Doug Kass Probably Does Not Understand QE

Doug Kass is a guy I admire a great deal.  He graces my “quotes and wisdom” page and he is a must-follow on Twitter.  But he just does not get QE, to be charitable.  

Let me explain.  Let’s start with yesterday’s “mea culpa,” about why he has been so wrong on the stock market in 2013.  It is not actually a mea culpa at all.  What he is actually saying is that he has been totally right about the fundamentals, but the market has not cared, because of Fed and other central bank QEs.  It reminds one a lot of another rich man complaining about quantitative easing at the recent Ira Sohn conference, Paul Singer.

Of course, this is not Kass’ first mea culpa for being too bearish.  Here he is from 2011.  The reality is, aside from strategic decisions to get bullish because he is in part a technical (or at least very pragmatic) guy, he has been pretty bearish for a long time, and largely because he doesn’t like QE and doesn’t think it does anything good.

He is just wrong.  A tweet today prompted this post, in which he echoed a recent theme that QE widens the gap between the haves and the have-nots.  That is a new tactic or theme though, and immediately he laid bare the real concern, which is that Bernanke is screwing the savers.  That’s what he is really upset about.   And that is a class issue, and an age issue (Kass is twice my age).  Because the reality is, even an old person living on a fixed income is not a have-not if he or she has money to invest in bonds for income!  That person may be income poor, but income is not the same as wealth.  And the real have-nots (and there are millions of them) are the elderly who rely only on social security, and have no other significant savings.   

So essentially, Doug defines the “have-nots” as the poorest of the haves, and excludes the impact of QE on the real have-nots.  QE helps debtors.  And the poor are the debtors.  The poor are those with revolving credit card debt they only pay the minimum on.  The poor are those still in adjustable rate mortgages.  The poor, more often than not, particularly as defined by net worth, are the young.  The young, too, are those looking maybe to buy their first house, and who will benefit potentially for 30 years from epic low interest rates.

So let’s be clear what is going on here.  A lot of rich, older people, who are otherwise very smart and very sophisticated, hate QE, and whether they know it or not, it is for ideological and/or class and/or age-related reasons.  You can either choose to believe them because they are smart and have a big megaphone, or you can recognize their human biases for what they are.

In an era when federal taxes on the wealthy are at a long-term low, in an era when we are all worried that baby-boomers are going to bankrupt us all with their use of Medicare, in an era when inflation-adjusted spending on public-schools just fell for like the first time in thirty years, in an era of sequestration cutting services for the poor and the young, in an era when colleges are charging ever-more tuition, in an era when many Millennials can’t even find jobs and many still live with their parents…in such an era…, is it so f**king horrible that there is actually one policy out there that does, on balance disproportionately benefit the young and the actually poor, over the “savings class?”  Is it, Paul?  Is it, Doug?

A Few Brief Thoughts on United Health Group, Inc.

This is a stock I purchased in my IRA on September 1, 2010, when it was trading at $32.48/share.  Today it trades at $58.92/share.  Needless to say, it has been a big winner for me.  However, it was always a small position, at a $617.12 original cost basis.  I only bought 19 shares.  By comparison, I own over $4,000 in XOM stock, and have similarly “large” (for me) positions in MSFT, INTC, and BRK.B.

The position has remained small because I have been guilty here of price anchoring.  I think I got afraid of the increased nominal price, and have failed to pay attention to the underlying business.

It’s time for an update.  In my update, I conclude that the company is not wildly undervalued.  It would be a strong buy at $54.88, not far below where it is today.  If it goes above $82.32/share, and the fundamentals have not changed, it is time to say adios.  It is obviously nowhere near that level.

Here is my most recent sheet.  As you can see, I keep things fairly simple.

