Portfolio Time

With the market ripe with opportunity I've had to reallocate my portfolio some to balance the risk reward situation. True, the market in general will come back strong and financials will lead the pack at some point. However, there are some opportunities beyond the arbitrage and dividend plays I've mentioned thus far. 

I will be setting many of my new positions into companies that appear to be valuable given the current market turmoil. There are many, but three jump out at me:

Alliance Resource Partners (ARLP) is in the coal business. Unlike the typical oil-energy plays which will probably make money as oil increases, coal has two benefits. Coal prices will follow oil up on sympathy alone. Since coal is cleaner (believe it or not) to burn in power plants and more power plants are coming online in 2009 based on coal, the bias is towards coal domestically. Assuming no more coal mine disasters, Alliance is positioned well to benefit from increased coal demand. At the same time, the company is well funded and while the stock isn't a bargain at current commodity prices, they pay shareholders over 8% in dividends while waiting for the stock to rise. Not too bad.

 I've always been partial to utility companies because they have so little competition and rarely lose customers. But most are priced in accordance with their dividends and don't offer much appreciation benefit. With the market turmoil, a few equities have unearthed some opportunities. One such firm, is Great Plans Energy (GXP). This utility is based in Missouri and services about 500,000 customers. Recent margins have been a little higher than historical levels but the market turmoil has knocked the stock price into levels not seen since the '80s. The firm isn't without its burdens, but the income levels are very attractive for the current price and again, an 8% dividend will help steady the way of rocky market fluctuations.

Now my favorite is a little Michigan chemical company called aptly named Dow (DOW). You may have heard of them. Dow is fairly well diversified and since it has operations in 35 countries it isn't a bad dollar hedge either. Under normal market conditions, the stock would be priced in accordance with their value but currently shares are trading well under the value of the balance sheet. The market turmoil beat up this fortune 500 player and Kuwait recently bailed on a commitment to form up a new partnership and help pay for a large acquisition of Rohm and Haas (ROH). Now the story gets interesting. The acquisition was supposed to be a $78 cash play which would lead one to jump on Rohm shares and wait out Dow shares until after the acquisition. Indeed, Berkshire Hathaway committed $3B into the play which already puts a nice shine on Dow to begin with. But the Rohm purchase may be on the rocks despite sentiment in the last couple of days. Dow has some cash, to be sure, but $15B is a lot of cash to put up for a company that generates less than $1B in cash on a good year. Market turmoil has sent Dow's credit rating under A- which means that financing the deal is probably a show stopper. 

So here's my logic. If the merger happens, I'm cool with the results because Mr. Buffett blessed the deal with his own cash and at current levels, but stock is bound to outperform the market. If the merger doesn't happen, the stock will bounce up since Dow still makes a fortune and their cash levels remain intact for other opportunities. Either way, this stock is going higher soon. Oh yeah, and if you buy now they'll throw in a set of steak knives. Oops, I misspoke. You'll have to buy the knives yourself with the 10% dividend they're currently paying.

OK, recap on the Dow thing since this one was a little wordy. You give your broker about 16 bucks for one billionth of Dow Chemical. Off the bat, you just bought $21 worth of balance sheet across 35 countries. You wait for the stock to get back over $40 where it belongs (and was less than 12 months ago). While you wait, Dow pays you $0.42 per quarter. Savvy? 

HAPPY NEW YEAR... now pay attention

This is no time to be sidelined from the market. And don't try to time an entry. Dollar cost average in so you don't get stuck on the wrong side of the volatility. But Jerry... you always seem bullish, what's different now? (I don't talk to myself often, but sometimes I get lonely)

Here are some very important facts to consider:

1. The high for the Dow Industrials was 14,000 in late 2007. 
   
2. The market gave up 6,500 points through late 2008, approx 46%.
3. Since the lows in late November, the market has recovered 1,500 points, approx 20%!!!
4. "Typical" volatility (as measured by VIX) is under 20 for most cycles.
5. Volatility in November was over 80, but is now under 40!!!
6. Short selling is down across the board (only a few poor performers are exceptions, like GM, go figure).

