Recent turmoil....what to do??

Events of the past few weeks have been unprecedented, and understandably make any investor very nervous....here are some ideas.......

• Initiate or add to positions in Berkshire Hathaway. There is simply no one better than Warren Buffett to navigate the next few years successfully. Berkshire's balance sheet at this point is better than the government's, and as the only AAA-rated company with significant liquidity, Buffett is in his element and can cherrypick assets like the recent buy of Constellation Energy, which was purchased for at a significant discount to book value.
• Gold stocks or ETF's should be a good hedge against a drop in the dollar, as the recent rescues will involve running the printing presses flat out. Some stocks include: Barrick Gold (ABX), AUY, Goldfields (GFI), Goldcorp (GG), Lihir Gold (LIHR), GSS, Newmont Mining (NEM), and an interesting ETF is GDX. Mining stocks moved significantly lower this summer when gold prices dropped (more on a % basis), but have since recovered. It is for this reason that mining stocks look somewhat more attractive than gold itself, which can be purchased thru the GLD ETF. Note that buying the GLD ETF is considered the same as owning a collectible, so the long term tax rate is higher, 28% vs. 15%. Finally, South African gold stocks are somewhat less attractive than those located elsewhere such as Canada or Indonesia, the reason is that production has been constrained the last year because of lack of power.
  

Otter Tail Corp. (OTTR)

Otter Tail is a utility but has made numerous investments in other fields, most recently in wind energy thru a subsidiary called DMI Industries, which manufactures wind towers. The stock is down 25% recently to about $30, but yields 4% with a good history of increasing dividends. OTTR completed a stock offering last week and is expected to invest in DMI.

Bill Gates thru his investment vehicle, Cascade Investment, owns almost 9%.

Master Limited Partnerships (MLP)

• Created in 1986
• Enterprises engaged in certain businesses, i.e. natural resources, energy, pipelines...designed to encourage infrastructure investment
• Investors are limited partners, allows use of depreciation to reduce taxable liability. Dividends are essentially tax free until MLP is sold.
  

http://www.dailywealth.com/archive/2008/jun/2008_jun_13.asp

They are not subject to swings in commodity prices, since business is based on pipeline usage and volume, and also tend to be recession-resistant, as domestic use of energy is always increasing. The best known MLP's are Enterprise Production Partners (EPD) and Kinder-Morgan (KMP), both yield over 7%, but stock prices have also done well over the last 10 years. Total return has far outpaced performance of the SP500.

Atlantic Power Corp (ATPWF or ATP-UN.TO)

Atlantic Power is an interesting company involved in the power generation business. It consists of what is known as a stapled unit, which is comprised of an underlying interest in sub debt and an underlying interest in common stock; these are known as an Income Deposit Security (IDS), or other similar type names like Income Participating Security (IPS).

Earnings were announced today and were very strong. Cash flow available for dividend distributions increased over 500%. Currently, APC distributes $0.0884 per month, for a current yield of over 13%.

Recently, APC also announced a buyback program to repurchase up to 8% of the public float of outstanding IPS's.

Ralcorp Holdings (RAH)

One trend that I think we will see is a reduction in expenditures by a stressed consumer on expenses such as casual dining. This should be beneficial for grocery stores, WalMart, and Costco, but also for Ralcorp, which is one of the leaders in private-label food brands.

In addition to cutting back on casual dining, consumers can also be expected to look for alternatives to name brands. Ralcorp is in a unique position to take advantage of this trend, and is a way for the investor to participate and also avoid the competitive grocery sector.

Safeway recently reported their latest quarterly earnings, which were below expectations, and noted that one reason was because sales of private-label goods was higher than expected.

P/E is modest at just 14, and stock is down about 20% over the last year, probably because of higher than expected input/commodity expenses, but these costs will eventually be passed on via higher prices and the current price of $54 appears to be a good entry point for the investor to take advantage of what looks to be a long term trend.

Chicago Tribune Article about Buffett & Berkshire

Today's Chicago Tribune has a nice article about Buffet's view on the economy and the short term prospects of insurance premiums and insurance company earnings. I think his most interesting comments are what he says about the risk of stagflation and his view that the economy may not recover within the next year.

This is a link to the article: http://www.chicagotribune.com/business/chi-mon-buffett-0707-jul07,0,6682432.story

Unitedhealth Group (UNH)

Unitedhealth Group provides health care services in the managed care sector, and has sold off around 50% since the beginning of the year and currently trades at $26/share, or a trailing P/E of about 7.5. UNH was involved in a stock options backdating scandal about two years ago that lead to the resignation of it's chairman.

