A Couple of Late Presents.

There is an inverse relationship between the likelihood of a sure thing and its potential to return profits. Anyone suggesting otherwise should be kept as far from your wallet as possible. 

That said, in the market everything is a sure thing. The market will do exactly what it was supposed to do EVERYTIME. Unfortunately, humans are not very good at understanding what was supposed to happen. (but we're very good at explaining why after the fact)

Market risks are typically balanced. The smaller the return potential, the more likely the investment will work. The smallest and "surest" of said investments are arbitrage plays where two different holdings are likely to converge and a savvy investor can play one side (or both) to capitalize on the convergence. 

Some arbitrage plays are almost risk free and return fractions of pennies, but gains nonetheless. Other arbitrage plays involve risk but nothing that is currently visible. In other words, who could forecast a snow storm in June that might upset an agriculture play. 

A good example is upon us in the form of PSD a utility concern in Washington. The company was set for acquisition over a year ago at $30 per share cash. After initial excitement, the stock traded in the low $20 range for fear that the Washington regulators might squash the deal. Two announcements in as many weeks have indicated a green light from said regulators. Financing for the deal appears in hand, and executives suggest culminating the deal in a few weeks time. With the stock still under $28, a quick 5% return is likely for those willing to play short term deals such as this. 

Another, less sure, but highly likely arbitrage play is NNDS which is going private. At $63 per share cash, the current offering price is low and the deal will probably culminate by Feb 2009.

Enjoy...

Why I insist on rearranging the deck chairs on the Titanic (aka - MCG Capital)

This post will be dedicated to a single company that has lost over 90% of its value since I started accumulating shares: MCG Capital (MCGC). 

Everyone knows that the financial markets have been battered, but while many firms have rebounded more than 20% since November, MCGC has not. Since I've recommended this security to others, and this is the most battered holding in my portfolio, I've had significant doubts regarding my judgment. 

Knowledge is power, so digging for data is my only savior on this one. And believe it, or not, I'm buying more shares. Why?

First, let me start with the risks that seem to convince other analysts that this company may not make it. With the recession in full bloom, the companies that MCGC has investments in will feel pressure. Indeed, over 10% of MCGC's portfolio is in companies that don't appear profitable. Most of the firm's investments are leveraged to some degree and with the credit crunch still in force, renewing credit lines that are coming due might prove difficult and/or expensive. 

OK, I admit that these positions are not arguable. However, the devil is in the details. The company has gone to some length to reduce the second issue since the first issue is probably not fixable. A few months ago, the company had lines in excess of $150 million expiring. These lines have, by in large, been handled and less than $20 million will expire in the next 12 months. The risk that the firm’s $600 million in debt will force the company under in the near term is not significant. 

Analysts suggest that the credit crunch will not allow the firm to originate new business and thus not grow. Agreed, the company must sit back for a while and service the existing portfolio and originations will lag. However, layoffs have already occurred in response to the slowdown these savings are increasing existing profits. 

The company could struggle if the portfolio companies do not pay their interest, dividends, and fees to MCGC. However, current situations don't appear too dire. Let's look at the numbers.

The current stock price is $0.65 providing a market cap of just under $50 million. I'm going to work everything back into a share price comparison so the point appears vivid. The company has a Net Asset Value of $9.39 per share. Hypothetically, the company could liquidate today for 9 bucks and every shareholder would get $8.35 more than the current share price. OK, don't run to the bank yet, because some investments may not be marketable and need to be considered. The net value of the investments less leveraged borrowings is $8.45 per share. Since the investment pool is not leveraged too much let's exclude the whole mess and assume that no further investments will be made and the current investments will not be sold. What's left is a firm with $64 million in cash or $0.84 per share. In other words, the cash in this company after settling out the rest of the balance sheet is almost 30% higher than the current stock price. 

It gets better. The current investment portfolio appears somewhat stable aside from the recession and associated risks. Holdings such as Cleartel have already been put on non-accrual status and don't figure into recent earnings. Considering such, the firm will earn over $70 million in cash net of expenses in 2009 if nothing else happens. In other words, absence any investing or other cash activities, the company's cash will grow by more than $0.90 per share each year. If the investment portfolio continues to be hammered by the mark to market rules of FASB, portfolio losses will overcome the cash earnings and dividends will not materialize. 

