Barry Ritholz has a very interesting column today at the Big Picture.  His main thesis is that if someone who has a ton of money (namely Mark Cuban in this example) makes a call that the stock market is going to tank, it is probably for the better that you are on the other side of that trade.  Ritholz freely admits that he is in a large cash position right now, but outright worries about it while wondering aloud wrt the Recency Effect:

I don’t doubt the business acumen of either of these gentlemen; Each is wildly successful in their chosen fields. However, I cannot help but note that neither of their fields involve analyzing the data that goes into determining economic or market collapses. Indeed, it smells more like a case of Recency effect than anything else.

Note that I am not talking my book: We have been mostly cash since May 5th (as much as 100% then, 50% cash in June). We are now over 80% cash, and are looking for a move down towards 950 on the SPX. So what both of these commentators are saying actually matches both our positioning and our perspectives (as well as this AM’s futures).

What I am pointing out is the unusual perspective of two businessmen discussing a crash that is so far outside of their expertise, following a 55% drop from the market top, and a 16% drop from the April highs. Perspectives such as this would be more valuable before, rather than after, a huge crash. (We will revisit this in 6 months).

It reminds me in some small part of the parade of sports figures and celebs on CNBC in late 1999 discussing their equity trades, or the Playboy bunny turned RE Agent in 2005 (also on TV) just as that market peaked. These were all late cycle momentum calls, as opposed to insightful analysis based on new data, fresh perspectives, or creative research.

I doubt this rises to the level of full contrary indicator, but it makes me nervous to be on the same side of the trade of what can be described as “scared” or “dumb” money.

Oddly, I base a lot of my market research on contrarian indicators and it appears Ritholz (who is a baller to be sure, unlike me) does as well.  Most of my contrarian indicators consist of me hearing someone who I think to be a dunce (Paul Kru#man, Mark Cuban, others) and going the opposite way.  Yes, this is simple and is certainly not a recommended way to invest as opposed to thoughtful research, but it works for me.

The short answer is, not too well. The average of the six stocks had a dividend yield of 2.4%, and an overall performance (after factoring in dividends) of -2.4%. For the market as a whole (I used the Vanguard Total Stock market ETF as a proxy, and the SPY S&P 500 ETF gave virtually the same result) there was a yield of 2.2%, and an overall return of 9.6% including dividends. Thus my picks under-performed the market by 12%. Gulp.

Here is the data. I used the yahoo closing prices on that day with their historical data and also by selecting “dividends” only you can quickly determine the dividends paid out during this period.

This year wasn’t a great year, and I hope to do better in 2010. Some (slightly) mitigating factors are that no one picked Adobe for their portfolio, which became embroiled in a big battle with Apple over the iPad. That one was the biggest stinker of my picks.

We will keep monitoring the trend; if I keep under-performing perhaps I will move to ETF’s, although there are other down sides to this which is that they are really a black-box and you don’t learn much about particular stocks and businesses nor the types of drivers that move a stock price. Overall my track record on the longer portfolios is good, but once again I am open to changes in the longer term. For each of the trust funds the return on THEIR invested capital (since they put in $500 and I put in $1000 if they get the full match) is far higher in all circumstances, so the kids are doing fine relative to what they invested.

Given that I want to teach about investing, my goal is to make it simple; we pick stocks.  I realize that a 100% stock portfolio isn’t balanced and there is much research that says that individual stock pickers can’t beat the market (most of my personal money is in ETF passive stock indexes) but since this is not intended to be the primary wealth building vehicle for my nieces and nephews but more of an informed assistance in getting their life started I am sticking with this method.  Dan has joined the blog and since he has helpful comments I wanted to put my preliminary list out for some comments before I cull it down to six.

During the year I track major themes that I want to include in portfolios each year, and then stocks that fit under those themes.  I also want to provide a variety of options in terms of industries, countries, currencies and (ideally) size of companies.  Since my time horizon is 18 months plus I don’t want to pick smaller capitalization companies subject to wide variations; this is my preference; but I don’t want just all giants, either.  For foreign companies I only take those that have US based ADR’s to ease investing challenges.  I also don’t try to “chase” performance, I would rather buy on reasonable valuations or a stock that seems to be a bit “beaten down” recently.

