Betting on M&A

I recently purchased Index IQ Merger Arbitrage ETF (ticker symbol: MNA).  I have written previously about the glut of cash on corporate balance sheets and would anticipate this cash to be used for share buybacks, increases in dividends, or possibly merger activity.  Merger activity has started to increase in recent weeks, most notably as HP and Dell continue to battle over 3PAR.

As opposed to traditional merger arbitrate hedge funds who long takeover targets and short the acquiring firms prior to an official announcement, MNA only purchases funds after a merger has been announced.  By doing this, MNA seeks to profit from the spread between the current stock price and the deal price.  The risk in doing this lies in the possibility that the deal falls through.  While this is always a risk, I think the risk might be less in the current environment.

More importantly, MNA is not highly correlated with more traditional asset classes, so this should lessen overall portfolio volatility.  The fund only has under $30M in AUM currently, so it will be interesting to see if this ETF is able to pick up steam in the coming months as M&A activity continues to pick up.

Who Will Fill Buffett's Shoes??

I thought this was an interesting video from Morningstar.  They presented a few options for people who might be in a position to take over once Warren Buffett decides to step down at Berkshire.



However, Buffett recently told the WSJ's Deal Journal that he plans to work past the age of 100, so retirement doesn't seem to be imminent.  This certainly seems to be the most likely scenario.  Intrade hasn't even started making a market for Buffett Retirement bets, so I would say the likelihood is low.

Week in Review

The week that was:

US stocks closed lower for the week as economic data showed weakening and joblessness rose.  Producer prices, announced on Tuesday, rose in the US thanks to the rising costs of raw materials.  This news should help soothe deflation fears to some extent.  The Labor Department reported on Thursday that weekly initial jobless claims came in at 500,000 for the first time since November 2009.  This new data marks a step backward in the jobs recovery as investors had hoped for claims to fall below 450,000.  In a healthy economy, initial claims average fewer than 400,000 per week.  Jobless claims are now up for three weeks in a row and four out of the last five.      

Japan’s GDP for the 2^nd quarter confirmed that China is the biggest economy in Asia and the second-largest in the world.  Japan’s GDP reading came in at $1.28 trillion, slightly less than $1.33 trillion for China.  Some experts say that China will replace the US as the world’s biggest economy by 2030. 

Stocks:

The S&P 500 fell 7.56 points this week, or 0.70%, to 1071.69.  The Nasdaq Composite rose 6.28 points, or 0.29%, to 2179.76.  The Dow Industrials fell 89.53 points, or 0.87%, to 10213.62.  The S&P is down 4.45% over the last two weeks.

• Intel Corp (INTC) said Thursday that it will buy McAfee (MFE) for about $7.7 billion in cash.  Interestingly enough, McAfee’s CFO was awarded thousands of stock units about two weeks ago, before MFE’s stock was bid up by the takeover premium.  INTC is down over 11% over the trailing month, while MFE is up over 55%. 
• Wal-Mart (WMT) said its second-quarter profit rose 3.6% as demand from Mexico and overseas markets carried the company’s growth while US spenders remain cautious.  WMT is down 6% year-to-date.

Bonds:

End of week bond yields:

6 Month yield = 0.17%, up 1 bps from last week.

2 Year yield = 0.49%, down 4 bps from last week.

3 Year yield = 0.77%, down 3 bps from last week.

10 Year yield = 2.61%, down 6 bps from last week.

30 Year yield = 3.66%, down 20 bps from last week.

• Treasury prices rose Friday, pushing short-term yields to new record lows and adding to weekly gains after Thursday’s surprisingly weak data that called into question the ability of the US to sustain a recovery.  The stocks of the Dow Jones Industrial Average are now paying a higher yield than 10-year Treasuries.  Many analysts are calling for bonds to be the next bubble to burst.  I have a feeling that Professor Fama would say that bonds are appropriately priced currently because people really want safe assets, and there is a shortage of safe assets so naturally their price is very high.
• Johnson & Johnson (JNJ), one of the few remaining AAA-rated companies, recently sold $1.1 billion of corporate bonds with record low interest rates of 2.95% for 10 years and 4.5% for 30 years.  What’s more interesting to me is that they were able to price 10-year bonds under 3% while the common stock pays a 3.6% dividend yield.