The broader markets are well off the lows in November and while I don't expect a rocket back to 2007 levels, we are certainly nearing (or at) the bottom of this recession's impact on valuations. MCGC will be reporting earnings for Q4 and there will probably be another net loss due to portfolio mark downs. But this same portfolio is the generator of the cash and is, indeed, still performing. 

Let's assume that valuations continue to slide through Q1, they can't really slide much further with small gains appearing everywhere else. Since MCGC is a BDC by charter, it must pay out 80% of net earnings. Failure to do so will bring the IRS in to hammer earnings with taxes, so I don't see this status changing. 

Let's take a very conservative approach and assume that 2009 has just enough valuation pressure to keep dividends low. We're still talking about something like $0.30 in distributions in 2009 and full earnings in 2010 which would look something like $0.70. 

If you’ve followed this so far, here’s the skinny. Forget the huge fall in the stock price since 2007. If one purchases the stock today at $0.65, I’m suggesting that each share will probably receive at least $1.00 in dividends over the next 24 months. Such an occurrence would be a 77% return for two years.

This ship may be sinking, but I just can’t peel my eyes off these good looking deck chairs.

Many Thanks for the Holiday Market

What a pleasant start to the Holidays, a 10% increase in the market. Granted, most of us are pretty bummed over the 50% - 70% drops in our accounts, but gains are gains.

Several key points are in front of us. First, we're FINALLY going to head into a recession. After 16 months of battering from the press and neophite politicians claiming we were already in one, we might just fulfill their prophesy. We've had one quarter of declines and this shopping season did not start well enough to keep another quarter at bay. Expect Q4 to show some contraction which means we technically enter a recession. On more fundamental grounds, the market has already priced in the financial markets weekness and a major turnaround isn't expected until mid 2009.

However...

...two points need to circle this grim forecast. First, the market pricing ALWAYS preceeds events, even if the preface is only a few hours. The market volatility has been extreme in past weeks. Further, most of the market is oversold due to investors pulling their money from stocks and some (albeit limited) short selling. In terms of the DOW, the market has shown some resiliency at 7,500 and 8,200. Unfortunately, each new low has been in succession which could mean another dip in the near future. But, I digress. Without getting into too much technical babble, it is important to realize that the lows aren't holding. I believe that 8,000 is a support level and represents a good entry point for new money. However, when the bulls start to right this ship, the bears will jump in a hurry causing very volatile up spikes. If the fundamental health of the financial system is stabilizing (as indicated by the interest rate spreads) and swings into healthy numbers by mid next year, the markets will probably start pricing these bits of good news in the next month. In other words, don't try to time the market.

The second point is a bit more somber. The incoming administration makes no bones about the intent to increase government. While most of the "bail-out" money isn't a real cost and will probably be repaid, increases in the social security net (unemployment, medicare, social security, etc) will only push up spending and encourage Congress to increase taxes. Basic economics suggest that taxes are repressive and will further stall the economy. Assuming the feds can combine their cranial masses into at least half of one functional brain, California is sure to spoil to mood. I'm certain the California State government is the product of our failing schools. When the largest state in the country has unemployment 10% higher than the rest of the country, the highest sales tax, the highest income tax, and nearly the highest business tax, the last thing the economy needs is MORE TAXES. Apparently, the legislature has run out of fingers to count on, because more taxes appears to be on the table.

While the markets appear to be stabilizing, the government looks poised to mess it all up. If the tax burden is increased, the recovery will probably be at least one year further out. Paying the unemployed to stay unemployed is not going to create jobs. Taxing the corporations more is not going to create jobs, paying the farmers not to grow will not create jobs. Bailing out the automakers WILL NOT create jobs. Limiting the ability of energy companies to build more refineries, more oil exploration, and more nuclear plants hampers job creation.

Unfortunately, it apperas that the recovery might be getting pushed back by our incompetent governments. Obama appears to be continuing the spend now, ask later mantra of the Bush administration. US markets usually succeed despite the well intentioned blunders of US governments, so I'm still bullish for 2009. Unfortunately, I think we'll have to wait a few years before we see some real growth unless somebody in Washington, New York, or California figures out how to limit the politicians spending habits.