Foreign Companies:

• VALE (VALE) – Brazilian mining giant, able to take advantage of overseas mining opportunities in continents like Africa that US / European companies cannot because of corruption or political reasons
• LG Display Company (LGL) – subsidiary of Korean giant LG maker of flat panel displays taking a bigger chunk of that market and poised for future growth
• ABB (ABB) – Swiss engineering company denominated in strong Swiss Franc and positioned for world wide expansion of infrastructure business tied to growth in developing nations
• UBS (UBS) – Giant Swiss bank on upswing after various crises also denominated in Swiss Franc
• Canadian Imperial Bank of Commerce (CM) – Canada has a balanced, well run economy and a good currency and this is a way to play the entire country.  Their banks were not subject to the same boom / bust as US / European banks
• ENI (E) – Italian energy giant also poised to do well overseas, likely oversold due to Euro crisis
• Hitachi (HIT) – Japanese technology firm with strong position across a range of areas, including storage which is growing rapidly, also in yen
• CNOOC (CEO) – Giant Chinese oil company poised for future growth and overseas deals

US Companies:

• Oracle (ORCL) – strong technology company poised to battle Google and other firms and well run financially
• Bristol Meyers Squibb (BMY) – well run pharmaceutical company with a high dividend
• MDU Resources (MDU) – well run, smaller diversified utility and energy company out of North Dakota with high dividend
• MGE Energy Inc (MGEE) – a smaller utility based out of Madison, Wisconsin with a high dividend and takeover potential (to be acquired)
• Alcoa (AA) – US based metals company that is efficient and seems reasonably priced and poised to participate in a future upturn in the economy
• Verizon (VZ) – US cellular and land line company, huge dividends, seem to be reasonably well run not making stupid acquisitions and giving back money to shareholders
• Hewlett-Packard (HPQ) – a well run technology company that has new disciplined management put in by Hurd, their CEO recently forced out.  Seems like stock has been overly hit due to this change and they can still stay his same course
• Schlumberger Limited (SLB) – oil field servicing company poised to grow as foreign countries drill for their own resources rather than contracting with major companies; also poised to survive outcome of BP spill.  This type of drilling is not going away but now beaten down
• DuPont (DD) – Chemical company with strong dividend and well run

I am going to cull this list down to six probably 1/2 US and 1/2 overseas and looking for any input from Dan or informed commenters.  Sadly this doesn’t include the thousands of spam commenters caught by Askimet.

With Treasury bond yields at or near historically low levels on one hand but with commodity prices near 8 month highs, and with the personal feeling that outside of a home, a computer and a flat screen tv, the cost of living seems to only go higher on the other hand, here is another perspective on the inflation/deflation debate. Since June 1981 when Volker started to lower interest rates from 20% as high inflation rates started to fall, the absolute level of CPI rose 142% to the high in July ‘08 (90.5 to 217). Deflation is defined as a decrease in the general price level of goods and services but to quantify the current fall in prices, the CPI has fallen just 1% from its all time high. This tiny price move, notwithstanding we are still near an all time high in the daily cost of living, has led to talk that the Fed needs to do more to avoid deflation at all costs and thus create inflation via more QE. An example, oil goes from $50 to $85 in one year and the next year falls 1% to $84.15 and we’re told there is deflation and deflation is bad.

The view is that with excess capacity and a lack of demand combining for softer prices, we must have even lower interest rates to spur more borrowing and thus more economic activity to increase demand and thus reduce the large output gap. Think about this, policy makers think we should raise the cost of goods and services in order to cure a lack of demand. The law of supply and demand says lower demand must be met by lower prices in order to get to the proper equilibrium. What the Fed really wants to do is create inflation in order to not deal with an overleveraged economy in the most responsible way, either paying debt off or writing it down. They want us to pay off the debts with inflation. Inflation is a hidden tax on every single one of us and thus the corollary is deflation is a tax cut. Inflation is good for those who are highly indebted as those debts get paid back with inflated money while deflation or flat prices are good for those who save and have little debt and vice versa.