What to look for next week:

           

9:00 AM          Tuesday           Existing Home Sales

• Expected to have declined 4.3% since June

7:30 AM          Wednesday     Durable Goods Orders

8:15 AM          Friday              GDP

• Economists expect the US 2^nd quarter GDP figure to be revised down to 1.4% growth from 2.4%.

High Yield Bonds in a Slow Growth Economy

This article makes a strong case for high yield bonds in a slow growth economy:

Yet slowing growth is a far cry from a double dip—a key distinction for high-yield bonds, which have seen surging issuance in recent weeks and continued inflows from mutual-fund investors. Even tepid growth makes it likely that riskier companies will be able to continue making interest payments and sidestep default. Stocks, meanwhile, need far stronger growth to justify any price lift.

My choice for the high yield space is the Barclays High Yield SPDR (JNK).   While the fund is up over 7% over the trailing year, it still has room to run in my opinion.  The current yield is over 12% and the expense ratio is only 0.40%.  The average credit quality is B and the duration is 4.7.  For someone looking for exposure to high yield bonds, JNK is the way to go due to the diversification provided in the index structure.

Structural Unemployment

I had not heard structural unemployment theorized as a major cause for the current high unemployment rate, but this article presents a reasonable case.  In my opinion, current unemployment can be attributed modestly to structural factors.

As a reminder, structural unemployment is defined as unemployment arising from technical change such as automation, or from changes in the composition of output due to variations in the types of products people demand.  This runs counter to cyclical unemployment, which is defined as workers losing their jobs due to business cycle fluctuations in output, i.e. the normal up and down movements in the economy as it cycles through booms and recessions over time.

Happy 75th Birthday Social Security!!!

Good analysis of the Social Security system from the LA Times...

I'm only speaking in sentence fragments right now because it's 3 a.m. and I have to be up at 7 to catch a flight to Denver.

State of the corporate bond market

Interesting article from The Economist 

The article notes that the corporate-bond market has proved more resilient than feared.  US returns year-to-date are a decent 12% and have smoked the stock market.  However, we are starting to see spreads increasing.  Junk bond spreads have also widened and at 680 bps are at the widest levels in a month.

Week in Review

The week that was:

After eeking out a small gain on Monday, the markets stumbled throughout the rest of the week.  The sharpest drop came on Wednesday when all 30 Dow stocks feel, and volume was higher than normal.  Federal Reserve officials announced on Tuesday that they will reinvest principal payments on mortgage bonds into long-term US Treasuries in an effort to bolster the economy.  Take directly from the Fed statement:

“Information received since the Federal Open Market Committee (FOMC) met in June indicates that the pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.

To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities The Committee will continue to roll over the Federal Reserve's holdings of Treasury securities as they mature.” FOMC press statement, August 10.

The Fed cannot cut the funds rate any further so this is the next best option.

Stocks:

The S&P 500 fell 42.39 points this week, or 3.78%, to 1079.25.  The Nasdaq Composite fell 114.99 points, or 5.02%, to 2173.48.  The Dow Industrials fell 350.41 points, or 3.29%, to 10303.15.  This snaps a three week winning streak for the Dow.