Change of the Guard

Needless to say, the market wasn't thrilled with our new choice for Commander In Chief. Further, across the country, voters agreed to more tax increases (mostly sales tax), and 100's of billions in bonds (debt) across the state and county measures. All three branches are run by the Democrats although they don't have a filibuster proof majority. Regardless of your political leaning, higher taxes and higher debt infer a slower recovery and potentially long recession. The market thinks this government might ignore economic laws and simply pass around the currency feedbag. 

Certainly, if the governments (fed and state) increase taxes even further, we will most definitely slip into an official recession. Job losses will likely increase, and further pressure on corporate valuations will hold back a solid recovery. On the off chance that our "leaders" come to their senses, we might still avoid a recession or, at least, keep it short. 

The financial crisis appears to be over. Some smallish banks will still fail and several corporate bankruptcies are likely to surface. However, the shrinking of the LIBOR indicates some level of stability arriving with the credit markets. 

Most equities appear well beaten down and while volatility will stay high for months to come, the general direction will not likely fall much more. Now is the time to research healthy companies and buy into the market. A dollar cost average into your choices will avoid a major timing risk. 

Next week appears shaky and similar to this week so hang on...

Hold the Fort

If you've had the fortitude to stay the course to this point, hang on. Despite the ramblings of one, Ben Bernanke, our hapless Fed Chief, the market appears to be reaching its bottom. I have to question whether the government efforts have actually had much effect. But, I'm certain that Bernanke not keeping his wild comments in check are causing harm. 

Regardless, it would appear that most issues are oversold. Which sectors are ready for investment is not clear, but the broader financial market (XLF) appears ripe for the picking. I'll post other tidbits worthy of consideration as they appear, but moving cash back in to the markets appears to be a wise move. I still recommend a hedge with UUP since the dollar is gaining nicely on the currency stage.

The choppy markets will continue, but expect some generally upward moves from week to week as money pours back in. I would expect the retail season to be very weak this season. Much of the retail stocks are already priced for bad news so the market should not be impacted dramatically. However, the retail weakness will create a vacuum that could finally push us into recession if the taxes are increased anywhere. Beware all tax increases and bond issues like the plague. This blog is not designed to be political but any proposition involving bonds should be sent packing no matter the bleading heart cause the ballot measure claims to benefit. Our proverbial credit cards are maxed and more borrowing will tip the scales in the wrong direction.

For the short term, expect some very nice spikes in the market, but brace for big corrections as well. If you have the stomach, index options could be a very lucrative play these days. 

Are we there yet?

Expectations are quite low when the new "up" is "not down 500", according to CNBC. Well, I guess today was a down day then. The only solice perhaps is that trading days are looking very predictable. 

I had to break open my history books to compare this bear market to past bear markets and my research suggests there is a light at the end of the tunnel. I believe (in the minority) that the credit crunch is predominately behind us. Now the mop up is a totally different story as we keep seeing various financial institutions fall under the weight of their own balance sheets. These things always go in cycles and history suggests we are not in a unique spot just yet.

The government hasn't started spending on their shiny new 700B credit card yet. When they do, it appears that some of the money will be put into the markets directly and such a move will definitely help. Another interest rate drop appears on the horizon which should help some. While the dollar typically cringes at rate drops, our peers are dropping faster which means the dollar is being held up (nice hedge, see my previous blog about UUP). The doomsayers are in full force regarding some major tech earnings announcements next week but such announcements are usually backed into the prices ahead of time which suggests that we probably are near the bottoms from a P & L perspective (IBM was a nice surprise). Some industries appear to be slowing but not tanking like those tied to the financial markets which suggests, again, that the broader index should be nearing the bottom of this mess. 

So maybe we've hit bottom, and maybe not. Regardless, the bear market WILL end at some point, and the bounce off the bottom WILL be notable. As mentioned in previous blogs, diligence will find some nice bargains in the market and a dollar hedge isn't a bad side bet. The business develepment funds like MCGC and AINV have gotten their heads chopped off and while the prices look incredibly bad, their investments don't seem to be going south as fast as their own stock prices. The credit squeeze held up their ability to make new business, but if their performing assets can provide enough cash, they should see it through the storm.

Don't sell!!! Hang tight, buy good value shares if you have the ability, and look forward to next year.