Summary: a fall in volatility suggests a move toward fundamental investing. A fall in short selling suggests a tendency toward normal equity trading where investors buy and hold companies that represent a good value rather than jumping in and out or flipping positions to ride waves. This summary doesn't mean that the market will be back to 14,000 this year but it does mean two things. First, shorts have to purchase equities to cover positions. A reduction in volatility usually signals a reduction in selling across both long and short positions. Therefore, when the shorts cover while the longs are buying, the stocks move up rapidly and without warning. Thus, you can't time it, so you better be in when the spikes occur. Second, there are trillions on the sidelines waiting to buy into a good position. At a minimum, this usually suggests an end to freefalling prices. Again, when the big pension funds start buying you don't want to be sitting in a money market account. 

Should you get back into the same positions you held before the crash? NO!!! As a rule, I like conservative investors to buy whole market indexes such as SPY or DIA. However, I think the prudent investor will actually look more toward value and income. Eventually a whole market position will cover your losses and then some. But down markets are the time to be opportunistic and make back more than you lost plus the opportunity loss. I think it was Ben Graham that said you don't have to make back your losses the same way you lost them. 

The mark to market FASB rules that hammered the financial segment balance sheets will do the exact reverse as the markets recover. Did you know that your mortgage is probably for sale at something like 60% - 80% of its book value? Would you buy back your mortgage at 60% of the balance you owe if you could? This inversion of value doesn't happen often but it means that financial firms that have the capital to survive the next 6 months will make more with their balance sheet than other segments. 

Let's look at an example: Big Mortgage Bank (BMB) has $100 million in mortgages issued that expect returns in the 6% range (some low risk at around 5%, others higher risk around 8%. BMB's balance sheet of mortgages are now only worth $80 million per FASB but BMB isn't going to sell these loans so the book value is largely unimportant for this example. But BMB is cash healthy and decides to purchase the mortgages of the Risky Business Bank (RBB) across town. RBB over extended their position and a run on the bank caused it to fold (sounds like IndyMac, huh?). Let's say RBB had $100 million in mortgages, too. But BMB has now purchased the mortgages of RBB for $80 million. Since BMB originated the first $100 million in loans their cost was actually $100 million. But the second tranche of loans was purchased, not originated. So now they have another $100 million in loans earning 6% but they only paid $80 million so over 20 years of servicing these loans they will make 7.5% instead of the lower 6%. The same business, doing nothing but keeping an eye open for opportunities will make 25% more profit because the business has a healthy cash position. Sears, or United Airlines won't have the same opportunity. So financials will be a great play. 

So how do you know which financials are healthier? Darwin has taken care of this for us. Only the healthy are surviving, so a purchase of all the surviving players will give you much of the upside without having to research their balance sheets. While the S & P fell over 45% from the highs in late 2007, the financial sector fell over 70%. The market will return smaller than the original so don't expect a 70% recovery soon (or 230% gain). However, the earnings potential is still there for the survivors so expect the financial sector to gain more than the broader markets. XLF is a ticker for the Financial Select Sector of the S & P. It's up 35% since November. Expect more of this.

What else? Income. Some companies are very geared toward benefiting the shareholder. This sort of management team is exactly what the small investor wants. I've always been a Frontline (FRO) fan and expect a dividend of at least 20% in 2009. Their more financial cousin, Ship Finance (SFL), will probably return a similar amount. These shipping companies can be volatile since much of their cargo involves oil. If you prefer a retail play which many believe are the first segment to gain out of a recession, check out Cherokee (CHKE). They don't actually make anything, but you can't leave a Target or major retailer without seeing Cherokee related products in your face. Wouldn't you like to have a company with 20 employees that earned $50 million every year? They get a piece of every shirt and jacket their licensee's sell. Oh yeah, they pay about 11% in dividends, too.  

Happy investing...