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The New Plan
Executive Summary
As the market wends its way higher, the Secretary of the Treasury in the U.S., along with the FDIC and the Fed are trying to obtain from Congress new powers of regulation that arguably could have prevented the current crisis and may be necessary to solve it. This opens up the possibility of an efficient public-private partnership to address the persisting financial disarray. Off balance sheet "assets" that will be returning to the banks ledgers via defaults, however, may delay or derail the anticipated recovery, and securitization of debt, one of the underlying causes of the current crisis, appears to be getting a boost in the proposed solution, instead of being euthanized.
Meanwhile, some Consensus companies are barely feeling the effects of the recession. International Business Machines (IBM) posted a record quarter in Q4 of 2008. PetMed Express (PETS) is growing nicely, as well. Additionally, Sunoco Logistics Partners (SXL) is another high-yield pipeline company you should know about. All have PWR ratings above 60 and are profiled below.
The Best 4 Quants Model Portfolio finished last week at -5.9% vs. the S&P's +1.6%. So far this week the Best 4 Quants Model Portfolio has a return of +30.5% vs. the S&P's +6.7%. Since Inception 3/14/2003 the model has a return of +167.5% vs. the S&P 500's -1.7%. The Best 4 Quants Model has ten picks this week: MUR, LECO, DRQ, TRA, ACL, WBD, GTI, SSL, INFY, ZEUS.
For those who do not follow the Best 4 Quants model portfolio, we offer our TSR Timing Model as general guidance on the relative safety of the current market. On 3/23/09, the Timing Model went from +175% invested to +200% invested.
Detail
The S&P 500 advanced 7% last Monday in anticipation of a more detailed plan from Treasury Secretary Geithner to reverse the financial crisis. At the close of trading on Monday, the market had posted its largest two-week gain since 1938. We have already cited quite a number of parallels between this market and the 1930s, not all of them positive.
One characteristic to keep in mind is that the strongest rallies occur in bear markets. The bigger the bear, the bigger the rally. We did not have a single 6% up-day during the 2000-2003 bear market. During this decline, however, we have already had three days in which the market has advanced more than 6%. Our conclusion: a bigger bear does not a bull make.
The New Plan
That cautionary preamble notwithstanding, the good news is that a number of very smart uber bears, including Professor Nouriel Roubini of NYU, the well-regarded prophet of doom, have expressed positive comments on the Public Private Partnership concept proposed by the Obama administration. The plan is an alternative to continuing on the path of indiscriminant bailouts, which, after the AIG bonus scandal, are no longer politically feasible.
The New Plan creates a government partnership with bond funds such as PIMCO, mutual funds, hedge funds, private equity funds and pension funds to redistribute the toxic assets (what an oxymoron!) on banks' balance sheets to the private sector. The assumption is that a fair market price can be achieved that is higher than the current marks at the banks, and yet low enough to provide an attractive return for the investors. Commentators such as Bill Gross at PIMCO have long criticized the Shadow Banking system, which originally referred to the massive unregulated derivative market. Now, functioning as collective undertakers, Mr. Gross and his cohorts will have the job of performing an autopsy on the system and recycling its viable parts to healthier bodies.
The government will probably end up holding the worst of the loans to maturity, while letting private interests cherry-pick. Additionally, the plan will be implemented by the Treasury without having to bother with congressional approval in the form of a bill or other specific authorization, because most of the funds will come from the Fed and the FDIC. The plan also includes new powers to take over giant financial institutions whose condition pose a risk to the financial system. Approval from Congress for these powers is being requested and guidelines within that legislation would spell out under what circumstances the powers could be used.
We have no problem with increasing regulation over what is ultimately a public financial system in private hands. What worries us, however, is the lack of any proposals to fix the underlying problems within that system, one of them being the securitization of debt, which is not only being left alone for the moment, but is actually being used in the plan as a means to solving the crisis. Debt will be moved from the books of the banks and insurance companies to private and public hands via the same kinds of instruments, with the same kind of unrealistic valuations, as got us into this mess in the first place. Who, besides the taxpayers, are the chumps who will buy this junk, and what are they being promised to get them to do so?
Enron Redux
The stock market is reflecting some optimism about the Geithner proposal, but there is a particularly large and dark cloud on the horizon in the form of off-balance sheet "assets" at the major U.S. banks that is not being addressed by the Geithner partnership. At the end of 2008, the four largest U.S banks (Bank of America, Citigroup, JP Morgan Chase and Wells Fargo) held $5.2 trillion of asset-backed securities and other obligations off their balance sheets. These assets included mortgages, auto loans, credit card debt and commercial loans that were repackaged, securitized and sold by the banks.
