Sunday, July 29

Week 56 - What is Private Equity and Why Has It Become a Political Football?

Situation: Back in the day, the division of an Investment Bank that bought companies for a client was referred to as “Acquisitions.” Likewise, the division responsible for subsuming a newly purchased company into another company was called “Mergers.” Then, in the 1980s, we had Investment Banks that performed “leveraged buyouts” by using lots of borrowed money to accelerate the process. That fell into disfavor and has given way to a new nomenclature, “Private Equity,” where private investors take a company out of the public sector (its stock is no longer traded on an exchange) and into the private sector. Indeed, there no longer are any Investment Banks. The last two (Morgan Stanley and Goldman Sachs) converted their charters in 2008/09 to become government-regulated commercial banks.

The truth is that Private Equity does exactly what it says: Private investors buy up all the exchange-traded stock of a struggling public company, which removes that company from SEC (Securities & Exchange Commission) regulation. The purchased company no longer produces quarterly/annual reports, and the investing public no longer has access to its balance sheets, income statements, and statements of cash flows. Then a new management team tries to turn the company around by using its last remaining ammunition (cash flow) and adding lots of newly borrowed cash. If the company’s existing Business Plan is no longer considered viable, it is summarily terminated to make way for innovation, asset sales, and layoffs (“right-sizing”). The purpose of these drastic changes is to restore profits while preserving as many jobs as possible. This process was labeled “creative destruction” in a 1942 book by the late Joseph Schumpeter (1983-1950), the famous Harvard economist. While that excellent book is abstract theory, there is a new book that reveals the living, speaking faces of people who “creatively destroy” a plant and its equipment: “Punching Out: One Year in a Closing Auto Plant” by Paul Clemens (2012, ISBN: 978-0-385-52115-4). We recommend it.

Creative destruction is the ugly part of the story. The pretty part is that the new managers have the advantage of a fresh start, better pay, and more money to spend. The new managers are really no smarter than the old managers (who knew the company and its workers better), and given enough guts, focus, vision, innovation, and borrowed money, most of the original managers and workers probably could have kept their jobs--at least in theory. But does that ever actually happen? Rarely. Check out Ford Motor Company, which did accomplish it. In 2005, Chairman Bill Ford asked the Americas Division President (Mark Fields) to come up with a plan for downsizing and innovation. Mark Fields’ proposal, The Way Forward, was accepted by the Board of Directors in January of 2006. (It looked to be right out of the Private Equity toolkit.) In September of 2006, a new CEO, Alan Mulally, was brought in to execute the plan. He started everything rolling in a BIG way by mortgaging the entire company for $25B. He even mortgaged the logo! The rest is now history. Ford was the only major auto manufacturer that didn’t need a government bailout; it turned a $2.7B profit in 2009 and its retiree health benefit plan was fully funded by the end of 2010. Ford (F) now pays a 2.1% dividend (15% of estimated net income) and has an S&P credit rating of BB+.

Private Equity comes into play when the internal cash flow of a public company is no longer sufficient to maintain its property, plant, and equipment at a competitive level (let alone meet its payroll). The distressed company is said to be “burning cash”. Its stock and bond holders are giving up and selling out at a loss. The company is on the verge of declaring bankruptcy. In this scenario, Private Equity represents its last chance to survive. So, Private Equity is about securing a big loan to a) buy the company and b) make improvements in the company’s cash flow with the hope of taking it public in the future. The new management team often pays itself premium salaries because attractive compensation is thought to incentivize performance, and because they could soon be out of work in spite of their best efforts. (Remember what happened when Cerberus Capital Management took Chrysler private in 2007?) Officers of the newly reconstituted company also enjoy the advantage of less “friction”. For example, there are no time-consuming (and labor intensive) Sarbanes-Oxley reports to file. Nothing magical has been added to the mechanism for making the company’s new Business Plan effective but the glue & sand have been removed from the working gears and levers. How does that work? It works because borrowed money is used to tide the company over while new management fixes problems that had been obvious to old management for some time.

Private Equity was an opaque backwater of finance until the current political season turned “Bain” into a household word. Editorial coloration around that word has often shifted to the red end of the spectrum, suggesting that Bain Capital is doing The Devil’s Work. But the CEO of another finance company has suggested that Private Equity is “doing God’s Work.” Wherein does the truth lie? You’ll have to decide for yourself.

Bottom Line: There is nothing magical about Private Equity. Think of it as extra dollars being deployed by good managers who are trying to save a company by using an innovative new business plan (combined with the sale of outmoded assets), free from prying eyes looking to “see how the sausage is made.” It’s basically the same as Public Equity (where the success rate is about the same if you include government bailouts) but needed changes happen more quickly and quietly. This is something which pleases private investors and makes financing easier to obtain for companies in trouble. Private Equity has now become a political football because 
   a) layoffs happen faster and are often permanent,
   b) the new managers are paid well whether or not they save the company, and
   c) it happens outside the public sphere and SEC regulation.


