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Elliott Morss | February 21st, 2018

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Investment Strategies III – Specific Suggestions

© Elliott R. Morss, Ph.D.

Introduction

In earlier investment postings, I argued against using asset allocation techniques as a mechanism for diversification – all allocation categories have fallen 40% or more in the current market collapse. I also warned about staying on the sidelines too long: on average, the S&P has come back 32.8% in the first year of recovery (http://www.morssglobalfinance.com/investing-during-the-global-recession-and-beyond/). I also made a case for betting against the dollar, and finally, I pointed out that low corporate earnings will keep price/earnings ratios high for some time to come. I emphasize that these are only thoughts and not predictions: while I did not invest via Madoff, I did find my own ways to lose enormous sums of money over the last year (Ben Stein, NYT, December 26, 2008).

In this posting, I posit three time periods following the global credit freeze and offer my investment thoughts for each period.

I. Just After the Global Credit Freeze – Absolute Security

The global credit freeze caused panic; nobody knew what would happen, so absolute security was perfectly understandable. What did it mean? It meant that worldwide, most people thought there was very little chance the US government would default on its debt. So they bought US dollars (debt issued by the Federal Reserve) and Treasuries (debt issued by the US Treasury).

While there is lots of bad news still to come, things are calming down somewhat, and people are starting to realize they are not getting high returns on their US government debt.

II. Right Now – The Search for High Yields

For a time, bank CDs and money market accounts made sense – after all, the US government guarantees them. But rates have fallen: a 2% rate on liquid CDs or money market accounts is all you can get.

How about bonds? Without government guarantees, you have to find companies or government agencies that will not go bankrupt. But even if you do, I worry about bonds. Interest rates are not going lower. And as I have argued before and do again below, the dollar will probably weaken and interest rates will rise. And when that happens, bond prices will fall. But you might find some undervalued bonds or bond funds you like. I don’t buy bonds, so I don’t know.

I prefer equities paying high dividends. Buying these stocks also sets you up to earn capital gains when things get better. What you have to avoid here are dividend cuts and bankruptcies. So how do I find the good ones? I start by using a reasonably reliable financial database, such as the Morningstar Premium Screener (http://www.morningstar.com/Cover/Tools.html). An annual subscription costs $174 but I have found it well worth the money (a 2-week free trial is also available).

I then do a database search filtering on several fields at the same time. The filters allow me to select stocks:

  • that currently have a dividend yield between 4.5% and 15% (I exclude higher-yielding stocks because there has to be a problem with them);
  • that have payout ratios (dividends as a percent of net income) of 35% or less; having low payout ratios lessens the chance that a firm will cut its dividend;
  • that have earnings per share for the last 12 months are positive, another safeguard against a dividend cut.

I copy the results to a spreadsheet. I then eliminate the nonsense listings, e.g., companies with a dividend rate of 10% and zero payout ratios (no financial database is perfect). Here is what I got when I did this search a couple of days back.

Dividend

Payout

1-YR EPS

Market

Financial

Firm Ticker Industry

Yield

Ratio

% Increase

Cap

Rating

Teekay Tankers, Ltd. TNK Water Transport

19.17

32.81

2.99

325

C

Hopewell Holdings Ltd. HOWWY Money Mgmt.

17.31

26.58

126.71

2,374

A/S Steamship Company Torm TRMD Water Transport

16.29

18.35

235.29

640

C

Excel Maritime Carriers, Ltd. EXM Water Transport

13.54

9.72

172.44

395

D

Telemig Cellular Holding Compa TMB Telecom Svcs.

12.26

10.30

17.83

788

Himax Technologies, Inc. HIMX Semiconductor

11.38

30.56

46.15

554

City Bank CTBK Regional Banks

11.08

26.72

11.97

51

F

Continental AG CTTAY AutoParts

9.50

20.02

17.73

3,777

D

Paul Mueller Company MUEL Machinery

9.23

31.01

28.15

31

C

Preferred Bank PFBC Regional Banks

9.13

22.70

13.12

38

C

MicroFinancial, Inc. MFI Finance

8.77

31.51

57.14

32

C

Telenor ASA TELNY Telecom Svcs.