In the state of deleveraging the US is in where the low cost of money doesn’t matter much to an individual or a business in making spending and investment decisions, artificially low rates mostly spurs just refinancing and higher commodity prices. While maybe or maybe not higher commodity prices makes there way into government consumer price statistics, the commodity inflation is still there and has to be eaten by someone. Food for thought.

I put one part in bold because I just refinanced my house.  I have a fifteen year mortgage with about 9 left on it, and the rate went from 4.875% down to 4%, with very little closing fees.  My bank was even nice enough to let me fold the fees into the mortgage.  I saved $3800 by doing nothing more than signing some papers.  Not having a large amount of debt and being a fanatical saver I am staunchly in the deflation camp on a personal level.  Cash is already king and will be even a bigger king in the future.

But I am afraid the books are cooked.  The Fed is going to gerrymander this game until we get inflation whether we like it or not, which is good for those who are in debt up to their ears since future dollars are going to be worth less, and they get what amounts to a big tax break.  It makes me feel like a sucker at times for doing things right, and beating down my personal debt to zero within a few years.  Think of it like this – why am I paying for things now like my mortgage when I could pay the mortgage in the future with cheaper dollars?  It makes me mad.

But I was always taught that it was right to own things and get out from under the debt trap, so that is what I do, in a fanatical way.  And if we get deflation like we are supposed to, I will be the king of the mountain.

On an unrelated note, pork bellies are soaring and are around all time highs.  This means bacon lovers will be paying more in the future.  I am lucky that I contract with a local farmer for a whole pig a year and have a large stock of wonderful bacon in my freezer.  The theory is that a lot of the large producers cut their herds of pigs in the economic downturn and the lack of supply/inventory is pushing the price up.

Yield and Interest Income

Right now there is little yield available.  Interest rates in the US are very low and the “risk premium” received for taking on more risk is not high relative to returns.  At one point the risk premium on lower rated debt was very high (in 2008-9 during the height of the fiscal crisis) but now it is only a couple of points over Treasuries for comparable maturities which isn’t worth it, in my opinion.  Per the latest:

• 10 year treasuries 3%
• equivalent corporates 4%
• High yield 7.4%

Basically they are paying you only 1% more than what you’d get risk free for high quality corporates that still have a risk of default and then 4.4% more (pre-tax, meaning after tax about 3% more) for taking higher risk debt.  To put the “absolute” dollar amount in perspective, if you put in $100,000, you’d make $3,000 risk free with CD’s and then you’d make $4,000 with principal risk for corporates, and after tax the difference between the two is even less.  Why bother?

Picking stocks based on dividend yield is risky.  For one thing, stocks with a high yield (> 5%, for instance) tend to be paying out dividends at unsustainable rates, and when the dividend is cut, the stock price tumbles.  Examples of this from my portfolio include GE (since sold) and Nokia (likely soon to be sold).  Stocks with high dividend payouts are often valued by some investors on the stream of income, so that any “hit” to the dividend brings a disproportionate reduction in stock prices.  For other types of investors, dividends are one component of the valuation stream (along with potential appreciation in the stock price itself) so a hit to the dividend, while bad, won’t lead to a price free-fall.

Dividends currently receive a more favorable tax treatment than interest income from a bond.  Bond income is taxed as ordinary income (the highest rates), unless you are buying municipal bonds, which are an entirely different topic.  Dividends are taxed at a lower rate because they are already taxed at the corporate level, so taxing them again heavily when paid to investors essentially amounts to double taxation.  Dividends are currently taxed at 15%, while regular tax rates on interest income can go as high as 35%.  There is a lot of talk about letting these dividend rates lapse for personal taxpayers, however, in 2011 which would significantly reduce the value of these payouts and potentially impact behavior of corporations (who can often choose to do stock buy-backs which don’t have the same tax disadvantages), as well as likely pummeling the value of heavy dividend paying stocks. No one knows what is going to happen with tax policy; as I wrote here NO ONE thought that the US government would let the estate tax totally lapse in 2010, but it did.

Thus while you can view interest bearing bonds and dividend paying stocks as “equivalents” from a yield perspective, the stocks are MUCH more likely to fluctuate in value. Stocks can easily move 3% – 5% in a single day; bonds rarely move that much. Your “yield premium” from investing in a stock vs. a bond could be wiped out in ONE DAY due to a move in the stock price itself. Thus ideally you’d want a decent yield with the hope of price appreciation (or at least only a limited downside on price).