I have used a WACC of 11% here, which is in-line with consensus.  I assume no debt or cash.  (The actual net cash/debt position is about $4 billion of debt, but I assume based on its cash generation it can basically maintain that in perpetuity.)  For my free cash flow growth rate, I’m only assuming 3% growth over the next ten years, even though in last nine years it has averaged 9.67% annualized growth.  The problem is in the last three years that stalled to 7.59%, and in the last year, the annualized growth was only 3.12%.  I attribute most of this decline to recent regulatory changes, but I never assume higher growth than present growth.  In fact, even my 3% growth assumption may prove too optimistic, and is the thing I’m most worried about in my analysis.  

On the other hand, it matches Morningstar’s analysis closely, and even if you assume 1% growth, the stock is worth around $61/share.  My pessimism is also tempered by the fact the company has reduced its diluted share count by 16.2% in the past four years, which is great, and future such reductions should prove accretive to the value of future free cash flows attributable to my shares.  

Substantively, my thesis from 2010 has not been blown:  Obamacare will not destroy this company, its scale confers massive advantages in such a highly-regulated industry, and it is well-run.  Nothing since 9/2010 has changed these basic assumptions.  I actually think Morningstar in evaluating United Health’s ”moat” is probably being too pessimistic in assigning the company only a narrow moat, given the regulatory environment in which it operates. They likely attribute the declining free cash flow growth to moat issues, whereas I attribute it to regulatory changes.

That said, I think the massive gains here are likely done.  That is because these gains were to be had before the world had digested Obamacare as fully as it has now.  I do think the stock remains somewhat artificially depressed because of lingering and overblown concerns about the full implementation of Obamacare, which is why opportunity remains.  

Also, the dividend is quite low — 1.44%, even after it was increased from a quarterly $0.13 dividend to a $0.21 quarterly dividend, or a 61.5% increase, in the time I have owned it.  That seems to be the level this company wants to be at, and it is not enough to attract all those seeking yield in a ZIRP environment, so I do not attribute its share appreciation to a hunt for yield.  The fact that its P/E ratio has not really increased much at all since 2011 (in a time when the S&P P/E ratio has gone from under 14 to the 18 neighborhood) supports this view.

In short, I think this company remains highly investable.  I should consider doubling my position notwithstanding the recent share price appreciation I have seen, particularly since the share price has basically been stalled for the past year.  However, before doing so I should conduct a deeper analysis of Humana (HUM), which appears to be performing even better than UHN has been.

Investors Must Preserve Emotional Capital Too

I’m a buy-and-hold fundamental investor, but I follow a lot of traders on Twitter.  I do this for two reasons.  First, a lot of them are interesting and funny dudes (they’re almost all guys).  But second, I recognize that some traders do actually make money on a consistent basis, and that the reason the money-makers do so is because they follow rules, and possess wisdom.  And that’s applicable to fundamental folks like me.

Sunrise Trader had a great tweet this morning, that encapsulated what makes a good trader:  

  • Our job is to look for opportunity, manage risk, consistently take profits out of the market while preserving emotional and financial capital.

This is very applicable even to buy-and-holders like me.  I’m not taking profits out of the market often — only when I think a stock is really stretched beyond its fair value.  Instead, I’m just adding new capital every month from my earnings.  But sometimes I must take profits.  The really important thing that struck me again though is the importance of preserving emotional capital.

Notice he put that before preserving financial capital.  The first leads to the second.  For the buy-and-hold guy like me, you preserve emotional capital in three ways:  

