deleveraging....it takes time

Lately quite a few folks have asked me about the economy (especially after the gyrations of the stock market), the truth is I have no clue what is in store for us.

However a few things are clear the western world over the last 20 years has eaten more than it can digest, be it mortgages, credit card, car and other consumer loans that we could not afford to pay. Offering cheap credit was a great solution to paper over all the real structural ill in the society primarily not investing in human capital (failing education, no focus on math, science, trade schools, high end manufacturing etc). People may have been unhappy with their minimum wage job, but as long as they had half a dozen credit cards, unregulated payday lenders…who cared. Well in 2008 the party ended, and the hangover has set it. Everyone has a lot of debt - households, governments and even banks. Let me be clear, we can and will resolve this, there is no doubt in my mind about that. There are three ways of lowering debt

a) pay it off

b) the creditor writes it of completely - bankruptcy, foreclosures etc.

c) the creditor takes a haircut - partial write down of the principal, payment plans etc.

Now all of the above a happening, but the key point is all this takes time. Probably the best evidence for how long these things take is based on history. In “This Time Is Different: Eight Centuries of Financial Folly” an amazing book by Carmen Reinhart and Kenneth Rogoff they talk about pretty much all kinds of past financial crisis.

Its clear based on history of such deleveraging events that it takes 8-10 years for the process to play out. So based on this I believe we’ll be treading water until 2016-2020, So basically we are looking at another lost decade as far as stock markets are concerned.

Also just a note its pretty much immaterial who wins elections etc. Democrats or Republicans they will tinker around the edges, bark louder than bite on Sunday morning talk shows and pretty much nothing will happen. The only solution is to wait out the deleveraging. Meanwhile here’s a great article on deleveraging from The Economist dated July 7th 2011.

Image via WikipediaShall we start buying?

In today's New York Times Op-Ed my hero Warren Buffett said he was buying stocks and advised us to buy American stocks. Let me be clear he does say clearly that he has no idea if we have hit the bottom yet and that he is looking at a minimum horizon of ten years, preferably more. My two cents would be as follows

• Buy good companies with strong economic moats i.e. virtual monopolies or companies that can extract a toll from customers regardless of the economy

• When you buy, don't go all in buy gradually that way you dollar cost your way if the market goes down further

So what can we buy?
Johnson & Johnson (JNJ) : Tylenol, Band Aids, Heart stents are not going away, if anything we may need more of these during such challenging times
Diageo (DEO): Johnny Walker, Smirnoff brands command loyalty and stickiness, this is the worlds largest alcohol seller with a world wide distribution and brand
The DOW 30 - thru the exchanges traded fund ticker "DIA" own the top 30 american companies in one swoop, lower risk.

A more risky play if the market comes down a lot is Visa (V) its a risky one, but the key point is that Visa is a toll booth, credit defaults dont harm them its the banks that issue the cards that bear the responsibility. I would buy this puppy if it fell below its IPO price of $44.

Weeks like this separate the men from the boys

The headline says it all. I loved to see the sell off in the market this week, such sell offs are healthy, prices come up and come down. The Valueline universe of 1800 stocks was at a p/e ratio of 19.6 when the week began. This is high, the long term average of past 15 years is somewhere around 17. Reversion to mean is a fact of life and markets are no different. Own good businesses and the stock will take care of itself.

Meanwhile Warren Buffet's annual letter came out yesterday as usual a super read, he was less scathing than usual about the excesses of Wall Street although does take on the high fees charged by hedge funds. He calls it the 2 and 20 crowd (2% management fees and 20%of the profits) . Mr. Buffet has been buying United Healthcare (NYSE : UNH) and Ingersoll-Rand (NYSE : IR), Here is the post on Industrial stocks and IR that I wrote about late last year.

Just finished reading Hedgehogging by Barton Biggs, its another great read. Talks all about hedge funds, the thing that struck me the most was the pressure that the managers feel to deliver. The fact that many funds get the 20% only if they beat an index and makes the point that 20% of zero is zero. Additionally most funds have a high water mark i.e. in the following year they have to first recoup the losses and then deliver. Another great read!!!

Performance of the 2006 picks

In this game performance is everything, if you cannot beat the market then why bother? Invest in a index fund, go home and sleep peacefully! But stockpickers inherently believe that markets are inefficient and greater than market returns can be achieved by picking stock using any number of philosophies, that is the heart of any debate between active versus passive investing. So how did we do, on the stocks we picked last year. Without further ado

We did extremely well with Sherwin Williams (NYSE : SHW) and Bausch (NYSE : BOL) both classic short term distress situations up 58% and 17% respectively. Plum Creek Timber (NYSE : PCL) was a nice winner too up 18% with a juicy 4% dividend.

On a time weighted average , to account for the in and outs and well as timing issues we came out a 17.5% in returns assuming equal weights. Lets hope for a even better 2007.

Fedex and Caterpillar were the two laggards although CAT was recommended only in Nov 2006. Although I beleive longer term (5 years +) both are keepers. My usual term for stock holdings is forever.

