Sunday, November 28, 2010

The Consequences Of A Breakup In The Eurozone

One aspect of the problems impacting a number of the Eurozone countries is the fact these issues were not addressed in the formation of the Euro. A recent article in the Telegraph notes, in 1990, Commission economists advised the EMU some of the issues facing the EMU today needed to be addressed before implementation of a single currency. According to the Telegraph,
"[the EMU] was told too that currency unions do not eliminate risk: they merely switch it from currency risk to default risk. For that reason it was all the more important to have a workable mechanism for sovereign defaults and bondholder haircuts in place from the beginning, with clear rules to establish the proper pricing of that risk. But no, the EU masters would hear none of it. There could be no defaults, and no preparations were made or even permitted for such an entirely predictable outcome..."
An article in the Financial Times, Investors Must Try To Predict German Politics (registration required), provides some thought on potential outcomes if there is a breakup of the Euro.
"A sovereign debt crisis will naturally affect equities. Banks hold their governments’ bonds on the assumption they are virtually risk-free. Any change to that assumption could drastically worsen their financial position. A devaluation to the currency would reduce the value of companies’ domestic earnings to foreign investors and make it harder for them to finance foreign debt.

But it is startling to see the extent of the pain that international stock markets think eurozone-based companies must endure. According to MSCI indices, developed world stocks outside the eurozone are up 7.22 per cent. European stocks outside the eurozone are up 4.45 per cent. And yet eurozone stocks themselves are down 9.82 per cent. Even within the eurozone, there is a stark division. Germany’s stocks are up a decent 4.4 per cent, according to MSCI. All the zone’s other big markets are down terribly. It is not surprising that Spain or Greece are down – but note that France has fallen 8.5 per cent and Italy 19 per cent. This implies extreme bearishness about the prospects for everyone in the eurozone, bar Germany."
In the Guardian, the Dutch bank Ing, opines that a breakup would be far worse than the issues dealt with in the bankruptcy of Lehman Brothers.
"In a bleak assessment, entitled "quantifying the unthinkable", they warn that in the first year alone, so by the start of 2012, output would fall between 5% and 9% across various member states, while their new national currencies would fall by 50%....

On the basis of a euro break-up by the end of 2010, he warned: "In 2011 a deep recession across the eurozone emerges, dragging down the global economy. In the eurozone output falls range from -4% in Germany to -9% in Greece".

But he notes neighbouring European economies are also caught up in the chill, with GDP falling 3% in the UK and 5% in central and eastern Europe.

"While the US would be less adversely affected, the combination of lower global growth and a strongly appreciating US dollar would see it flirting with outright recession in 2011," Cliffe added."
Lastly, in a paper commissioned by European Parliament's Committee on Economic and Monetary Affairs, a number of proposals are put forth to address the issues in the Eurozone. Much of what is addressed are guidelines that should have been put in place prior to the introduction of the Euro. I suppose better late than never. The document does address the consequences of removing members from the EMU: primarily the contagion that might follow.

At the end of the day it seems Germany is being asked to finance the profligate ways of some of the smaller European countries. Does Germany have the desire to keep the Eurozone together at the potential expense of its own financial stability? A number of difficult decisions need to be made by countries on both sides of these issues. These issues will be more difficult than determining a European standard for electrical plugs.

Friday, November 26, 2010

Eurozone: Living Beyond Its Means And Implications For U.S.

If the U.S. looks at the issues facing a number of the Euro Zone countries, it is not too much of a stretch to say the U.S. could go down that same path. Certainly the U.S. economy is more diversified than those of the coutries that are encountering financing issues. However, much of what is occurring in a number of the Euro Zone countries is a result of countries living far beyond their means. In the U.S. we seem to be going down that same path. Recent government policies and entitlement growth are creating a situation where the public sector is absorbing more of the financial burden versus the private sector. Not only is there a large burden (that is, budget deficit) at the federal level, nearly every state in the U.S. is dealing with significant budget deficit issues. As the below chart shows, the U.S.budget deficit as a % of GDP and gross debt as a % of GDP is pretty close to some of the Euro Zone countries that have encountered financial difficulties.

Recent articles in the Wall Street Journal address some of the issues impacting Spain. The first article, Spain: A Quick By The Numbers, notes the folowing financial characteristics of that country. As the above chart shows, the U.S. debt and deficit is worse than Spain's. Additionally, the U-6 unemployment rate for October is 17% and not much better than Spain's.
  • The fourth-largest economy in the euro zone.
  • Deficit-to-GDP in 2009: 11.1% (Ireland is 14.4%. Greece is 15.4%)
  • Government spending as a percentage of GDP: 45.8%.
  • Government debt-to-GDP: 53.2%.
  • Unemployment rate: 19.8% in the third quarter. That is more than twice the European Union average, although the figure is down slightly from 20.9% in the second quarter.
The other article, Spain: What Are Its Funding Needs?, provides details on the magnitude of the debt that will be rolling over in Spain. The article concludes, and we agree, that these issues will be headline material in the financial press and thus impact market volatility for the near term.