  1. Size your positions appropriately.  That means at a level you are comfortable with.  I never hold more than 30 different companies.  But never fewer than 10.  That’s what I’m comfortable with.  You may be comfortable with a different number.  If I put all of my money in one or two names, I would not be preserving my emotional capital.  This would leave me more prone to doing something stupid like selling on a dip even when I believe in the company.  As I grow as an investor I hope to shrink the number of companies I own.  But there is no reason to force it.
  2. Invest over time.  I add money to my investments every month, incrementally.  It is much harder emotionally to invest $100,000 or $1,000,000 or $1,000,000,000 all at once than it is to invest whatever your total capital is over a period of months.  This also gives you additional time to scale up in positions as you gain comfort and additional knowledge of the companies and the industries in which they operate.
  3. Buy-and-hold.  This itself is a means of preserving emotional capital.  I am sitting on huge gains in Microsoft stock that I purchased at about $18/share during the financial crisis.  I bought Intel for the first time at around $13/share during the financial crisis.  I have held those positions.  I bought Walmart under $50/share in 2010.  I have held.  Etcetera.  This is not to say I never sell.  Stocks I have sold at advantageous times include Hewlett Packard, Transocean, Tidewater and Exelon, and less smartly, Ebay and Disney.  But if I think my qualitative thesis is blown or the stock is way overvalued, I sell.  That’s my rule.  Sometimes I win, sometimes I lose, but I follow a rule, just as traders do.  (It’s just that my rule isn’t a price point based on technicals.)  When you are a buy-and-hold investor, and you follow decent selling rules, and you sit on long-term winners in whose business models you still believe, you see a lot of green on your screen after a few years.  This gives you emotional capital.  This makes you more confident.  This makes you less likely to do stupid things, even with your newer positions.
UPDATED IRA PORTFOLIO PERFORMANCE.   Basically, I got hurt last fall by Intel and Apple, and I have been helped in the past few weeks by their rise, and the rise of Microsoft.  This is only one account, but is the only one for which performance is easily available.  In my other two accounts at Zecco/TradeKing and Firstrade, they did not properly account, respectively, for: 1) the Berkshire takeover of Burlington Northern (they gave me a $0 cost basis on the new BRK.B shares!) and the switch from Zecco to Tradeking, and 2) at Firstrade for a bunch of Phillip Morris stock I deposited physical share certificates for when I initially set that up as a drip account in the late 1990s.  That’s what you get for being cheap with your online brokers.  So the returns are screwed up. I’m eventually going to sell all of the screwed up holdings and consolidate those accounts at Merrill Lynch so that I can show true returns for my entire portfolio.  Unfortunately, this may mean I have to liquidate the Zecco/Tradeking account entirely, because they are erroneously saying I made all of my purchases on a single day in 2010, so I’m worried that if I just transfer those holdings the failure to track will extend into the new account.  It is really frigging irritating, because the Tradeking accoung is where I made all of my 2009 purchases, which means I’ll have to pay a bunch of capital gains tax for the privilege of being able to use an online broker that will correctly track my portfolio in the future.  Not a fan of either of those two institutions….  I have recently been about $1,000 cash in this IRA, but recently added $2,000 more.  I have just under $20,000 in this account in total.
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UPDATED IRA PORTFOLIO PERFORMANCE.   Basically, I got hurt last fall by Intel and Apple, and I have been helped in the past few weeks by their rise, and the rise of Microsoft.  This is only one account, but is the only one for which performance is easily available.  In my other two accounts at Zecco/TradeKing and Firstrade, they did not properly account, respectively, for: 1) the Berkshire takeover of Burlington Northern (they gave me a $0 cost basis on the new BRK.B shares!) and the switch from Zecco to Tradeking, and 2) at Firstrade for a bunch of Phillip Morris stock I deposited physical share certificates for when I initially set that up as a drip account in the late 1990s.  That’s what you get for being cheap with your online brokers.  So the returns are screwed up. I’m eventually going to sell all of the screwed up holdings and consolidate those accounts at Merrill Lynch so that I can show true returns for my entire portfolio.  Unfortunately, this may mean I have to liquidate the Zecco/Tradeking account entirely, because they are erroneously saying I made all of my purchases on a single day in 2010, so I’m worried that if I just transfer those holdings the failure to track will extend into the new account.  It is really frigging irritating, because the Tradeking accoung is where I made all of my 2009 purchases, which means I’ll have to pay a bunch of capital gains tax for the privilege of being able to use an online broker that will correctly track my portfolio in the future.  Not a fan of either of those two institutions….  I have recently been about $1,000 cash in this IRA, but recently added $2,000 more.  I have just under $20,000 in this account in total.