Unitedhealth is currently ranked #2 in terms of membership and #1 in revenue, giving it considerable scale and leverage.

Current price is about a P/E of 9 of expected 2008 earnings, and valuation appears to be low enough to warrant establishment of an initial position. In addition, Warren Buffett of Berkshire Hathaway has been buying UNH, most recently in the April, 2008 timeframe, at higher prices.

TIPS substitute...floating rate preferred stocks

Earlier, I wrote about preferred stocks as an investment vehicle, however another way they can be used is as a substitute for TIPS, which are indexed to CPI and are considered a hedge against inflation. My big problem with TIPS is that the CPI is a poor index for inflation, since food and fule are excluded, and probably understates actual inflation by a significant amount. This means that any TIPS investor is losing money when they think they're protected.

An interesting substitute is floating rate preferred stocks, which are typically indexed to LIBOR. For example, Sallie Mae has a preferred B that yields LIBOR + .7% which resets in a few years to LIBOR + 1.7%. I think the reset is to encourage the preferred to be called, which is fine since this would represent a capital gain of almost 100%, based on the current price of $54 against the par value of $100. Obviously there is risk based on SLM but I think the exit of large competitors, the 'political' nature of student loans (they're not going away), and the focus on more profitable business with larger spreads means the preferred should do fine, since they are senior to the common stock.

Small regional banks.....

Times of distress usually yield good opportunities as even good companies fall prey to negative sentiment and trade at attractive levels. I thought it would be useful and interesting to being tracking a number of bank stocks, since they could become strong buy candidates over the next few months, similar to the opportunity presented by S&L's in the late 80's/early 90's. The general drop in the financial sector has led to significantly higher dividend yields, for example M&I yields almost 6%.

• Astoria Financial (AF)
• AmericanWest Bancorporation (AWBC)
• BB&T (BBT)
• Bank of Marin Bancorp (BMRC)
• Colonial Bancgroup (CNB)
• Century Bancorp (CNBKA)
• Evans Bancorp (EVBN)
• East West Bancorp (EWBC)
• First Horizon National (FHN)
• Farmers & Merchants Bank of Long Beach (FMBL.OB)
• Green Bankshares (GRNB)
• Hanmi Financial (HAFC)
• Hudson City Bancorp (HCBK)
• Investors Bancorp (ISBC)
• Lincoln Bancorp (LNCB)
• M&I Corporation (MI)
• Malaga Financial (MLGF.OB)
• People's United Financial (PBCT)
• Provident Bankshares (PBKS)
• Pulaski Financial (PULB)
• Sovereign Bancorp (SOV)
• Severn Bancorp (SVBI)
• West Coast Bancorp (WCBO)
• Wintrust Financial (WTFC)
  

Enterra Energy Trust (ENT)

An interesting special situation is a Canadian royalty trust, Enterra (ENT). It has sold off from over $20 a few years to around $1 earlier this year but has rallied sharply recently to $4.50. Previous management with conflicts of interest has been replaced, and assets sold to pay down debt. Remaining debt is expected to be restructured by 2Q/2008, with possible resumption of dividends by year end. 1Q report was very good with FFO up over 30%, and 2Q should be even better, given the rally in energy prices.

Book value is around $3.75, with most Canroys trading a 2-3x book ENT could trade at around $7-$10 by year end.

Wesco 2008 annual meeting

My wife and I began attending Charlie Munger's Wesco annual meeting last year, since I have relatives living in the area and since we were such big fans of Buffett's Berkshire Hathaway annual meetings. It's held in Pasadena, at the Pasadena Center, in a tent holding around 1000 attendees. The venue is similar, with microphones setup to allow anyone in the audience to ask a question. Munger kicked off the meeting with his own comments, which lasted about an hour. The session usually runs a few hours, from 2-5PM.