Updated: November 27, 2010. Next Debt Crisis May Start in Washington: Bair

Thursday, November 25, 2010

David Einhorn Interview On WealthTrack

Consuelo Mack of WealthTrack interviews hedge fund manager David Einhorn of Greenlight Capital. Einhorn rarely gives television interviews; however, he sits down with Consuelo Mack and provides his insight into what he sees occurring with financials, gold and various other investments. In this interview Einhorn discusses the rational behind some of his current long and short positions. Einhorn correctly called the precarious condition of financial firms from Allied Capital to Lehman Brothers and the financial system as a whole.

Investor Sentiment And Fund Flows

Two weeks ago bullish investor sentiment was reported at its highest level of the year coming in at 57.56%. At the same time the S&P 500 Index hit is yearly high of 1,225. In the following week the bullish sentiment level fell over 17 percentage points to 40% and the market has trended lower since this time. In the latest week the bullish sentiment level has ticked higher to 47.4% with the market trading pretty much in a volatile range.

From The Blog of HORAN Capital Advisors
This market volatility seems to be resulting in investors having uncertainty about investing in equities. The below chart shows investors continue to pour money into bond mutual funds at the expense of equity mutual funds. The chart captures data through mid September and the subsequent table contains weekly data for November.

From The Blog of HORAN Capital Advisors

From The Blog of HORAN Capital Advisors
Table Data Source: ICI

As noted in several earlier posts, one on the recent move in interest rates and the other on potential inflation, investors in long term bonds are taking on duration risk that is likely to result in poor bond returns.

Wednesday, November 24, 2010

More Evidence Of Inflation In The System

One area that is providing a hint that inflation seems set to increase is the change in commodity prices. As the below table shows, many commodity prices have seen significant increases over the past year.

From The Blog of HORAN Capital Advisors

Aside from investors allocating a portion of their portfolio in inflation protected assets like TIPS or commodities themselves, certain companies can benefit from these higher commodity prices. The key is the company needs to have the ability to pass on these higher cost to its customers.

Those companies that are in the beginning or intermediate stage of the production cycle have the best opportunity to pass along these higher costs. Those companies that sell to individual consumers are having the most difficulty in passing along these higher prices though. A recent Thomson Reuters report highlights several comments from recent company earnings reports.
“As anticipated, our first quarter operating income came in below the prior-year period. We see our price increases coming through across the board, but in the first quarter they still lagged sharply increasing commodity prices. We are confident that the additional price increases we have announced will mitigate commodity inflation for the full year. We also continue to execute against our capital plans with further share repurchases and the successful refinancing of $800 million of debt at an attractive rate in the first quarter.”
- Sara Lee Corp. (Nov 9. 2010)

“Commodity costs are now expected to have an unfavorable impact on EPS of approximately $0.08 to $0.10, attributable primarily to higher coffee costs. The company’s EPS expectation noted above reflects the impact of higher commodity costs.”
- Starbucks (Nov 4, 2010)

"Our long-term perspective in managing our business is backed by a strong financial position that provides the ability and flexibility to capitalize on opportunities that support our strategy," added Richard Smucker, Executive Chairman and Co-Chief Executive Officer. "As we look ahead, we anticipate that marketplace dynamics, including escalating commodity costs, will continue to present challenges. However, we are confident in the ability of our team to execute our strategy and address these obstacles."
- J. M. Smucker Company (Nov 18, 2010)

“The outlook for nitrogen and phosphate fertilizers is very favorable. Historically high grain prices and low grain stocks support high planting expectations and optimal fertilization practices.”
- CF Industries Holdings (Nov 4, 2010)

“Sales revenue for third quarter 2010 was $1.7 billion, a 29 percent increase compared with third quarter 2009 primarily due to higher sales volume and higher selling prices. The higher sales volume was attributed primarily to improved end-use demand in packaging, durable goods, and other markets and the positive impact of growth initiatives. The increase in selling prices was in response to higher raw material and energy costs.
- Eastman Chemical (Oct 28, 2010)

Monday, November 22, 2010

Higher Income Consumers Seem To Be Spending Again

Recent same store sales data seems to suggest high end consumers are opening their wallets and spending again. Recent same-store sales were up 9.5% at Neiman Marcus, Saks reported an 8.1% increase and Nordstrom same store sales were up 3.4%. The mid tier stores actually saw a decline with Kohl’s declining 2.5% and J. C. Penney Co. down 1.9%. The results at high end retailers does seem to be a sign that the higher income consumer is spending again after cutting back purchases during the middle of the recession.