8.66

24.70

5.67

Insteel Industries, Inc. IIIN Steel/Iron

7.88

32.08

85.71

138

C

Lafarge LFRGY Building Materials

7.61

24.88

31.79

12,096

ARC Energy Trust AETUF Oil/Gas

7.46

23.60

4.60

3,106

Hong Kong Aircraft Engineering HKAEY Air Transport

7.32

34.33

26.72

1,447

KSW, Inc. KSW Building Materials

6.97

29.85

13.56

18

C

Huntsman Corporation HUN Chemicals

6.79

19.61

827.27

1,381

Banco Latinoamericano de Expor BLX International Banks

6.27

21.40

28.57

470

C

Russel Metals, Inc. RUSMF Metal Products

6.09

12.33

110.98

686

C

Baraboo Bancorp, Inc. BAOB Finance

5.87

33.18

6.78

39

C

Cathay Pacific Airways Ltd. CPCAY Air Transport

5.84

3.59

53.93

25,481

FNB-Dennison, Inc. FIDS Regional Banks

5.56

20.19

9.94

12

C

Olympic Steel ZEUS Steel/Iron

5.52

19.00

164.26

234

C

Vimpel-Communications VIP Wireless Svcs.

5.44

18.24

80.21

10,882

Brookfield Properties Corporation BPO Real Estate

5.43

31.28

31.03

3,027

C

Bank Bradesco BBD International Banks

5.24

10.69

43.47

40,818

Anglo American PLC AAUK Mining (Nonmetal)

5.15

28.08

16.33

31,800

Unilever PLC UL Food Mfg.

4.85

9.59

11.30

62,313

B

BASF SE BASFY Chemicals

4.74

32.60

30.61

37,203

C

Albany International Corporati AIN Machinery

4.72

18.50

323.33

305

C

Summit Bancshares, Inc. SMAL Finance

4.60

15.82

2.16

12

C

Rurban Financial Corporation RBNF Regional Banks

4.57

32.08

63.08

38

D

International Shipholding Corp ISH Water Transport

4.54

10.96

223.40

159

C

L.S. Starrett Company SCX Metal Products

4.52

34.45

64.00

70

C

BEO Bancorp, OR BEOB Regional Banks

4.50

20.83

59.04

9

Source: Morningstar.com

This is a good beginning list to work from. There are certain industries I will not touch, such as banking. The accounting games bankers are now playing makes it difficult understand what is really happening with them. I quote from Jim Welsh in a posting on John Mauldin’s “Outside the Box” newsletter:

Over the last week a number of banks have reported first quarter earnings, which was a pleasant surprise. Citigroup said it made $1.6 billion. One of the ways Citigroup achieved this gain was booking a profit of $2.7 billion on the decline in Citi’s own debt. Say what? Under accounting rules, Citi was allowed to book a one-time gain equivalent to the decline in its bonds because, in theory, it could buy back its debt cheaply and save $2.7 billion over time. Of course, Citi didn’t actually do that. Even though more consumer loans went bad in the first quarter, Citi reduced its loan loss reserve from $3.4 billion in the fourth quarter to $2.1 billion in the first quarter, thereby picking up another $1.3 billion of ‘earnings’. And the recent change in mark to market accounting enabled Citi to book an additional $413 million in ‘profit’ on impaired assets. Without theses one-time adjustments, Citi’s $1.6 billion in first quarter profit becomes a $2.8 billion loss.

For the companies that really interest me, I read their latest quarterly reports (10-Q) to the SEC (http://www.sec.gov/edgar.shtml). While no equity selection process is perfect, this approach will at least provides a reasonable universe of possible stock picks for whatever criteria you might want to use. And for now, I like stocks with high dividend yields.

III. Investment for the Longer Run

In my most recent investment posting (http://www.morssglobalfinance.com/investment-strategies-ii-%e2%80%93-the-dollar-and-corporate-profits/), I made the case against dollar denominated investments:

  • the demand for dollars as a “safe haven” will ebb;
  •  the massive US government deficits that have to be financed in the next two years will dramatically increase the supply of dollars on global markets, and
  • a reduced demand for dollars and an increased supply should cause the dollar value to fall.