Utility Stocks

One possible substitute for bonds are utility stocks. I did a stock screener at google finance for utility stocks that were paying dividends between 3% and 7% with a reasonable sized market cap of > $1B, and a price / earnings or PE ratio of less than 12. In laymans terms I am looking for stocks paying a high but not unreasonable dividend yield, that were large enough that their stocks would be relatively more stable, and that weren’t over-priced relative to their profitability. Another item I was looking for was a lack of price appreciation over the last year or so; I don’t want to buy a stock that has had a big run up in value if I am looking for a dividend payer.

Out of this list came some reasonable candidates for review (I am excluding the foreign companies), including:

• Ameren
• First Energy
• Exelon
• UniSource Energy
• Public Service Enterprise Group
• Next Era Energy
• Cleco

I will start to review these companies as potential candidates for the stock selection and for maybe my own “yield portfolio” that I’d put some money into relative to CD’s (not a huge percentage, but a decent start).

Some factors I will be looking at, besides the unique characteristics of each company, include the new EPA rule-making authority on emissions, which could require these companies to shutter older coal burning plants or retrofit them with expensive scrubbers, as well as trying to guess on whether the dividend reduction will be repealed.

Stocks are a big part of any portfolio.  But they can’t be the end all - I don’t care how diverse you are in choosing those stocks.  To that end, I try to find other types of investments so not only am I diverse in the companies that I invest in, I am diverse in the instruments I use.  A few of these instruments are corporate paper, preferred stocks, and convertibles.

Back in Dec. 09, my financial advisor turned me on to FPRS, or the long legal name of Ford Motor Company Capital Trust 2.  I bought a block.

So what is it?  FPRS is a convertible preferred.  Here is the skinny:

FprS can be converted into 2.8249 Ford common shares any time before January 15, 2032.  It pays a $3.25 annual dividend per share.
It can be called by Ford at par value ($50) any time before January 15, 2032.  On January 15, 2032 it will be redeemed at par value for $50.

So this thing has a lot of characteristics of bonds and stocks, with the caveat that it is a preferred and a convertible - if there are dividends to be paid, this has priority over the common.  And in the grand pecking order in case of bk, you are after the paper but ahead of the common. 

Ford hasn’t paid a dividend for a long time - FPRS was about a year and a half in arrears.  If Ford suspends their dividend, the dividend payments on FPRS go into arrears, and it gets paid before any of the common gets a taste of any dividend.  And not only does FPRS get paid, it gets paid ALL of the missed payments.  I got paid today by Carl’s hero Alan Mullaly, king of the debt cramdown to the tune of $5.08/share.

The current share price for Ford is $11.86, making FPRS worth $33.50 if you decide to convert it to common.  My original block was bought for $35.44 so I am almost even as far as redemption value goes on that.  I doubled down yesterday at $43.74.  At the $35.44, my dividend payment gave me a 9.17% yield – but remember that I bought these in Dec. 09, so I got a full year of dividends in arrears for free.  Nice.  The current $43.74 price puts the yield at 7.4%, still great.  The key here is the $50 call – I have a sneaky feeling that Ford will be calling these pretty soon to keep retiring debt and I believe others are thinking the same thing as the price is heading close to that $50 mark.  Either way I am a winner as I am really in it for the yield.  Of course the previously mentioned yields are pre-tax.

I have used a simple buy and hold strategy with this thing, but you could certainly lever it with a convertible hedge strategy - but the price is getting pretty high and a convertible hedge is a pretty complex strategy for what we are trying to preach here (although I like it since it is market neutral).

Now, of course, this thing has risks, such as Ford could go TU at any moment - which is what GM and Chrysler did before they got on the federal teat.  I guarantee the GM and Chrysler bondholders and common holders (are there any left?) are hating those dogs right now.  Sometimes you need big stones when taking on the type of risk that Ford had back then – but no risk, no reward as the saying goes.  All the news from Ford has been pretty upbeat lately, and this has been a huge winner for me.  I think the F common isn’t a bad play right now either, but that is a different discussion.