Top picks for 2007

Here we go with my top picks for the year and the reasons for them

Cummins Inc (NYSE : CMI) - Maker of generators and engines, low p/e around 8, cheap compared to its peers like Caterpillar. This is a gem that is trading cheap, do not get turned off by the high stock price. Price $116.75

Fedex (NYSE : FDX) - See my previous post, its trading cheaper to UPS and a great company. Price $108.86

Conoco Phillips (NYSE : COP) - Cheapest of all the oil giants, has a p/e of 6, hated by the market because of all the acquisitions and belief that they paid too much for Burlington Resources. Price $63.83

Taiwan ETF (NYSE : EWT) - Cheapest of all Asian markets, an indirect play on China. Worldclass companies like Hon Hai and TSMC. Price $14.46

Omega Healthcare Inc (NYSE : OHI) - This is a REIT that specializes in owning and financing of elder care facilities. They had some accounting issues last year but seem to have come out of it bruised but in good shape. Price $17.53

Limited Brands Inc (NYSE : LTD) - With brands like Victoria Secret, Bath and Body Works and others this company has built a strong economic moat (Warren Buffet's term). Limited trades at a p/e of 15, gives a decent dividend of 2.2%. Price $28.62

Cheers for a great 2007 - more to follow.
(Disclosure : I own OHI and plan to own all of the above, probably average into all of these during the next few months)

CAT in the doghouse?
Mea culpa for being persona non grata. I am making an early new year's resolution - a promise to update the blog regularly, atleast once a month.

The market in the meantime has been on a rip roaring ride. There are two aphorisms that come to mind, In a rising market everyone is a genius and a rising tide lifts all boats. So I suspect most stocks have done well, the key though is to beat the market and I will be doing a post mortem of all my picks and comparing them to the S&P 500 before the year ends.

Heavy machinery stocks have taken a huge beating while the market has been on a tear, mainly because these are cyclical industries and the US economy is slowing down, probably moderating is the right word.

One stock that is a fundamental value play is Caterpillar (NYSE : CAT). Caterpillar is being unfairly punished by the market it dropped almost 10% after last quarter's announcement. I believe it is a good buy based on the following
- on a strictly value analysis DCF the share price should be $68.00 (based on a Free Cash Flow growth rate of 8% for the next 10 years and 3% after that)
- the P/E ratio is 11-12x is below the historical norm of 14x
- although the residential construction is slowing down and the US economy is slowing down, this is being more than adequately compensated by international growth in mining and the China infrastructure boom, indeed today the company announced it was moving its Asia headquarters to Beijing from Tokyo. The 2008 Beijing Olympics should also give the construction boom in China a greater thrust.
- the company gives a 2% dividend

I believe that CAT will return a 12% gain over the next 12-18 months.
Since the stock is currently in Wall Street's dog house and probably will stay there for some time, it is probably wise to start buying in smaller blocks and lower your cost basis. (Disclaimer : I own CAT and plan to increase my holding)
Other industrials worth a look are Cummins (NYSE : CMI), and Ingersoll-Rand (NYSE : IR). Cummins is particularly interesting at a P/E of 9.5
All these three stocks CAT, CMI and IR are strong industrials, with great brands and economic moats, currently beaten down that are keepers. Even if you dont buy them make sure they are on your watchlist.

Seeing the forest for the trees

The market seems to have embraced the old axiom "sell in may and go away". But the fact remains that its a great time for finding valuable gems in these rough times. Lets start with a Trivia question : Name an investment class that has beaten the stock market consistently over the long term? a hint: the Harvard and Yale endowments invest hundreds of millions of dollars in this investment. The answer "Timber"

So is timber really that good of an investment and how can you and me own the asset without the hassles of cutting down trees and hauling lumber to the yard?

Firstly timber as an asset class that has beaten the stock market consistently. From 1973-2002, managed timber returned roughly 15% annually as an investment, while stocks returned about 11%. Timber like most commodities is uncorrelated to stocks. Trees don't know about the rising oil prices or interest rate hikes. And ever more imprortant in today's rising inflationary environment, the price of timber has consistently beaten inflation. We should think of a timber investment as a good inflation hedge. According to legendary investor Jeremy Grantham, over the last century, timber prices have risen at 3.3% above the rate of inflation. Add 5% a year in income, and you've got a timber investment asset that has returned double digits, competing with stocks over the long run.

Large endowments and funds have the luxury of owning timberlands or holding options on the timber output on acres of forests. Large corporations like International Paper and Wayerhauser own timberlands that they use as raw materials in paper manufacture and sell timber in the open market but there are two companies that stand out in this area Plum Creek Timber (NYSE:PCL) and Rayonier (NYSE:RYN)

Plum Creek Timber (NYSE:PCL) ($34) is a Real Estate Investment Trust (REIT) and the largest private landowner in the United States. They have about eight million acres of timberland under management. The company produces lumber, plywood and fiberboard at ten facilities in the Northwest. It has a $6.5B market cap and pays a dividend of 4.5%. Currently PCL has set an aggresive $400M share buyback plan and as a REIT enjoys all the favorable tax advantages. A more attractive company on a fundamental and technical basis is Rayonier (NYSE:RYN) ($36.8) also a REIT a slightly smaller one. RYN has about 2.4M acres under timberland in the United States, Australia and New Zeland. It also has the added benefit of a diversified a performance fiber unit, these fibers are used in tires, rayon yarns, paints, ink and even diapers. RYN had a great run this year hitting $47.50 but is down almost 20% at $36.85 and yields a attractive 5%.

On a technical basis both the stocks have broken down (blame the housing slowdown) and are likely to go down south even further. Reasons as follows:
- timber is a key material in housing construction.
- these companies have in the past sold land at high prices for housing development
- the resolution of the US-Canadian timber dispute is making Canadian timber competitive again

However it may be a good time to watch these two since both these companies are long term keepers for the follwoing reasons:
-high income yielding companies
-owning a tangible asset "timber"
-inflation hedge

I think an attractive entry point may be at the stocks 52 week lows PCL ($33.60) and RYN ($34), only if you want to hold on to these for 5 years or longer.