On the second point, I quote John Mauldin from his weekly “Thoughts from the Frontline” newsletter (http://www.2000wave.com/article.asp?id=mwo050109). John is one of the best financial writers.

The Fed and the Obama administration are playing a dangerous game. The Fed is going to print trillions of dollars to forestall deflation and try to re-ignite the economy. But for a variety of reasons we will go into next week, a real, sustainable recovery may be a few years away. What happens when the market starts balking at high and unsustainable national deficits? What happens when inflation (finally) does return? Can the Fed remain independent and take back the money it is printing in the face of what will likely be a tepid recovery? And if they don’t, what happens to the dollar?

Next year, we will be entering what will certainly be the most dangerous era in my lifetime for the US economy. It is not clear what will happen.

In light of these troubling times, I have three thoughts on longer term investments which I discuss below under “Weakening Dollar”, “Commodities”, and “Emerging Markets” headings.

Weakening Dollar

Accept for the moment that I am correct: that the dollar’s value will fall. What should you do? You should minimize your dollar holdings by purchasing other assets such as real estate and commodities. You might also buy non-US assets such as foreign stocks and real estate.

Commodities

While most commodities are bought and sold in US dollars, their prices incorporate a weaker or stronger dollar. For example, a significant portion of the oil price increase of the previous few years was a direct result of a weaker dollar. So buying commodities is a way to benefit from a weaker dollar.

There is a second strong general reason for buying commodities: Western speculative money fed their price rises until the global credit freeze; then it pulled out, and commodity prices fell. At some point in the future, it will be back. In the meantime, the demand for certain commodities will continue to grow.

Which commodities? We know that over a five to ten year perspective, the global demand for food and energy are growing. Major energy fuels are coal, oil, and uranium. I don’t get excited about coal (high pollution, readily available), but investments in oil and uranium should pay off. On food, the global agricultural brokers (brokers always do better than farmers) and equipment suppliers should do well as global populations increase.

Oh, banks: banks are not commodities. But like commodities, they have dipped and will recover. As I have indicated in earlier posts, banking as traditionally practiced is a good business, and it is clear the government wants them to survive.

Emerging Markets

Over the last few decades, I have worked as an economic consultant and private investor in developing countries. When I started, things seemed grim and pretty hopeless. But I don’t feel that way any more. In particular, a number of countries have a growing urban middle class and just as in the West at an earlier time, this middle class has become “an engine for growth”. Admittedly, the Western credit mess has slowed growth in other nations. But I feel strongly that the growing urban middle class of these countries will bring their economies back more rapidly than Western nations.

What countries, regions?

  • Certainly China and all the other Southeast Asian nations that it “controls” financially. Some investors like India because it has a legal system that works. But I am not enthusiastic about India – it is a democracy and unlike China, it is difficult to “get things done” in India.
  • Most South American nations: while their growth rates are lower than those of China et al, they show steady growth, have a growing middle class, and unlike China, most of them are natural resource rich;
  • South Africa: Jane Jacobs was absolutely right when she said that cities and not nations are the engines of growth. And finally, major urban centers are starting to develop in Africa. The political reform that took place in South Africa was truly remarkable, and Johannesburg is emerging as the financial center of Africa. South Africa is also natural resource rich.

I am not taken with Russia and its satellite nations. Look at its history: from Tsars, Stalin, and now Putin, Russia has always been centrally controlled with no understanding or appreciation for free markets.

The Middle East? A dynamite keg ready to be ignited.

Investment Vehicles

Let me start with an example: suppose you invest US$100 in the stock market of an emerging market via a mutual fund, an ETF or directly. For the investment, your dollars first have to be converted into local currency. Assume the exchange rate is 5 local currency units for every dollar. Suppose the value of the US dollar falls to an exchange rate of 4.5 local currency units per dollar during the period of your investment. That would mean you get back $111.11 when you liquidate. In other words, you make money on the weakening of the dollar. This works as well with ADRs, because ADRs are legal claims on foreign equities. In short, by investing in the stock market of another country, you can make money if the dollar weakens. And I believe it will.