A Brief Update on Coke

There has been a lot of talk about overvaluation of consumer stocks like Coke (KO) lately, some of it by me on Twitter.  And I think inarguably stocks like this are somewhat leading the market right now.  I therefore decided to take a quick check today to see if I should consider selling, if it was that overvalued.  It has been awhile since I actually ran the numbers.

My results are here. What I found surprised me.  I used a WACC of 7% as my discount rate, even though some sources put the WACC at 6%.  Still I come out with a valuation roughly in the $39/share range.  That puts me squarely in between Morningstar ($42) and S&P ($36) — I always check them AFTER I have run my numbers.  

So as of today we’re around $42/share.  Is the stock cheap?  No.  Is the stock wildly overvalued?  No.  I have pegged $48/share as a potential sell price, assuming the stock clears that level without further substantive improvement in the business.  But for now, while there is always risk of a decline, I think the coast is fairly clear.

As many have said, part of what is driving stocks like $KO is the perception of safety, and the desire for the dividend.  Fair enough.  There has been talk of a “dividend bubble” lately, so I must note I first talked about the elevation in values of dividend stocks in a pitch on the fool.com website in 10/2010 for Intuitive Surgical (ISRG).  Good thing I didn’t avoid dividend stocks since that time, though!  This isn’t over.  The Fed isn’t done what it’s doing, and we aren’t about to see ZIRP end, and the reality is, while dividend stocks are outperforming the market now, and some like Coke have been for years, this could go on for at least another year or two.  And even when it ends, the reality is, Coke is not that overvalued.  It’s not cheap, but at least part of what is going on here is a reach for moat, as well as a reach for yield.  And the reach for moat won’t go away when ZIRP ends.

Learning my Lesson (Again) on Diversifying for the Wrong Reasons

In early 2011 I added small positions to my portfolio of EPI and BRF.  In early 2012 I added to the EPI position at a much lower price.  These, respectively, are small-cap ETFs focused on India and Brazil.  At the time my thesis was that India and Brazil were fast growing economies, and that I even though I didn’t know a ton about the mechanics and details of their economies, I should “diversify” and capture some benefit from those markets, without taking on the risk of investing in individual stocks.  Thus I made the same mistake I made in 2007.

I recently sold out of those positions.  Who knows, maybe that will prove to be a mistake and those markets will roar in the next two years.  But I don’t really care.  

I sold because as I delved into their economies, I saw inflation and rampant corruption and particularly as to India, political sclerosis that makes US politics look exceedingly vibrant (which is saying something).  I also was sitting on 40-odd points of under-performance vs. the S&P in each position. (A lot less in that later add to my EPI position.)

The kicker is that in 2007 I had bought a European index mutual fund for very similar reasons.  It resulted in one of my largest-ever losses, and if I had held it, my performance relative to the S&P (which is my primary measure of performance) would have been lowered even further.  It was a large position, and I sold it in fall 2008.

Thus I learn my lesson again.  Even though I use a DumbMoney moniker to  poke fun at those who say individual investors like myself are “dumb money,” sometimes I really am the dumb money.  It hurts to say it but it’s true.  I am not a hedge fund.  I do not have dozens (or more) of analysts working for me to evaluate markets around the world.  I have developed an expertise after years of work in what makes the US economy tick, and in how US companies work, and in how US companies interact with the world economy, as well as how to analyze companies both quantitatively and qualitatively.  But every time I step out of my comfort zone, I get hammered, performance-wise and pride-wise at least (I didn’t lose a ton of money on these positions because they were quite small relative to my portfolio.)   

I highlighted the bold text above because it shows my primary mistake.  I think it is important that I recognize my limitations.  I did not buy these ETFs because I knew a lot about the countries.  I did not even buy these ETFs because I was simply wanted wanted rote diversification.  I bought these ETFs because I made an ill-considered and uninformed bet that their economies would grow faster than the U.S. economy.  In doing so I made two errors:  I bought with inferior information and strategy, and I mistakenly assumed that stock prices are largely connected to GDP growth, even though I know in the context of the US economy that they are not.