Don’t ignore different types of investments in your portfolio for not only risk diversification, but asset diversification.  Preferreds and forms of them have been a major area of concentration for me in the past several years.

My method is this – I am going to let a computer pick stocks at random.  That is it.  I will track performance much more simply than Carl, by just using the initial purchase price – knowing that a) I don’t want to spend a ton of time on this and b) that both of us reading here understand that the actual performance would be a bit lower due to fees, etc.

I am thinking that in the end I will probably kick myself for not random investing sooner.

The Agricultural Bank of China is about to come out as an Initial Public Offering next week that will be one of the largest IPO’s of all time.  Per this article:

Hong Kong and China have dominated the global IPO market. That dominance will only increase when Agricultural Bank of China starts publicly trading next week.  In 2009, Hong Kong was the world’s largest IPO market, with companies raising a combined $32 billion in capital, according to Dealogic, a data-tracking firm. This year, China is on track to assume the mantle, with $31.7 billion raised by early July.

The Wall Street Journal had a recent article titled “How to Fix the IPO Market” by Jason Zweig.  I didn’t agree with their analysis or recommendations but the article did have a lot of useful facts and figures that illuminate the changes in the public markets in the United States, such as the following:

Ten years ago, around 9,100 companies filed annual proxy statements with the Securities and Exchange Commission. Last year, roughly 6,450 did; so far in 2010, only about 4,100 have, estimates Wharton Research Data Services.  In two-thirds of the years from 1960 through 1996, the number of initial public offerings exceeded the number of stocks that dropped out. Since then, however, there have been more deaths than births among stocks every year: 7,725 stocks have disappeared over that period, while just 4,299 new ones have arisen to replace them, according to Wharton.

What is happening is that existing companies are swallowing up smaller companies and other ones went bust during the market tumult.  New companies, however, haven’t joined them.  Recently there was a bit of a hoopla about a recent IPO for Tesla Motors, which raised $266M.  However, prospects for the car maker are cloudy and the stock has declined below its offering price since then.  If Tesla, a loss making niche enterprise is the future of our growth companies, we are in trouble.

The reason that this matters is that the entire “stocks outperform over the long run” is based on data from a few markets that haven’t suffered major disruptions (war, occupation) which pretty much brings you down to US and UK market data, mostly US data.  And this data was based on a continuous growth in companies launched through IPO’s with a growing market for companies; today the market for US based companies is small and much of the new and larger IPO’s are happening overseas.

There is nothing wrong with overseas markets growing; it is just that the US markets seemed to have stopped, and investor money (both US and foreign based) is going where the IPO’s are.  While we do not see the “full” effect of this trend, because many large multinationals are still US based and doing well, we will see it in the future as the newer companies don’t fill in the gaps and come through the ranks at some point in the future.

This doesn’t mean that I am saying that US markets will go up or go down as a result of this; I am just saying that the long term data was based on a premise that new companies would grow to replace the old (“creative destruction”) but in fact the new companies aren’t coming up in the footsteps. Perhaps stocks are best in the “long run” in aggregate across all markets but it may not be US based stocks if we just have aging companies and the young, growth companies are nurtured elsewhere.

Cross Posted at Chicago Boyz and LITGM

He recently came out with some sort of “another depression” deal in a column, and that was my signal to immediately jump in and buy stocks.  Pretty much everything PK says is wrong, so my intent is to go 180 degrees and do the exact opposite of what he predicts.

Barry Ribholz put up this post the other day that got me laughing.  It is about the Lex Team over at the FT.  Here is the money from the letter:

“Dear Investor,

It has been a profitable first half for Contrarian Partners. Our core investment strategy remains unchanged: to mine the research produced by investment banks every six months to establish consensus trading strategies. Then trade against them . . .

In general, though, the advice was reassuringly poor. The markets continue to reward us for listening to the experts – then doing the opposite.”

I don’t have access to the full letter since I don’t subscribe at FT (Maybe Carl can post) but all in all, this is probably a pretty good strategy.  Just like betting against PK, betting against big banks and their “research” can, I imagine, pay pretty good dividends.  Could they make any worse calls than in the last half decade or so?  I think not.