Above, I looked for individual high dividend stocks. I would not go the individual stock route for foreign equities. Company data is not as detailed or reliable as it is in the US. In addition, foreign stock markets are more subject to market manipulation than US markets. So no direct equity investments and no ADRs.

Two possibilities make sense: mutual funds and exchange traded funds (ETFs). Mutual funds have individuals picking stocks while ETFs are indices of one sort or another. ETFs have become increasingly popular, and you can get them for virtually any index you want: there are now 953 ETFs, and the number grows almost daily. ETF popularity is attributable to the fact that:

  • unlike mutual funds, you can buy and sell them like stocks;
  • they have lower management fees than funds, and
  • a very significant portion of mutual funds under perform the indices, e.g., for the five year period ending 2/28/2006, only 37% of American mutual funds outperformed the S&P 500.

But what if, for a sector that interests you, you can find a mutual fund that regularly outperforms the appropriate index? I have done the research and have found such funds. When looking, make sure that the fund manager (and I mean person and not management company) has been on the job for at least three years. But as mentioned above, funds are a nuisance to buy and sell. In particular, you get the closing price and you don’t know what that will be. So I still do the research and choose mutual funds only when they significantly outperform a comparable ETF. An example of the research I do is presented in the following table which pares down to the best mutual funds and ETFs just before the credit freeze – look at those returns and weep!

Fund Name

 3 Yr

5 Yr

Objective

Ticker

Type

Emerging Markets Overall

 

 

 

 

 

BLDRS Emerg Mkts 50 ADR

31.28

Diversified Emerg Mkts ADRE ETF
iShares MSCI Emerg Mkts

29.96

Diversified Emerg Mkts EEM ETF
Bernstein Emerging Markets

35.82

41.18

Diversified Emerg Mkts SNEMX M

 

 

 

 

 

 

Latin America

 

 

 

 

 

T. Rowe Price Latin Amer

49.61

34.07

Latin America PRLAX M
iShares SP Latin 40

45.10

31.05

Latin America ILF ETF
South Africa
iShares MSCI South Africa

29.50

South Africa EZA ETF
Asia
iShares MSCI ex-Japn

24.68

21.63

Asia EPP ETF
Matthews  Pacific Tiger

19.51

30.82

Asia MAPTX M
Guinness Atkinson Asia

26.45

34.82

Asia IASMX M

Source: Morningstar Principia and Don Dion’s ETF database

In terms of my time periods, where do I think we are now? I think we are still in II. The Search for High Yields, but I am definitely looking ahead to III.

If you took the time to read this and use a wealth manager or stock broker to manage your money, I have a suggestion: the next time he or she asks you to lunch, send along this posting and say you want to discuss it at lunch!

I am not an investment adviser and nothing I say should be taken as a recommendation to buy or sell an asset.

P.S. Some of you might have seen the letter by Cliff Asness the managing partner of AQR Capital Management that is copied below. I would like your thoughts on it to incorporate in a comment I will be making on the letter in my next posting. Please send any comments you might have to my e-mail address – elliott@morssglobalfinance.com and indicate whether I can use your name in quoting you.

The letter:

The President has just harshly castigated hedge fund managers for being unwilling to take his administration’s bid for their Chrysler bonds. He called them “speculators” who were “refusing to sacrifice like everyone else” and who wanted “to hold out for the prospect of an unjustified taxpayer-funded bailout.”

The responses of hedge fund managers have been, appropriately, outrage, but generally have been anonymous for fear of going on the record against a powerful President (an exception, though still in the form of a “group letter,” was the superb note from “The Committee of Chrysler Non-TARP Lenders,” some of the points of which I echo here, and a relatively few firms, like Oppenheimer, that have publicly defended themselves). Furthermore, one by one the managers and banks are said to be caving to the President’s wishes out of justifiable fear.