Lesson (hopefully) learned.  I do retain a position in VWO, Vanguard’s broad international ETF.  I am keeping that because I bought it out of a more generalized sense of portfolio diversification.  I am well aware, lest you worry, of contemporary ideas of correlation of asset classes, and the limited benefit of diversification, but I do allow myself this, wearing my hat as financial adviser to myself, rather than virtual fund portfolio manager.  EPI and BRF were portfolio manager mistakes that I hope not to repeat a third time. 

Why Cyprus May be BULLISH for the Eurozone

There has been a lot of discussion lately about the Eurozone bailout of Cyprus.  Many pundits have focused on the horror of the fact that the Eurozone is planning to tax/levy/whatever the deposits of depositors who have money on deposit with Cyprus’ insolvent banks, in amounts above the insured limit.  A lot of the bru-ha-ha arose because originally, the plan was apparently to tax even the insured deposits.

I think we can all agree that the insured deposits should not be taxed, levied upon, or in any way subjected to losses in the bailout of a country and/or banking system, and that no plan should ever have been floated that did so.  When a bank deposit is insured, that has to mean something, or the banking system can have no trust.

However, it is perfectly acceptable for the non-insured deposits with these banks to be taxed, levied upon, or otherwise wiped out.  And the fact that the Eurozone is willing to do so, indicates that there is a level of confidence in the system that has been missing, and that is often missing in the United States.

Here is what the populist depositnistas appear to be missing:  bank depositors are creditors of the bank.  The whole point of creating some sort of deposit insurance is to ameliorate the worst impacts of this.  But nowhere is it written that uninsured deposits should be de-facto insured by tax payers.  That is what people opposed to this are really saying.  In a normally-functioning economy, when any corporation fails, it is the shareholders who get wiped out first, but the creditors, usually bond holders typically get wiped out as well, at least in part, and often in full.

So in fact, the Eurozone and the government are taking nothing from these non-insured “whale” depositors.  Rather, by making them bear anything less than a total loss, the Eurozone is actually giving the “whale” depositors the remainder as a partial bailout, which they would not otherwise get as uninsured creditors of an insolvent banking corporation.  That the Eurozone is willing to do this is perhaps foolish, but is also perhaps a sign that markets, and governments’ perception of their fragility, is returning to a more pre-crisis, market-oriented posture.

Beware of Companies that Loathe Their Regulators

This is not an ode to Big Government and regulation.  But I think most reasonable people recognize the need for some regulations.  And the more complex or larger a system is, the more regulation is needed.  It’s exactly like the difference between two country roads in the middle-of-nowhere, and an intersection in a city.  The two country roads do not need a stoplight.  There a stop sign is quite sufficient (still a form of regulation).  But just try to imagine New York City without stoplights.  It would be total bedlam.  The current situation with JPMorgan has me thinking about this.

Now JPMorgan is a great company, and a very profitable one.  And its CEO/Chairman, Jamie Dimon, has been in many ways wonderful.  But he has been slamming the post-Crisis increased bank regulations quite a bit as well for some time.  For example, he slammed the $1 billion cost of new regulations.

Of course, then his seemingly fake CIO, which really seems like it was a shadow proprietary trading desk, lost $5 billion.  For the record, $5 billion is more than $1 billion.  And JPMorgan lost that money arguably doing something the regulators prohibited.

There is a lesson here:  Companies that constantly complain about regulation and have antagonistic relationships with their regulators probably want to engage in behavior that is against the best interests of long-term shareholders.

A great counterpoint exists in Warren Buffett’s most recent (as of this writing) 2012 letter to his shareholders.   In it, on page 10, he wrote: 

  • “It is in the self-interest of governments to treat capital providers in a manner that will ensure the continued flow of funds to essential projects. And it is in our self-interest to conduct our operations in a manner that earns the approval of our regulators and the people they represent.”