Consumer confidence is not only driven by the level of employment but also by the level of the stock market. The latest release of the unemployment data shows the unemployment rate for individuals with at least a bachelor’s degree is 4.7% which is down from a 5% peak earlier this year. This unemployment rate is half the national average.

From The Blog of HORAN Capital Advisors

H/T: Argus Research

High Quality Stocks Are Cheap Based On Free Cash Flow

The below chart shows companies’ free cash flows (excluding financials and utilities) compared to BAA corporate bond yields. The ratio is the highest seen in the last 50 years. It is free cash flow that pays investors and one reason we take a hard look at a company's cash flow statement and dividend practices.

From The Blog of HORAN Capital Advisors
Source: Fidelity

Saturday, November 20, 2010

Higher Tax Rates And Performance Of Dividend Payers Versus Non Payers

As the end of 2010 is fast approaching, it appears Congress is having difficulty deciding how to handle the expiration of the Bush era tax cuts. If the Bush era tax structure expires, a whole host of tax increases will be thrust upon nearly all tax payers. One tax that will be impacted is the tax rate on dividends will increase.

From a performance perspective, higher taxes on dividends does not necessarily translate into the stocks of dividend payers underperforming the non payers. A recent Reuters article, Tax Changes Won't Kill Dividend Trend, highlights where Allianz reviewed tax rates from 1972 to the present, identified nine distinct time 'regimes', and found dividend-paying stocks outperformed nondividend-paying stocks in all but one period: 1987 (see below chart.)

From The Blog of HORAN Capital Advisors

If tax rates do increase, the current high level of cash on corporate balance sheets could lead these firms to institute special dividends before year end.

From The Blog of HORAN Capital Advisors
Source: PIMCO

Wynn Resorts (WYNN) recently announced an $8 per share special dividend and Progressive Corp. (PGR) announced a $1 per share special dividend. More firms may follow this lead before the end of 2010.

Given the fact firms that have consistently paid a growing dividend tend to exhibit strong fundamentals, if a higher dividend tax rate is realized, the performance of these firms is still likely to be good. The current low rates on fixed income investments is also making dividend paying stocks look attractive on a relative basis.

Friday, November 19, 2010

Dividends Matter And More So During Inflationary Periods

As noted in a number of earlier posts, at HORAN Capital Advisors, we use the dividend paying actions of companies as one way to evaluate a company's future growth expectations. In some ways, the dividend actions by companies provide investors with insight into management and the board's expectations of a company's future earnings prospects. This valuation methodology is what led to using the "dividend discount model" as a way to value companies. Importantly, the DDM can further be used to relate the value of a stock to a company's fundamentals.

Generally, companies do not want to reduce or slow their dividend growth rates as investors in these types of companies have come to expect a certain level of dividend growth or income growth. If the growth rate slows or other financial ratios begin to trend in the wrong direction due to a company's desire to maintain a certain dividend growth rate, this provides investors with important insight into the future return potential for a stock.

Additionally, as noted in a recent research report by Fidelity's Market Analysis, Research & Education group, dividends are a critical component of a stock's overall return. The opening paragraph of the report notes,
"Companies that regularly return some of their profits to shareholders in the form of stock dividend payments are predominantly mature businesses that have steady cash flows, relatively stable profit outlooks, and lower operational risk on average than non-dividend-paying companies. These characteristics generally have led to less share price volatility for dividend-paying companies compared to the broader market. Typically, a company does not start paying stock dividends unless it is confident it can continue to generate enough earnings to distribute dividends on a regular basis going forward. The primary reason: cutting a dividend may be interpreted by investors as a negative statement about the company’s profit outlook, which may result in a decline in the company’s stock price."
One aspect of the current actions by the Federal Reserve, specifically, round two of quantitative easing (QE2), concerns us at HORAN in that it is likely to fuel inflation at some point in the not too distant future. In an inflationary environment though, stocks actually perform okay when looking at the entire inflation cycle. Our post titled Where To Invest In An Inflationary Environment addresses this point.

The Fidelity report also notes during the period 1974 - 1980, the rate of inflation was 9.3%. During this time period the return on the S&P 500 Index averaged an annual rate of return of 9.9%. The dividend component of this return (4.9 percentage points) accounted for nearly one half of the overall return as can be seen in the below chart.