Sunday, July 22

Week 55 - Canadian Commodity Producers

Situation: Let’s say you visited Canada 10 yrs ago and converted $1,000 USD into Canadian dollars (CDN) at the airport but then had to cut your trip short and returned without exchanging those bills. You get around to exchanging that currency now 10 yrs later and you receive ~$1500 USD for your CDN$. Feels like there must be a mistake, eh? Well there isn’t. You’ve been holding a currency that was issued by a commodity producing country. (You’d have done even better had you gone to Australia.) Net of fees, your initial $1,000 USD bought you $1,519 CDN on July 1, 2002 , which grew in value and were worth $1,545 USD on July 2, 2012, representing a total return of  4.1%/yr. That was your “reward” but there was also a “risk”: CDNs fell 21% in value relative to USDs during the 18 month “bear market” from 10/07 to 4/09. Therefore, the notional “Finance Value” of your investment (risk minus reward) was 4.1 minus 21, or approximately minus 17. If you check out the Table accompanying this week’s blog, you will see that’s quite good, and in the range of a good hedge fund (Week 46). Congratulations! You’ve just received a grade of “A” in your first class on how to invest (not speculate) in commodities.

“But,” you say, “wouldn’t I have done better by investing in a high quality, no-load natural resource mutual fund with a low expense ratio?” Perhaps, but then you would be speculating. Think about it. That fund would likely have been T Rowe Price’s New Era Fund, with a 9.1%/yr total return over the past 10 yrs. However, it lost 46.3% between 10/07 and 4/09 leaving a notional Finance Value of -37.2%. You could have made more money than our currency example but only if you hadn’t been scared into selling at the bottom of the bear market. Let’s try to do better using another example and check out our “Gold Standard” for stock performance in a commodity-related economy--the diversified Fidelity Canada Fund (FICDX). Total return was 11.3%/yr over the past 10 yrs but it also lost 44.9% during that 18 month bear market, for a Finance Value of -33.5%. By comparison, the Vanguard Admiral S&P 500 Index Fund (VFIAX) had a total return of 5.6%/yr but lost 41.5% during the bear market, for a Finance Value of -35.9%. Well-run hedge funds lost only 64% as much as the S&P 500 Index during the bear market so their Finance Values were in the -10 to -20% range. Blackrock’s Global Allocation A Fund (MDLOX) is a full-load mutual fund run by a company that specializes in hedge funds. We use MDLOX in our tables as a benchmark for hedge funds.

This week we’ll look at Canadian commodity producers and railroads (see the attached Table). The major companies are analyzed by S&P and co-listed on the New York Stock Exchange. NOTE: Imperial Oil, the leading oil & gas producer, isn’t listed in our Table because ExxonMobil (XOM) holds 69.6% of its stock; XOM is listed instead. Alcan, the largest aluminum producer in the world, also isn’t listed because it is now a wholly-owned subsidiary of an Australian company, Rio Tinto (RIO); RIO is listed instead.

Bottom Line: Companies that extract, develop, and transport commodities for end-markets are risky endeavors because lead times are long and fixed costs are massive. But it remains a worthwhile endeavor because those same markets reflect population growth, infrastructure investment, and improvements in standards of living. Canada has a long history and much experience in extracting and developing commodities, which has been funded mainly by its banks. The Toronto Stock Exchange and Ottawa government have also played leading roles. Indeed, the entire Canadian economy is permeated with a deep understanding of risk management. That is why there was no subprime crisis in Canada.


Sunday, July 15




   1) relentless growth in Tangible Book Value (TBV); 









Sunday, July 8

Week 53 - Commodity Producers in the S&P 100 Index

Situation: We’ve discussed commodity-related companies in broad strokes in a number of previous blogs (see Weeks 10, 20, 26, 34, 35, 40, 42, 45). In terms of Finance Value (Reward minus Risk) and prospective future reward vs. risk only 4 companies, Exxon Mobil (XOM), Chevron (CVX), Occidental Petroleum (OXY) and Hormel Foods (HRL) stand out. All 4 are already on our ITR Master List (see Week 52) of stocks recommended for DRIP investing. In this week's blog, we’ll try to determine which commodity producers have a chance to meet the qualifications for our Master List in the next few years. Given that risks relating to debt and cash flow tend to diminish as a company grows larger, and given that this blog is for risk-averse investors, we’ll begin our analysis with the largest companies which are also commodity producers, i.e., those found in the S&P 100 Index.