Truer words were never spoken.  He was writing in the context of his utility-like businesses, BNSF and MidAmerican Energy.  However, the lesson is the same in banking.  Banking is far more of a utility-like business than Jamie Dimon would like to admit.  Most of the problems we have had with our banking industry in the last decade have arisen because bankers have succeeded in convincing many people that they are not utilities.  And of course then they subsequently torched themselves.  The lesson is not dissimilar to airlines, which used to be heavily regulated.  Their record since deregulation has been absolutely miserable for shareholders, though wonderful for consumers.

The lesson for JPMorgan is clear.  Stop whining.  You lost far more money on your CIO office in a few months than you had made in its entire previous existence, and you did it while engaging in activities that arguably were designed to circumvent regulations you were complaining bitterly about the cost of. It was ironic, and unnecessary.  It’s time to head Buffett’s advice.  Stop whining, deal with a regulatory reality that impacts your competitors just as much as it does you, and move on.

Taking an Initial Look at Parker Hannifin Corp: Another Lubrizol?

Every so often I literally just start plugging various letters into morningstar.com’s quote box.  I do this to help myself move beyond my cognitive biases, one of which is that I tend to focus a lot on the stocks of companies I already own, another of which is I tend to concentrate my energies in companies people are already talking a lot about, and still another of which is that I tend to focus on particular industries.  I was doing that a few weeks ago and out popped Parker Hannifin Corporation (PH).  This is a highly investable company, though my research is not yet complete.  Here are some rough thoughts:

What are some cool things and interesting facts here?

  1. This is a $14 billion company that people rarely talk about.
  2. It’s the self-described #1 motion & control company.  It makes things that go in other things, largely, and/or that are sold to other businesses instead of directly to consumers.  It makes 816,000 different products, and employs 60,000 people in 40-some countries.
  3. It’s clearly a cyclical company with some lag.  Revenue tanked hard in 2009 and even 2010.
  4. But revenue is more than double what it was nine years ago.
  5. Free cash flow is four times what it was nine years ago.
  6. Share count is down over 11% from nine years ago, including a big repurchase in the 2012 fiscal year.
  7. Earnings per share are up three-to-four times what they were nine years ago.
  8. During this time financial leverage has remained steady.  And now debt-to-equity is in the 30% range.
  9. Dividends have more than tripled in the last nine years.
  10. 2012 was a record year.
  11. Company is about 100 years old.

What are a few warts?

  1. Highly cyclical, to the extent this counts as a wart.
  2. Exposed to defense industry cuts.
  3. Exposed to currency fluctuations.
  4. Pension underfunding.  (Though see note 10 of the recent annual report, which indicates it has reduced the discount rate of its pension obligations significantly, to 3.91%.  This is in response to ZIRP and pension-related laws, and likely means it is is over-estimating its pension liabilities.)
  5. Dividend yield is only 1.70%, and recent dividend growth has stalled.

What do we think of valuation here?

  1. On my quick-and-dirty chart I derive a valuation estimate of $119.60/share, with a range from $95 all the way up to $145/share.  Current market appraisal is about $97/share, so it’s trading in the low range of my estimates.
  2. Assumptions:  I’m using a WACC of 11% as my discount rate, as I believe is most appropriate.  I’m assuming annual FCF growth of 6% for ten years, and 2% thereafter.  That 6% matches annual FCF growth since 2008, through the Great Recession, but is significantly lower than it has shown if you look back for nine years.
  3. Caveat:  There is no such thing as an accurate valuation of a company, and the future is unknowable.

Things I’d like to know:

  1. More about the individual business segments.
  2. How long the CEO has been in charge.
  3. More about compensation policies.

Conclusion:  This is a great company and warrants further research.  It is highly “investable.”  It is only wildly undervalued if growth returns to a higher rate.  But it’s a solidly-run shareholder-friendly business based in Ohio.  I would have no problem initiating a position today.  I may back-up-the-truck the next time we have a real cyclical downturn in this country.  If I were buying the whole company I might even pay as much as $120 or even $130/share today.  I think this is a “Lubrizol-like” company (and a similar market cap prior to acquisition) that just had a record year and is firing on all cylinders, and it would not surprise me at all if Berkshire Hathaway under Buffett bought it, assuming diligence on the management checked out.