• Dynegy (DYN) will be acquired by Blackstone Group (BX) in a deal valued at $4.7 billion.  The deal price of $4.50/share represents a premium of 62% for Dynegy shareholders.  However, Blackstone’s structuring of the deal should be applauded since they are putting no money down and coming away with an immediate $800 million profit.  They are paying $540 million to DYN shareholders and assuming the company’s $4 billion debt.  After the deal closes, Blackstone plans to sell Dynegy’s best natural gas plants for $1.36 billion to NRG Energy.  Once the Dynegy shareholders are paid off, that leaves about $800 million for Blackstone.
• Cisco (CSCO) reported a 79% jump in profit for its fourth quarter as sales of networking gear surged, but fell short of Wall Street’s expectations.  The stock was crushed this week and fell 11.26%.  Analysts are saying that this was CSCO’s worst earnings report in a decade. 
• Hewlett-Packard (HPQ) continued to reel from the departure of CEO Mark Hurd.  HP shares are 12.63% lower since this news was announced on Friday, August 6^th.  This represents over $10B in market cap.
• General Motors is preparing for the second biggest IPO in US history ($16 billion) after posting $1.3 billion in second quarter profit.  GM also announced that Dan Akerson will assume the CEO role as of September 1^st.

Bonds:

End of week bond yields:

2 Year yield = 0.53%, up 3 bps from last week.

3 Year yield = 0.80%, up 5 bps from last week.

5 Year yield = 1.45%, down 5 bps from last week.

10 Year yield = 2.67%, down 15 bps from last week.

30 Year yield = 3.86%, down 14 bps from last week.

What to look for next week:

           

7:30 AM          Tuesday           Housing Starts

7:30 AM          Tuesday           Producer Price Index

• Expected to fall for the third straight month

8:15 AM          Tuesday           Industrial Production

Walmart, Home Depot, Target, and Gap will report fiscal second-quarter results as earnings season nears the end.  These retailers are expected to post modest improvement in sales and earnings.

Working

I recently read Working by Studs Terkel.  This, or other Studs writing, is a must-read for anyone who calls him/herself a true Chicagoan.  Working was written in 1974 and as the subtitle implies is about People Talk About What They Do All Day and How They Feel About What They Do.  As I read the book, I constantly thought about 1974 Chicago and this era for my grandparents, who were residents of this city for most of their lives.  My grandfather owned and operated a vacuum cleaner repair business on the southside of the city at this time.  I wondered how he might have responded to Studs' queries about his work at that time, but I suspect he would say that he was motivated by his desire to fix things, help others, and provide for his family.

While I read the book, I also focused on the motivations of the stockbrokers that were profiled and tried to relate each of them to my own experience in a stockbrokering environment. It seems that there have not been fundamental changes in what motivates stockbrokers over the past 30 years. The first stockbroker, David Reed Glover, is motivated by a sense of responsibility to do right by his clients. He says, “when you’re dealing with an individual’s money, it’s a terrific responsibility.” The second stockbroker, Ray Wax, seems to be 100% driven by money and believes that the market is rigged in the favor of the major brokerage houses. He seems to be somewhat less ethical than Glover and less motivated to do the right thing for his clients. He comments that the ethics that he was forced to learn about the business is “all mumbo jumbo.” I have witnessed both of these motivations at work in my interactions with brokers and I could probably think of a Glover or Wax that I've encountered in my own work. Typically, it seems that brokers are motivated by some combination of money and a sense of doing right for their client. In my experience, it is a very rare case when one motivation severely dominates the other, especially in the case of responsibility trumping financial gain.

The University of Chicago Solution to the Immigration Problem

I haven't had the pleasure of taking a class with Professor Gary Becker yet, but I hope to at some point because he seems to have no shortage of interesting ideas.  His latest proposal is to create a market for US citizenship.

Read more here.

How much would you pay for US citizenship??

A Tale of Corporate Greed

A company can pay out $50 million in bonuses to executives during liquidation, but they can't pay the benefits they promised to retirees??

The full WSJ article is here.

How will Dodd-Frank impact GS??

Staying on the same topic of regulation, I read an insightful article in Forbes that explained why Goldman Sachs stands to benefit from the regulation.  With regard to derivative trading being moved onto exchanges in order to increase transparency, the article notes that:

But Goldman is welcoming the shift to the exchanges, because in a business where profits come from volume and speed of execution, Goldman tends to win. It proved that in foreign exchange, where until the early 1990s transactions were conducted mostly by facsimile machine and phone. As the action shifted to computers, bid-ask spreads narrowed, but transaction volume surged. Total North American forex volumes doubled between 2004 and 2010 to $754 billion a day, according to the New York Fed.