We don't know which rating agencies, if any, rated these securities. They were originally created to make the balance sheets of the banks look healthier, which contributed to fueling the credit bubble. It is, of course, a myth that no one expected real estate to fall. Everyone I know did, it was just a question of when, and people kept betting that it would be after their next deal, or that it would fall and rebound again before they needed to sell. In fact, the end came when more and more people realized that prices had just gone too far, too fast, so they began being justifiably shy about buying. Then they began to wait for what they believed was an inevitable correction, and the more people waiting, the more demand dried up, and the correction began. Now, these are "retail" home-buyers who knew prices were too high and who knew a correction was coming. Who can believe that actuaries of Citibank and AIG didn't know? They knew, and like the retail home-buyer did until just before the end, they continued to bet that they could make their next big buck before it came. The risks they took, and convinced others to take, with their highly leveraged securitization of debt that they knew very well was doomed, must be considered criminal, and it is hard to imagine going too far in regulating this kind of behavior in the future.
There are approximately $2 trillion in subprime-backed mortgage securities on the banks' books right now that are expected to default in the next two years. If the banks are low-balling the off-balance-sheet risk, then the $1 trillion Public Private Partnership starts to look awfully puny. It may need to be 5 times as large.
Bye Bye Greenback
Concerns about the true magnitude of the debt crisis is one reason gold is rallying this week. The larger the hole in terms of dollars, the better gold looks. In fact, both the U.N. and China floated proposals this week to dethrone the dollar as the world's reserve currency and Secretary Geithner publicly endorsed the idea for about 5 minutes until he thought better of it. Geithner told the Council on Foreign Relations that he would be "quite open" to superseding the U.S. dollar as the primary global reserve currency. The alternative would be a hybrid currency such as the one developed by the IMF in 1968.
Devaluing the dollar is certainly not official U.S. policy by any means, but it is a direction that Geithner would presumably like to take because it would help stimulate exports and allow the U.S. to pay back debt in "smaller" dollars. In a deflationary environment, such as we have today, currency devaluation is not likely to boost inflation much at all, so this is the perfect time to quietly let the dollar fall.
We think the Chinese Yuan, which is pegged to the dollar, will fall along with it, which in the currency game of musical chairs means that the euro will probably rise. A research agency associated with China's most important economic-planning body said the government should permit an appropriate depreciation in the value of the Yuan as a strategy for increasing the nation's growth. The State Information Center made a statement advocating the devaluation of the currency enough to counter the effects of plummeting foreign demand for the country's products.
Bottomline: Consider protecting your assets from a devalued dollar by owning gold and/or gold miners, which we have recently profiled. Below, you will find some additional alternatives.
International Business Machines (IBM), P/E 11, Market Cap $132 billion, Yield 2%
"Breaking news. IBM just reported earnings that were up 26% year over year to $2.3 billion on an 11% revenue rise to $24 billion."
That was our lead line in our April 2008 profile of the company known affectionately as Big Blue. We noted in that profile the fact that IBM's shares were still trading slightly below where it was in 1999, but we nevertheless touted the company for a number of reasons, all of which still apply.
We noted its relative strength, which means it had not fallen with the rest of the tech sector. We identified it as an anti-financial defensive play, which proved to be the case. We remarked on the company's ability to deliver consistent earnings and noted that 18% earnings growth in a global economy that is expected to only grow 4% is an impressive accomplishment, especially for a large and mature company. Indeed, while many tech companies have disappointed analysts, IBM has exceeded earnings guidance for each of the past five quarters.
We also highlighted the fact that with 58% of its revenue coming from outside the U. S., IBM would be at least partially insulated from the slow-down in the U.S. economy. This has also proven correct. We commented favorably on the fact that IBM still had pricing power in its services segment, something that was rare in 2008 and even rarer today. Amazingly, IBM had a $118 billion services backlog a year ago and still does, give or take a billion.
We wrote then, "If the U.S. is headed for a recession, which we think is the case, it's time to think outside the box and recognize safe havens when they arise. We think Big Blue is a good port during the coming storm."
IBM UPDATE: The company has a take-no-prisoners attitude when it comes to the global recession. In fact, for IBM, there has barely been a recession. Chief executive Sam Palmisano wrote in this year's letter to shareholders, "We will not simply ride out the storm... rather we will go on offense." It already has. Earnings per share rose 17% in 2008 and the company set records for quarterly revenue, profits, earnings, and cash flow in Q4 of 2008, which was a horrendous quarter for most international companies. Big Blue is also sitting pretty with nearly $13 billion of cash equivalents, so it does not need to borrow.
One measure of the company's commitment to technological leadership is that fact that in 2008 IBM was the #1 patent filer, applying for more patents than Microsoft, Cisco and HP combined. Specifically, IBM wants to be the leading global "smart" infrastructure company and is already working to manage traffic in Stockholm, water systems in Brazil, power grids in emerging economies and automating health records in countries with aging populations such as the U.S.