Time To Hedge

OK, the volatility is high and the latest reports suggest we are probably in for a week retail season. While we've not been in a recession, the risk of a decrease in GDP is looming and it's time to consider some hedges. 

I've mentioned in the past that those who prefer a gold hedge might want to consider GLD as an ETF equivalent. But I've not personally made that plunge. While I don't mind metals as a commodity play, I'm a little nervous about gold's volatility as well. The stock market is very much a pricing of future performance. And typically a drop in overall economic performance would suggest a drop in the dollar against other major currencies. However, I think we are in a unique situation. While I expect more volatility in the broader market, I expect even more volatility in overseas markets. The US markets appear more advanced in this financial drama than our foreign counterparts and that is why the dollar has been gaining in the last several weeks. Further, we are likely to be out of this mess in the first half of 2009 while some foreign markets will not rebound as quickly. 

After a long battering of the dollar over the last couple of years, the dollar has certainly taken a turn up. Two thoughts bring me to a currency play. First, currency trends tend to be long. While the peaks and valleys aren't obvious, once the trend starts it usually represents a significant economic shift. Second, the US economy has been well beaten down. At this point any additional losses in the market will likely see equivalent or greater losses in foreign markets. Again, a weak US market still trumps a weaker foreign market. Hence, the dollar will rise further. 

If  you buy in to my bullish dollar sentiment, you might consider an investment in UUP as a hedge to your market positions. The UUP is an ETF that paces the dollar against a basket of currency futures. If the dollar strengthens, UUP rises. 

While interest rates are increasing in some areas and might be worthy of a cash investment, I still prfer a broader approach. And I think the dollar is coming back. 

"We have met the enemy and he is us."

Pogo nailed it. In the last two decades, I've never seen so much activity over so little data. Oh sure, we have much to read and more to hear from the folks whose paychecks are dependent on you listening to them. But the words being spread are so innaccurate the authors are teetering with irresponsible reporting. 

The financial sector has a liquidity problem. Interestingly there are few other problems. Interest rates are low, unemployment (while rising) is historically quite low and much lower than the global average. Mortgage default rates are higher but not necessarilly "high". Well under 3% of mortgages have been foreclosed. But such a low number is boring so reports use words like millions and 40% increase to give listeners something to "ooh" about. And I suppose it would be too much to ask to hear a little about the billions in profits that are being booked shortly after purchases of these so-called "toxic" assets. I wish I would get an offer from my mortgage holder letting me purchase my own mortgage for how little they are potentially selling it for. One report had a private equity fund paying 22 cents on the dollar for mortgages from struggling banks. That sort of fire sale covers the buyer if 75% of the loans are worthless. The financial crisis is an accounting issue more than a fiscal issue. We've created an environment where according to regulations assets (loans to you and me) are being sold for prices based on prior recent sales rather than standard present value calculations. If a bank can't sell a performing loan package for a present value of the loan, what's the point of selling it at all? If they can't sell loans they don't have the cash to make future loans and the credit cycle clogs up. BUT NONE OF THIS IS BEING REPORTED! So, the market takes an emotional plunge because the Congress won't pass a liquidity bill. It isn't a bailout or a rescue. It's probably profitable to the taxpayer over time and I don't particularly like it because Congress has no business on Wall Street anyhow. 

OK, so I've vented on the ignorance of the people we're supposed to be getting our guidance from. Now, what to do about it. Well, some say I'll lose my shirt but I'm buying XLF (the S & P Financial Index) at anything under $18.50 because it's a bargain. Then I'll sell some covered calls to make some short term gains, probably in excess of 10%. Oh yeah, and if that doesn't work I'll pocket the premium and teh 4% dividend while I'm waiting for the recovery. If you can hold your hand steady, there is a lot of money to made right now. 

Ignore the press, check your emotions, and go with the math...

Will All the Banks Fail?

The list of market problems just seems to keep getting longer. We're down two Macs (Indy and Freddie), a Fannie, a Bear, and the Brothers Lehman. With a partridge and a pear tree we would have a little diddy. 

Are we doomed to repeat the 1930's? Is the mattress safer than the depository? Will we all be destitute by Christmas waiting in a communal soup line?