I run an approximately twenty billion dollar money management firm that offers hedge funds as well as public mutual funds and unhedged traditional investments. My company is not involved in the Chrysler situation, but I am still aghast at the President’s comments (of course, these are my own views, not those of my company). Furthermore, for some reason I was not born with the common sense to keep it to myself, though my title should more accurately be called “Not Afraid Enough” as I am indeed fearful writing this… It’s really a bad idea to speak out.

Angering the President is a mistake, and my views will annoy half my clients. I hope my clients will understand that I’m entitled to my voice and to speak it loudly, just as they are in this great country. I hope they will also like that I do not think I have the right to intentionally “sacrifice” their money without their permission.

Here’s a shock. When hedge funds, pension funds, mutual funds, and individuals, including very sweet grandmothers, lend their money they expect to get it back. However, they know, or should know, they take the risk of not being paid back. But if such a bad event happens, it usually does not result in a complete loss. A firm in bankruptcy still has assets. It’s not always a pretty process. Bankruptcy court is about figuring out how to most fairly divvy up the remaining assets based on who is owed what and whose contracts come first.

The process already has built-in partial protections for employees and pensions, and can set lenders’ contracts aside in order to help the company survive, all of which are the rules of the game lenders know before they lend. But, without this recovery process nobody would lend to risky borrowers. Essentially, lenders accept less than shareholders (means bonds return less than stocks) in good times only because they get more than shareholders in bad times.

The above is how it works in America, or how it’s supposed to work. The President and his team sought to avoid having Chrysler go through this process, proposing their own plan for re-organizing the company and partially paying off Chrysler’s creditors. Some bond holders thought this plan unfair. Specifically, they thought it unfairly favored the United Auto Workers, and unfairly paid bondholders less than they would get in bankruptcy court. So, they said no to the plan and decided, as is their right, to take their chances in the bankruptcy process. But, as his quotes above show, the President thought they were being unpatriotic or worse.

Let’s be clear, it is the job and obligation of all investment managers, including hedge fund managers, to get their clients the most return they can. They are allowed to be charitable with their own money, and many are spectacularly so, but if they give away their clients’ money to share in the “sacrifice”, they are stealing. Clients of hedge funds include, among others, pension funds of all kinds of workers, unionized and not.

The managers have a fiduciary obligation to look after their clients’ money as best they can, not to support the President, nor to oppose him, nor otherwise advance their personal political views. That’s how the system works. If you hired an investment professional and he could preserve more of your money in a financial disaster, but instead he decided to spend it on the UAW so you could “share in the sacrifice”, you would not be happy.

Let’s quickly review a few side issues.

The President’s attempted diktat takes money from bondholders and gives it to a labor union that delivers money and votes for him. Why is he not calling on his party to “sacrifice” some campaign contributions, and votes, for the greater good? Shaking down lenders for the benefit of political donors is recycled corruption and abuse of power.

Let’s also mention only in passing the irony of this same President begging hedge funds to borrow more to purchase other troubled securities. That he expects them to do so when he has already shown what happens if they ask for their money to be repaid fairly would be amusing if not so dangerous. That hedge funds might not participate in these programs because of fear of getting sucked into some toxic demagoguery that ends in arbitrary punishment for trying to work with the Treasury is distressing. Some useful programs, like those designed to help finance consumer loans, won’t work because of this irresponsible hectoring.

Last but not least, the President screaming that the hedge funds are looking for an unjustified taxpayer-funded bailout is the big lie writ large. Find me a hedge fund that has been bailed out. Find me a hedge fund, even a failed one, that has asked for one. In fact, it was only because hedge funds have not taken government funds that they could stand up to this bullying.

The TARP recipients had no choice but to go along. The hedge funds were singled out only because they are unpopular, not because they behaved any differently from any other ethical manager of other people’s money. The President’s comments here are backwards and libelous. Yet, somehow I don’t think the hedge funds will be following ACORN’s lead and trucking in a bunch of paid professional protesters soon. Hedge funds really need a community organizer.

This is America. We have a free enterprise system that has worked spectacularly for us for two hundred plus years. When it fails it fixes itself. Most importantly, it is not an owned lackey of the oval office to be scolded for disobedience by the President.

I am ready for my “personalized” tax rate now.

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