The accompanying Table lists 15 such commodity producers found in the S&P 100 Index. There are 12 petroleum-related companies, including 9 drillers (OXY, APC, CVX, APA, XOM, SLB, NOV, COP and BHI) and a pipeline company (WMB). There are also 2 that produce commodity chemicals (DD, DOW). There is only one mining company, Freeport-McMoRan (FCX), which produces copper, gold, and molybdenum. Monsanto (MON) produces genetically-engineered seeds and growth supplements for agriculture. Caterpillar (CAT) produces mining equipment as well as equipment used in agriculture and drilling. Three of the 15 are already on our ITR Master List (XOM, CVX and OXY), so we’ll sift through the remaining 12 companies looking for any that might to be able to join the Master List within the next 5-6 yrs. We see that one, MON, is almost ready. It only needs to increase its dividend yield from the current 1.5% up to the yield on the S&P 500 Index (currently 2.1%). Apache (APA) is attractive in most respects but would have to increase its dividend annually for another 8-9 yrs to qualify. 

Bottom Line: We like to invest in commodity producers because commodity prices usually keep up with both inflation and population growth. However, these companies have high fixed costs and long lead-times before investments pay off. There is often a sharp fall-off in revenues during recessions, the effect of which is compounded by the inability to raise prices. So you have to do a lot of research before buying stock in a commodity producer and have a lot of patience during recessions, before benefiting from their outperformance over time. Of the 15 commodity producers in the S&P 100 Index, only 4 appear to be suitable for a risk-averse portfolio of long-term investments: ExxonMobil, Chevron, Occidental Petroleum, and Monsanto.


Sunday, July 1

Week 52 - 2012 Master List (Quarterly Update)

Situation: Since the last quarterly update (Week 39), 11 companies have fallen off the ITR Master List: CNI, LOW, CB, JNJ, CHRW, MCD, NSC, PEP, PG, GPC, MKC. The stock price for Canadian National Railroad (CNI) has had good appreciation but less growth in its dividend, thus its dividend yield is no longer as high as that of the S&P 500 Index (2.1%). Lowe’s (LOW) and Chubb (CB) don’t meet our requirement for a 10% return on investment (ROI). The other 8 stocks have cash flow issues that are probably temporary and related to the economic crisis in the EuroZone.

Mission: To date, our blog has avoided analyzing or recommending derivatives, those financial instruments that bundle or otherwise capture the value of stocks, bonds, mortgages, rents, precious metals, collectibles, currencies, or fee income. Bond mutual funds are our only exception. For the 50% of assets we suggest you allocate to equities, we recommend you start with small amounts of a stock and add money to that position regularly (while automatically reinvesting dividends). That can be done at very low cost by using online dividend re-investment plans (DRIPs). The companies that we follow are those that:
   a) issue stock with an A- or better S&P rating,
   b) issue bonds with a BBB+ or better rating,
   c) have a dividend payout that equals or exceeds the dividend payout of the S&P 500 Index,
   d) have at least a 10 yr history of increasing their dividend annually.

For most companies, i.e., those that aren’t a state-regulated utility, we have additional requirements:
    e) no more than 45% of total capitalization comes from bonds (cf. pg 3 of the company’s S&P analysis),
    f) have a free cash flow (as defined by
wsjonline) that at least covers the current dividend, and
    g) have a return on investment (ROI) of at least 10% (cf. “stockfinder tool” at

The accompanying Table lists stocks in order of decreasing Finance Value (reward minus risk). We quantitate Finance Value as the annualized total return since 7/1/02 minus the 2007-09 “bear market” total return. Not surprisingly, the top half of the list (n = 11) has an average 5 yr Beta of 0.62 and the bottom half (n = 12) has a 5 yr Beta of 1.23. In other words, stocks in the bottom half move up or down in price twice as far as those in the top half in response to changes in the S&P 500 Index. This is a point we’ve tried to make in past blogs, i.e., that risk expresses itself as volatility. The main sources of risk are an over-reliance on debt financing and a fall-off in cash flow.

Five of those 11 companies in the top half were discussed  in our Stockpickers Secret Fishing Hole blog (Week 29) highlighting the Dow Jones Composite Index: Wal*Mart (WMT), NextEra Energy (NEE), Southern Company (SO), Chevron (CVX), and ExxonMobil (XOM). If you’re just getting started with long-term investing through regular additions to a DRIP, we recommend taking a close look at these companies. This will introduce you to our goal for retirement investing, which is to avoid uncertainty.

Bottom Line: Stock markets are going to be uninspiring (and sometimes scary) while the world is paying down its debts. In the meantime, enjoy dividend income that just keeps growing.