While some individuals may be hit so hard personally that the end appears near, the broader picture is nowhere near as bleak. It does make for good drama, though. And the market will continue to roller coaster on each verbal slip from Ben, deal from Hank, and the various jetsam from Congress. Don't expect to see calm seas anytime soon. 

That said, I must reiterate my buy signal for those willing to sift through the rubble. Even in the days of sky high commodities and the mergers and acquisitions that follow such a run, we will soon find financial M & A activity to be more voluminous than any other sector. The global financial market is exhibiting Darwinian theory at its best. While it seems a shame to see a bank falter, why should a competitor prop it up when the pieces will be half price after the fall? We've already seen several acquisitions of opportunity including Merrill Lynch and Countrywide both purchased by B of A. Several Sovereign Wealth Funds have invested in various institutions at fire sale prices. Chase and Wells Fargo are both positioned well to profit handsomely from a pending train wreck. The system isn't as broken as it appears if the strong are swallowing the weak. 

While consumers spent too much on credit, banks lent too much without cash assets. Both parties will now suffer the consequences while those who didn't participate look on with only temporary hits to their savings. 

I'm not saying that one can avoid the calamity, but keep avoiding the news and focus on the fundamentals. Buffett just announced a 5B investment in Goldman. While Mr. Buffett may offer his personal fortunes to philanthropic ventures, his Berkshire Hathaway company is ALL about profit. And Goldman isn't getting a handout. What we are witnessing is the savvy investor preparing a solid investment that will outperform the market in only a couple year's time. 

For those of you with the inclination, it is time to follow the Sage to the Market. The Blue Light Specials are plentiful and one's mattress will not offer a similar return. For example, Wells Fargo is one of those pesky financial firms that seem to be the root of all evil right now. But alas, they've not fallen foul as others have. Their fundamentals indicated strength while the financial sector dragged the stock down. With a balance sheet of 46B, the company was trading at less than 2 times their asset value in July. Since then, the stock is up 75%. What a handsome return. Now let's look at a potential acquisition target, WAMU. While they are likely to throw in the towel to a suitor, they are not in the exact same situation as one of the investment firms such as Bear or Lehman. This company has over 20B in net assets and is trading at a market cap of less than 6B. While it is certainly possible that WAMU files bankruptcy, it is highly unlikely because this bank as billions of cash in deposits and a tremendous credit card business. If they are acquired at a 50% discount, the stock will almost double. Hmmm...

But let's not look at fish bait, how about some solid positions for our 401K? Are there any financial firms still making money? While certainly off their highs, there is a company that still pulled over 6B in gross profit last quarter with an operating profit of 600M (one quarter folks). Maybe we shouldn't leave home without some American Express stock. If something smaller is your flavor, how about Apollo Investments (AINV). Their portfolio was beat up a bit from the turmoil, but they don't hold any mortgage securities and if you'll give them your money, they'll give you 12% in dividends. Oh yeah, and their stock is trading at barely 1 times their balance sheet. 

I suppose the folks in the 30's didn't see a light at the end of the tunnel but if history teaches us anything, it is that business will always survive and prosper... ultimately. A little research will find some very nice diamonds in this rough and the diligent will inherit this earth's cash while the meek will find their stash full of dust mites. 

Cry From the Hilltops, Jump From the Roof

OK, maybe I'm being a little dramatic. But probably not by much. Since the close of the market last Friday, we've seen a 7% drop in asset value (over 800 points) in three days. Obviously such a pace can not continue, but the volatility is certainly enough to give the stoic some pause.

The message this week: don't watch the news, cancel your subscription to the Journal, don't dare open up any financial website, and stop talking to the lady down the street who seems to always be walking her dog. If you sequester yourself, you might actually keep your nerves from fraying out of control.

The market will recover, it always does. In the meantime, only check your stock prices if you intend to purchase more. There are some amazing bargains out there and I don't mean the major risky shares such as AIG. Stick with the fundamentals, the following points might help some:

1. Timing doesn't work, dollar cost average into your holdings
2. Only invest in sound companies with strong balance sheets and profits to count on
3. Dividends are the answer to all problems, but the added cash flow is reason to consider companies that provide dividends
4. Never hold more than 5% of your portfolio in a single issue
5. Never, never hold more than 10% of your portfolio in a single sector
6. Tend toward EFTs if you want to invest but don't know where: SPY, DIA, QQQQ, etc

Surely, the next post will bring better tidings...