Below is a summary of some of Charlie's opening comments and answers:

• Berkshire Hathaway working model - Munger talked at length about how well Berkshire's version of the conglomerate model works so well and how no one else has been able to duplicate it. He reminded us that Berkshire only has 19 people in headquarters, and that the 'provinces' were kept happy without any envy or without retaliation against HQ. He mentioned GE as a company that also works well, but with much more central control and overhead.
• Derivatives - Munger definitely felt the use of derivatives was unnecessary, dangerous, and out of control. He felt the accounting industry was lax as well as the regulatory authorities. He thinks there will be a 'huge mess' and that the unwinding process will be very difficult.
• Investing returns - Munger thought it was amazing, 'hog heaven' as he phrased it, that returns had been so strong the last 25 years, especially with hedge funds/private equity, but did not feel it was sustainable, and thinks expected returns of around 4-5% are more likely.
• Management - He thought management at many financial firms had a tendency to follow the crowd and took unnecessary risks.
• Executive Compensation - Munger has felt for several years that executive compensation was excessive, and that executives should purposefully not fight for every last dollar.
• Berkshire Hathaway Earnings - Whitney Tilson got up to remark that at Berkshire's annual meeting how no one asked about the first quarter earnings, which had just been released the day before. Munger remarked that this was an example of the bond shareholders had with management, then went on to make some remarks about Berkshire's business.

Berkshire Hathaway 2008 annual meeting

This year's meeting had over 31,000 attendees, up from around 28,000 last year. The current site is essentially at capacity, and Buffett has hinted at other plans for next year, including the use of two sites.....

Each meeting begins with a humorous movie with a certain theme, this year's spoofed the primary campaigns, with Munger running for President. It also highlighted Buffett's interest in soap operas, with a guest appearance by Susan Lucci, as the supposed new CEO of Berkshire, with Buffett trading places with a new career on her soap. Past years have included appearances by Tiger Woods, Lebron James, and Arnold Schwarzenegger.

As usual, questions and topics were wider-ranging, since anyone can go to one of several microphones and everything is done live.

Some of the highlights include:

• Muni Bond Unit - Disclosure about the new bond insurance unit, Berkshire Hathaway Assurance, which in the first quarter wrote $400 million in premiums, very significant considering it's the first quarter of operation. Of interest was the fact that most of the deals already had insurance, from one of the existing players...a clear sign of lack of confidence in these supposedly AAA-rated entities. This is an excellent example of some of the opportunities Buffett is able to take advantage of.
• Credit Market Problems - Another example of how Buffett was able to take advantage of the recent turmoil was the auction-rate securities market. These are debt securities (often munis) whose rates are set weekly, at auction, with high penalty rates if there are no bidders. Berkshire accumulated as much as $4 billion worth at rates as high as 11%. He noted that the same security was priced at widely varying rates from week to week and that this reflected market inefficiencies, in contrast to the 'efficient market' hypotheses widely taught in business schools for over 25 years.
• Financial Markets - Several comments were made about all the problems in the financial markets earlier this year. Buffett and Munger agreed that Bear Stearns had to be saved, but were critical of the 'gestalt' of Wall Street, encompassing greed, overleverage, aggressive accounting, and poor risk management.
• Future returns - Buffett and Munger suggested investors not expect returns as high as seen in the past, confirming other comments made by them. They didn't give any specific numbers but somewhere in the range of 8-9% is likely.
• Other - Numerous other questions were answered, which contributed to the overall atmosphere....just to be present while Buffett and Munger shared their knowledge was such a privilege. These questions covered subjects such as whether Berkshire would consider buying the Chicago Cubs, how to grow oneself personally, recommended readings (Influence and Yes! by Cialdini)
  

ProShares UltraShort ETFs as portfolio hedges

ProShares first came out with UltraShort ETFs a little over a year ago. They're different from your normal 'short' ETF because they're geared to give you 2x the leverage. So if the index they're tracking is down 1%, the ETF will increase 2%. There are 2 in particular that track the financial sector, one, SKF, tracks the inverse of the Dow Jones U.S. Financials index, while SRS tracks the inverse of the Dow Jones U.S. Real Estate index.

They're ideal for hedging against other 'long' financial positions in your portfolio, or for removing the financial component from an index fund holding, for example.

They can be very volatile, though, so be sure you understand their behavior before making a commitment. Last year we used these to hedge holding of Berkshire Hathaway and Leucadia National, and effectively build our own long/short fund.

Closed end bond funds........

TCW has been adding mortgage backed securities to their funds the last few weeks and one attractive way to take advantage for the retail investor is by purchasing closed end bond funds. One possibility is TCW Strategic Income Fund, Inc. (TSI). Closing price 4/18 was 3.7, current yield over 8%, but best yet it's trading at a 13% discount.