From The Blog of HORAN Capital Advisors

In conclusion, certainly, the level of dividends paid by companies have declined in recent decades; however, this decline seems to be reversing at the moment. More importantly, dividends continue to represent a critical component of the total return on stocks. And when, not if, we see inflation increase, this inflationary impact will be more favorable for stocks than for fixed rate bonds.

From The Blog of HORAN Capital Advisors


Realizing the Impact of Stock Dividends (PDF)
Fidelity Management &Research Company
November 12, 2010

Tuesday, November 16, 2010

Interest Rates On The Rise

In spite of the Fed's QE2 program and desire to push down interest rates, the longer end of the curve is seeing a big jump in yield. The first chart below displays the price action of the iShare 20-year Treasury Bond (TLT). The price of TLT has declined from a high of over 108 down to yesterday's close of 94. This represents a 13% price decline. The yield moves in the opposite direction of price and the second chart displays the change in yield of the 20-year Treasury. At the end of August the yield on the 20-year treasury stood at 3.23% and closed yesterday at 4.01%. This represents a 24% rise in the yield.

From The Blog of HORAN Capital Advisors

From The Blog of HORAN Capital Advisors

Saturday, November 13, 2010

S&P 500 Index Share Weighted 3Q Earnings Spike Higher

Year over year 3Q earnings for the S&P 500 Index continue to show positive progress. Of the 456 companies that have reported out of the 500 companies in the index, share weighted earnings in Q3 2009 totaled $154.6 billion versus Q3 2010 earnings of $202 billion or a 31% YOY increase.

From The Blog of HORAN Capital Advisors

Revenue growth on a YOY basis is 8%. The sectors with the highest revenue growth rate are: Technology (+20%), Materials (+17%) and Energy (+16%). The only sector showing negative revenue growth is the Financial sector (-2%). From an earnings perspective though, financials are reporting a YOY increase of +94%. Obviously financials are reporting fewer charges.

Thursday, November 11, 2010

Earnings In Third Quarter Better Than Expectations

Over the past six quarters, Thomson Reuters notes 75% of S&P 500 companies have reported earnings above the mean analyst estimate. Additionally, during these six quarterly periods, the average negative to positive surprise is 1.2. This level is below the long term average N/P ratio of 2.0. However, in Q3 of this year, the N/P ratio did increase to 1.8., but still remains below the previously noted long term average.

From The Blog of HORAN Capital Advisors

It is apparent company earnings continue to be better than analyst expectations. At HORAN Capital Advisors, we do believe this positive trend in earnings will continue through the fourth quarter and into 2011 as well. This positive earnings picture, and the fact we have a second round of quantitative easing in process, should provide for a positive stock environment in 2011.

Wednesday, November 10, 2010

Should More Focus Be Placed On Public Sector Pay?

An interesting article appears in USA Today showing the number of Federal workers earning more than $150,000 has increased tenfold since 2005. It is the private sector that ends up paying these wages. This rate of growth in public sector compensation is unsustainable.

From The Blog of HORAN Capital Advisors

The article notes:
  • The Defense Department had nine civilians earning $170,000 or more in 2005, 214 when Obama took office and 994 in June.
  • The biggest pay hikes have gone to employees who have been with the government for 15 to 24 years. Since 2005, average salaries for this group climbed 25% compared with a 9% inflation rate.
  • Federal workers earning $150,000 or more make up 3.9% of the workforce, up from 0.4% in 2005.

Tuesday, November 09, 2010

Wholesale Inventory Growth Exceeds Expectations

Today it was reported that wholesale inventories rose 1.5% which was higher than the consensus estimate of a .6% rise. notes, "wholesale sales rose 0.4% in September after increasing 0.5% in August. The gains suggest that the growth in inventories was planned and not the result of shoppers leaving more goods on the shelves." Although sales did rise, they did not keep pace with inventory growth.

The inventory growth for August was revised higher to 1.2% versus the originally reported level of .8%. This revision was not expected and will result in a higher upward revision to GDP for Q3 at the expense of a downward revision in 4Q GDP. The resulting inventory to sales ratio increased to 1.18 versus 1.17 in the prior period. Although the I/S ratio did rise, it is in line with the average I/S ratio from 2003 - 2008.

From The Blog of HORAN Capital Advisors

Monday, November 01, 2010

Dividend Payers Maintain Performance Edge Through October

Given the roller coaster the market has been on over the course of the past four or so months, it has been an environment that favors higher quality companies. It is the higher quality companies that exhibit strong cash flow and/or dividend payments that tend to hold up better in down market environments.

Through October, the average return of the dividend payers in the S&P 500 Index are outperforming the non-payers, 9.73% versus 7.83%, respectively. The payers are also outperforming the weighted S&P 500 Index return of 6.11% on a year to date basis.