us, this group of economists thought the outcome of "shadow banking" would be inflation, as easy money created excess demand. None of them forecast the total collapse of the system and the resultant deflation. However, McCulley suggested the possibilty through his analysis of Hyman Minsky's work as an economist 30 years ago. McCulley uses Minsky to explain money growth and contraction, and does so at times with his stuffed bunny he keeps in his office (he calls "Bun-Bun").

I thought you might find this article insightful. Here is a sample with my paraphrasing in parantheses:

(It is the explicit responsibility of the Fed to provide a “more than proportionate” response to an economic contraction). That is indeed what is needed to save capitalism from its inherent debt-deflation pathologies. The paradox of deleveraging and the paradox of thrift are beasts of burden that capitalism simply can’t bear alone (that is to say, Capitalism is not a perfect economic system, but occassionally needs help when excess greed or fear get in the way). Only the Minsky Solution can lift that load.”

Here is the entire article:

http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2008/GCB+December+2008+McCulley+All+In.htm

PIMCO and specifically, Paul McCulley, is the originator of the idea of “Shadow Banking”, which has come to dwarf the Federal Reserve system in the last 10 years. The amount of assets controlled by the shadow bank makes central bank policy implementation difficult, if not impossible. Shadow banking is the creation of money from nothing by private institutions, like hedge funds. Such financial institutiosn were increasingly deregulated in the 1990s and 2000s. Because they could use instruments like the “carry trade” to create money with very little invested capital, by use of massive leverage, the system effectively grew the money supply outside the control of the Central Bank. This was thought to be inflationary by the PIMCO team as late as 2007, but proved to be deflationary instead.

Now, that the shadow banking system is collapsing, it is following exactly the Minsky model. The Minsky Moment, modeled as the “Ponzi Unit” (in the McCulley chart), was achieved almost exactly at the time the biggest real-life ponzi scheme was uncovered, the Madoff Fund. Talk about life imitating art!!

So, the real central bank must transfer the leverage that is disappearing in the private sector, to the public sector, in order that the economy does not collapse into oblivion. I would like to ask Mr. McCulley what is the step to follow in the Minsky Model: how does the leverage that the public sector absorbs from the private sector get resolved? By time alone?

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/IO+January+2008.htm

Saturday, January 03, 2009

My Projections for 2009

How bad was 2008 from an investment perspective? From Barrons issue on January 5: "The S&P 500's 37% loss of 2008 served to knock three-quarters of a percentage point off the annualized index total return since 1927, to 9.7% from 10.4%, according to Aronson+Partners. The 10-year trailing returns for large-cap stocks now appear to be at their worst level since 1827, says Morgan Keegan, and trailing returns of world equities versus bonds are at their weakest since the late 1970s, says BCA Research."

So, combined with the Tech Bust in 2001-03, we could say we are simply in the worst period for investors in 200 years. We should have "mean reversion" at some point. It has to get better!! The article goes on to say: "the lousy risk adjusted record for stocks that now dominate investors' memory is discrediting equities in the public mind as a wealth-building asset class." For those with a 20 year time horizon, this is what we want to hear. I was very worried a couple years ago when volatility had gone to less than 10 (as measured by VIX). Low market price volatility goes with a perception of low risk. When the market loses its risk, it also loses its prospects for return.

For the stock market to achieve its typical 4-6% real return (the return above inflation), there must be a perception of risk. If there is no risk, then returns will be only 1-2% over inflation (see TIPS returns as an example), and the ability to grow wealth by market investing will be lost.

Santoli goes on in his Barrons article: "This is helpful, and implies the direction of mean reversion for asset classes will favor stocks again before long, though who knows from what ultimate level? The five years following the 10 worst calendar years for stocks were always up in total -- sometimes not much, sometimes a lot, an average of about 10% annualized -- yet three times the year immediately afterward was down more than 20%."

All this is good and sounds very reasonable. But the title of this post is "Projections for 2009". I know you are looking forward to my annual amusing, but rarely insightful projections. I understand that by January 4, you have already seen more than enough forecasts. But I have been doing this since 2002 now (except last January when my crystal ball was all cloudy), so I don't want to break the string (though I just admitted I did last year). Here goes:

  • Government backed interest rates (mortgages and Treasuries) will stay low throughout 2009 (less than 1% for 2 year bonds); but sometime thereafter, maybe early 2010, they will start rising and continue going up as inflation heats up along with an economic recovery.
  • By the July 2009, the high yield and corporate bond interest rates will begin to decline, narrowing the historic spreads against risk free Treasuries
  • Crude oil will continue weak throughout 2009 in a range of $25 -$60 per barrel; as a result production and exploration will be reduced and lower production with higher demand will set the stage for a rebound to over $100 sometime in 2010 or 2011; enjoy low gasoline prices while you can;
  • Gold prices will stay under $1000 in 2009, but will not decline under $600; but gold could increase to over $1500 by 2012 because of a weaker dollar caused by inflation from excess money supply created in 2009;
  • In early 2009, GM will be forced to declare bankruptcy (or an equivalent government reorganization); same for Chrysler; this will set the stage for a revamping of the American auto industry and will usher in a new era of manufacturing competitiveness; Ford will escape bankruptcy, but will benefit from the changed labor and franchise rules;
  • At least five major mall retail brands will declare bankruptcy and will be closed; candidates: Abercrombie, Zumiez, GAP, Hot Topic, Lane Bryant, Foot Locker, Eddie Bauer, Ann Taylor; but look for the retail sector to outperform as soon as 2010;
  • General Growth may become a victim both due to the above store closings / bankruptcies, but also due to the debt it took on to acquire Rouse Companies; its survival depends on selling several of the Rouse flagship properties: Fanueil Hall (Boston), Harborplace (Baltimore) South Street Seaport (NYC) and its Las Vegas malls (Forum Shoppes, Fashion Mall, Highland Mall);
  • Official unemployment will top 8%, but will not top 10%;
  • Mortgage rates for 30 year fixed rate Fannies will be less than 4.5% with no points; but these rates will rise in 2010;
  • The stock markets will see a range and return by year end of DJI: 7000 - 10,500 (13%); S&P500: 725 - 1100 (15%); NASDAQ100: 1400 - 2200 (10%); with the lower end of the range reached in the first half of the year (there will be a retest of the November low, but that retest will be the bottom of a new 20 year secular Bull market, albeit the new Bull will be sleepy for several years while the economy and debt are repaired);
  • The best asset class return in 2009 will be in high yield bonds (junk) with a 30% total return;
  • The 2nd best asset class return in 2009 will be in energy stocks, both producers and equipement providers, though producers will have the best total return at 25%;
  • The worst asset class in 2009 will be Treasuries with 30 year bonds returning a negative 20%;