Duckwall-Alco (DUCK)

Duckwall-ALCO is a discount retailer that operates 189 ALCO stores and 67 Duckwall stores in 21 states. They're usually located in small towns and so hopefully avoid direct competition with larger stores such as WalMart. In addition, since the farm community is doing well because of high commodity prices, there should be a trickle down effect to retailers. The stock price is down significantly from over 40 to 12, but book value is around $28. A 60% discount to book value seems far too high; also, a hedge fund called Strongbow has a significant position in DUCK.

Tech stocks.....

In general, I avoid techs, they always seem to have high P/E ratios and seem to have a narrow economic moat, where another company can leapfrog existing technology and products.

Companies like Apple and Amazon are very interesting, but not at P/E's of 50-100.

Two that look interesting are Microsoft (MSFT), altho I wonder about the Yahoo! merger bid, and Qualcomm (QCOM), whose P/E is around 20 but which has 72 insider sales.

I'm sure there are other techs out there worth considering and welcome any ideas.....

Preferred stocks preferred........

In general, I think it too early to buy in the financial and real estate (such as home builders) sectors, except for some of the preferred stocks available. For example, Sallie Mae, Fannie Mae, and Freddie Mac all have preferreds that yield at least 9%. Since these have the implicit guarantee of the federal gov't, and are senior to common stock, adding these to an IRA for example is worth considering.

Some mortgage REITs such as Annaly Mortgage, MFA, and Anworth also have preferred stocks, altho in these cases the common is attractive also. These REIT's invest in mortgages, but generally minimize credit risk in exchange for interest rate risk. They're all rallying because short term rates are dropping, increasing their rate spread. Annaly is considered the best, especially since their CEO correctly anticipated the problems seen last year in the 2006 annual report and in other communications.

Microsoft buys Yahoo!

Yahoo shareholders should go for this, since Yahoo doesn't seem capable of coming up with a sustainable business model, for example they had a ten year lead with their purchase of broadcast.com and geocities then let those properties languish and were passed up by recent startups such as YouTube, mySpace, and FaceBook.

Microsoft, on the other hand, might be overpaying somewhat; it would have been interesting to see an initial bid in the mid-20's.

Market Sentiment - Positive!?

A few indicators are actually looking pretty positive, in spite of the lack of followthru by the market in general:

• Corporate insiders are buying at high levels
• Newsletter sentiment is overly negative, according to Hulbert.

Other sentiment indicators are negative (and therefore positive) as well. So, the market looks likely to rally, altho I think it best to sell into these rallys, and use them as a way to fine tune and position your portfolio. Continue to underemphasize the financial and technology sectors. NASDAQ gains in 2007 were primarily driven by Apple, RIM, Amazon, and Google, and they all have interesting and solid businesses, but the simple fact is that P/E's got too high. Amazon for example last fall sold at a P/E of close to 100, very few if any stocks can sustain a P/E that high.

Energy Sector....

Oil prices seem to me to be at the high end, and likely to decline as the economy slows, possibly into a recession. While demand growth from China and India will help, I don't think they are at the point where they can compensate for a slowdown in the U.S. Consider selling to raise cash, or, since options premiums are high, writing covered calls. 2008 is a good year to realize capital gains anyway, since tax rates are likely to go up next year with a change in administration.

Natural gas companies are probably a somewhat better play, but even there industrial demand is a high proportion of demand compared to residential and can be expected to drop as the economy slows. In general, natural gas appears to be well-supplied....no hurricanes last year, and a relatively normal winter so far.

Hedge where you can (as above), companies with a pipeline component for example can be held, these include El Paso (EP), Williams Brothers (WMB), and Questar (STR). In addition, partnerships such as Enterprise Production Partners (EPD) and Kinder Morgan (KMP) aren't really affected by prices, and both yield over 6%.

Current View

Last year, I thought financials such as banks/brokerages were heading for trouble and that's exactly what happened. We held highly liquid positions such as Berkshire Hathaway and Leucadia National, but just in case hedged these positions with some of the new UltraShort ETF's, in particular the SRS and SKF ETF's. This worked well as both BH and Leucadia had significant gains as well as the ETF's.

Currently, it looks like the latest rate cuts will support financials but I think there are still a lot of problems to come. I would continue to underweight financials, but would add to Berkshire Hathaway, in particular. It's one of the few legitimate AAA-rated companies with $50B in liquidity (more with leverage) and Warren Buffett should do well investing in this environment.

Introduction

I've been investing for over thirty years, with a value-oriented focus. I don't restrict myself in any to a particular asset class, since the value equation can change over time. I'm hoping this blog will be a forum for sharing ideas from others with a similar investment philosophy.