Financial Regulation

I heard Michael Barr speak at the Chicago Club yesterday.  Michael is currently Assistant Secretary for Financial Institutions at the Treasury.  In this role, he is responsible for developing and coordinating Treasury's policies on legislative and regulatory issues affecting financial institutions.  As part of his job, he has been touring around and giving talks about the Wall Street and consumer protection reforms in the Dodd-Frank Act, which President Obama signed into law a few weeks ago.

The Act, which has come in response to the turmoil in financial markets over the past few years, amounts to the most sweeping change to financial regulation in the US since the Great Depression.  Personally, I think that the Act certainly means well and may make a difference in areas such as whistleblowing, but I am always skeptical of overregulation.

Speaking of whistleblowing, here is a guide for What Not To Do When Blowing The Whistle.

How Much Is A CEO Worth?

Mark Hurd, now former CEO of HP, is apparently worth $10B.  Within minutes of HP disclosing his departure, the stock market value for Hewlett-Packard lost nearly that amount.  Hurd left amid allegations of unethical behavior.

The stock movement shouldn't be much of a surprise as HPQ stock has doubled since Hurd took the helm five years ago.  The market was obviously placing a lot of value in Hurd's ability to lead and navigate the company.  It will be interesting to see how the market responds to new leadership at HPQ.

Economic Outlook and Stock Picks

The US economy can often be characterized by the various forces at work, pulling in either direction.  At the present time, and much of the time, the strongest forces at work are the state of the consumer and the state of US companies.  One reason for current optimism is that US companies have enjoyed a strong earnings season with most companies beating estimates both on the top line (revenues) and the bottom line (net income).  Additionally, the consensus view is that corporate profits will increase by 35% next year.  One of the main reasons behind these strong results can be linked to a good amount of cost cutting by firms.  Unfortunately, firms have been sitting on these increasing amounts of cash instead of paying out higher dividends to shareholders or reinvesting the funds. 

Since these strong profits are not flowing through to the labor market or the broader economy, there are reasons to be concerned for the state of the US consumer.  Evidence continues to mount that the consumer, or roughly 70% of GDP, is in rough shape.  The biggest factor is most likely the 9.5% unemployment rate because this limits the availability of disposable income.  Consumer confidence readings continue to come in around 50.  (A reading around 100 is indicative of an expansionary economy).  Retail sales continue to decline as consumer savings rates increase.  Each of these factors, in addition to the looming withdrawal of fiscal stimulus, leads me to believe that the S&P 500 will likely be trading 10-15% lower, or under 1000, in the next six to twelve months.

Another concern stemming from the increasing inability of US policy makers to stimulate growth is disinflation, or eventually deflation.  Deflation, or falling prices, is painful because it makes businesses and consumers reluctant to spend and invest, further hurting profits and the economy.  Inflation has steadily fallen since the beginning of the year and is now at 1%.  Therefore the possibility of deflation is very real. 

Given cash-heavy corporate balance sheets and risks of deflation looming, I would suggest investing in companies with stable, or relatively certain, cash flows and the ability to increase dividends.  The rationale behind investing in these types of stocks is that the income is effectively worth more and more over time as prices fall because their cash flows and dividend payouts are relatively stable.  Three stocks that I would recommend holding during the current economic period are Eli Lilly & Company (LLY), PPL Corporation (PPL), and Paychex, Inc. (PAYX).  Each of these companies has a high dividend yield with the potential to grow dividends due to large amounts of cash on the balance sheet and should perform well regardless of whether the economy experiences deflation.