Down Come the Giants

I'm not sure if Monday will go down as another "black" day, but certainly the last hour of trading on 9/15/08 will make all but the most stoic shudder. A 200 point drop in 60 mins ended the session at over 500 points off the opening mark. Are we done with the bad news on financial firms and their massive mistakes? Probably not, however...

I shall tangent and remind the readers of what has transpired to introduce this storm of a market. I'm not a conspiracy theorist so if you're looking for a smoking gun, you've come to the wrong blog. The issues are much simpler than many would have you believe. And my mediocre assessment would blame the following culprits:

1. New-ish homeowners that don't seem to understand that assets don't always appreciate. (I blame new-ish homeowners because anyone who purchased in the 80's knew that property values don't always rise)
2. Mortgage lenders who relax their standards to increase volume without measuring the risk of their actions. Most lenders were just plain greedy, some were unethical in their positioning of ARM's and teaser loans but most explained the risks to the borrower and the borrower still swallowed the hook whole.
3. Construction related companies and individuals who milked the property boom just a bit too much.
4. Consumers who can't seem to keep their credit card balances in check.

OK, so we're all to blame. Notably absent from my target of suspicion is the Federal Government. As a general rule, superflous laws cause more harm through unintended consequences than good. Our politicians are typically some of the worst financial advisers this side of the Vegas strip, so anyone looking for their protection deserves the exposure. If the aforementioned parties had shown a modicum of restraint this particular asset bubble would not have occurred. Further, if consumer credit balances weren't so high, the risk associated with falling property values would have been much diminished. So the dominos looks like this: home buyers and consumers look to borrow too much; lenders oblige; the secondary market scoops up the debt and then freaks rather than servicing largely performing assets; lenders over correct on credit issuance; asset sales after write-downs don't generate enough cash to support historical operating practices; big banks crash and the general public freaks.

So here we are. Now what to do with freaking companies, a freaking public, and a government that loves to pontificate on how to cure the well freaked. For starters, go spend your money on what you need but not what you don't and certainly don't pay for anything that you can't afford. If consumer spending doesn't continue, a recession may pop from all this. That's right, I said MAY. Up to this point, we've not been in a recession and if you disagree please lookup the word recession on Wikipedia rather than arguing the fact.

In the meantime, there are a few investment opportunities that look interesting. If you've followed my ramblings prior to this blog, you know that I've been bullish on the general markets. Short term volatility considered, when interest rates are cut dramatically the market will typical rise over the next 12 months. Count on it. I think the Nasdaq in better shape than the NYSE due to the proportional difference in construction and financial companies between the exchanges. Going long on Q's is probably a very lucrative position right now. Regardless, the other indexes have been so beaten up that Spiders (SPY) and Diamonds (DIA) are probably near cyclical bottoms at this point.

On a more specific nature, I'm very bullish private equity. I'm not sure if the Berkshire will keep up pace with the Sage looking to exit his amazing career. That said, other private equity firms are probably in position for a nice up tick if they weren't vested heavily in real estate related products.

Energy will continue to fall, but other commodities may still show surprising resilience. A portion of your cash portfolio in something like a GLD fund is probably not a bad hedge for stock market volatility. I'm not a big futures fan for the average investor so stick with ETF's.

I've long been a fan of the FRO and SFL family. I think SFL is going to struggle for liquidity over the next several months and I've personally held or distributed my holdings. FRO on the other hand will see a drop from falling energy prices (oddly enough since they have to consume the stuff) and pressure from lack of leveraging capabilites for new builds. However, much of this has been built into the stock and there will be some significant price support in the low $40's. I'm personally accumulating shares under $45.

Retail will have some difficulty this holiday season but they are always the first to emerge from slowing economies so keep an eye on healthy subjects. I'm still fond of CHKE. While they don't make their products, they seem to have a good feel for what consumers like in clothing and they reward their shareholders with healthy dividends.

Finally, keep your idle cash in high interest products such as ETrade's checking accounts, Bank of Internet checking accounts, ING checkings accounts, etc. Don't let your idle cash gather dust from banks that don't value your business. They certainly need you more than you need them at the moment.