Globalization in production, not just in market expansion, has been a key part of Palmisano's strategy. IBM has been steadily increasing its workforce in India while downsizing the U.S. contingent. Foreign workers now account for a whopping 71% of Big Blue's nearly 400,000 employees. In January, IBM laid off 4,600 people in the U.S. and this week added another 5,000 pink slips.
At $98, shares of IBM are trading mid-way in the recent range from $70 to $130. We suggest accumulating IBM at these levels and below. It will be a premier play on the global recovery, whenever it finally happens.
Petmed Express (PETS) P/E 17, Market Cap $383 million
You've probably seen the ads on your favorite cable channel: a simple low key comparison of the cost of pet medications purchased from a vet and the same meds purchased from PetMed Express. The difference in cost is substantial and shipping is free. So what are you waiting for?
Founded in 1996, PetMed Express is America's largest pet pharmacy, delivering prescription and non-prescription medications and other health products for dogs, cats and horses. Slacking on medical care for one's pets is not an option for most owners, but offer someone an alternative to high priced meds in today's recessionary environment and customers will beat a path to your door. The company acquired 154,000 new customers in the fourth quarter of 2008, a 21% growth rate year over year.
Net sales were $43 million last quarter, up 16% year over year. Net income was $4.9 million or $0.21 per share, a 15% increase. These are not stellar numbers in ordinary times, but you probably remember that Q4 of '08 was the quarter during which retail spending bit the dust.
Shares of PetMed Express have been trading sideways for several years, which in this market climate is an indication of tremendous relative strength. One reason for the stock's stability is that management repurchased 336,000 shares last quarter. About 25% of the outstanding shares of PETS are sold short, which bodes well for an eventual breakout to new highs
Sunoco Logistics Partners (SXL), P/E 10, Market Cap $1.5 billion, Yield 7.4%
Like Buckeye Partners (BPL), which we profiled last week, Sunoco Logistics Partners, founded in 2001 and based in Philadelphia, is an MLP, which means it pays out most of its profits to shareholders in the form of quarterly distributions. The company buys, sells, transports and stores refined products and crude oil in 13 states in the Northeast, Midwest and Southwest. Its Eastern pipeline system operates about 1650 miles of pipe, while its Western network owns 3200 miles of pipeline outright and has ownership interests in 1500 additional miles of pipe, along with a fleet of tanker trucks, truck loading facilities and 36 refined product terminals with an aggregate storage capacity of 6.2 million barrels.
We like the simple strategy of the logistics business: generate stable cash flows, increase pipeline and terminal throughput, pursue complementary strategic acquisitions and all the while improve operating efficiencies. SXL is not as acquisitive as Buckeye and has completed only five acquisitions in the last three years, but the company managed to grow 2008 revenues 36%, while net income almost doubled to $214 million. SXL has demonstrated pricing power, has enjoyed increased volumes within its Western pipeline system in 2008 and managed to decrease interest expenses.
The credit-worthy company has no trouble borrowing. SXL has a five-year $400 million credit facility and last month issued $175 million of 8.75% senior notes, due February, 2014. The company has increased its cash distributions each quarter during the last three years. In Q4 of 2008, SXL boosted its distribution to $0.990 per unit, a 13% annual increase in payout.
There are 28 million shares outstanding, with a mere16 million in the float. A full 42% of outstanding shares are held by insiders, which fully aligns management with shareholders. Only 28% is owned by institutions, which means a transfer of ownership from insiders to institutions is likely over time. This process would be very beneficial for the share price. We consider SXL one of the premier Consensus dividend plays.
TSR Timing Model
Our timing model is a purely mechanical system that follows the momentum of the NASDAQ Composite index. The table below shows the triggers that would cause the investment level to change. Please note that our Model Portfolios are not affected by the Timing Model. The Models are always 100% invested.
Last Changes: On 3/23/09, The Timing Model went from +175% invested to +200% invested.
Current level is +200% invested.
Triggers for Increases or Decreases in Model's Investment Level Investment Level will go to:
First Upside Trigger: A new close at or above Nasdaq 1607.2 +200% (Maximum level)
Second Upside Trigger: A new close at or above Nasdaq 1645.2 +200% (Maximum level)
Downside Reversal Trigger: A closing price in the Nasdaq that is 6% below the highest intraday level since 3/25/2009. Note that this trigger cannot be anticipated as new highs in the market would continue to raise this reversal trigger. In the event of a reversal, the Model will decrease its investment level to -25% invested. Each additional 3% decrease in the Nasdaq would cause the model to decrease its investment level in 25 percentage point increments. If a reversal is in turn reversed again before it is "confirmed" by another 3% move in the same direction, then the second reversal returns the model to the same position as before the first reversal -25%
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