Eli Lilly and Co. is a leading maker of prescription drugs, offering a wide range of treatments for neurological disorders, diabetes, cancer, and other conditions.  Recently, the company has had a great deal of success in reducing operating costs by lowering marketing and administrative expenses.  This has led to strong near-term earnings growth.  The dividend is paid quarterly and is currently around 5.4%.  Cash and short-term investments currently comprise about 18% of total assets, which provides a large cash cushion and room for dividend growth or further investment in product development.

PPL Corporation (Pennsylvania Power & Light) is an energy and utility holding company with three operating segments:  the supply segment, the Pennsylvania delivery segment, and the international delivery segment.  The supply segment is involved in electricity generation and marketing of electricity and other power purchases to deregulated wholesale and retail markets.  The Pennsylvania delivery segment provides electric utility services in the regulated Pennsylvania market while the international delivery segment provides electric utility services overseas, mainly in the UK.  PPL’s dividend currently sits at 5.1%, and has increased at an 8% annual rate since 2005.  Cash flow from operations has doubled since 2002 while assets have grown only 42% so there is a significant amount of support for the dividend.  Additionally, PPL’s earnings mix is fairly diversified due to the geographic heterogeneity in operations. 
                       

Paychex, Inc. is a leading provider of payroll processing, human resources, and benefits services.  PAYX’s business success can be attributed to the low amount of capital required for operations and the company’s ability to capitalize on its competitive advantages.  One of the primary advantages of PAYX concerns high switching costs for customers since the cost of changing payroll processing vendors is a cumbersome task.  The company currently has no debt on its balance sheet and is able to generate strong cash flows that support the 4.8% dividend.           

What To Do With Commodity ETFs

Bloomberg Businessweek recently released this article which outlines the many risks to investing in Commodity ETFs.  The main risk/problem identified is contango, which is a market condition whereby contracts for future delivery of a commodity are more expensive than near-term contracts for the same commodity.  When ETF managers have to roll their contracts over, they are forced to buy the more expensive contacts.  Otherwise, they would have to take delivery of the commodity itself.  This process eats away at the ETF's value.

In order to invest in commodity ETFs, and honestly any security, you need to be aware of the risks.  In this case, contango is a large risk.  However, the article failed to mention anything about normal backwardation, which is the opposite of contango and works in an investor's favor.

Commodities are an area where I would possibly favor an actively managed fund over a passive index due to a manager's ability to navigate contango issues.  There are many mutual funds out there currently that do exactly this.  However there are no ETFs that actively manage commodities at this time (to the best of my knowledge).  There are a few in the pipeline, so look for those in the next few months.

The bottom line is to always be aware of your risks when investing.  Commodities can be a great way to diversify your portfolio and hedge against inflation, but be aware of the specific risks to this asset class.

Week in Review

The week that was:


US stocks ended July with significant gains even though figures released Friday show that economic growth slowed down in the second quarter. Earnings have come in strong for the second quarter. EPS of $19.26 on the S&P 500 so far this season are 42% higher than they were this time last year.



Stocks:


The S&P 500 fell 1.06 points this week, or 0.10%, to 1101.60. The Nasdaq Composite fell 14.77 points, or 0.65%, to 2254.70. The Dow Industrials rose 41.32 points, or 0.40%, to 10465.94. This was the largest monthly percentage gain for both the S&P and Dow since July 2009.

• Citigroup (C) will pay $75 million to settle a civil fraud charge brought by the SEC that the bank failed to disclose $40 billion in subprime exposure to investors.
• BP posted a record quarterly loss of $17 billion, the biggest in UK history, and selected Robert Dudley to replace Tony Hayward as CEO.

Bonds:


End of week bond yields:
3 Month yield = 0.12%, flat 0 bps from last week.
3 Year yield = 0.82%, down 12 bps from last week.
5 Year yield = 1.59%, down 14 bps from last week.
10 Year yield = 2.90%, down 9 bps from last week.
30 Year yield = 3.99%, down 3 bps from last week.




What to look for next week:


9:00 AM Monday ISM Manufacturing Index
7:30 AM Tuesday Personal Income and Outlays
7:30 AM Friday Employment Situation