Local stocks receive year-end energy boost

The Scout Partners Index of Western Colorado stocks rose +1.33% while the broad market fell -0.70% in December (total return including dividends). The 25 stock index focuses on large companies whose operations have a significant impact in Western Colorado. It includes major Mesa County employers such as Wal-Mart, Halliburton, Kroger (City Market), Exxon Mobil, StarTek, CRH (United Companies), and the Union Pacific Railroad.

Energy stocks were mostly positive during the month. The leader in December was Arch Coal (ACI), which rose +18.7% during the month to close at $44.93. The stock is up nearly 50% since the beginning of the year, putting it well ahead of the S&P 500 benchmark index. Bill Barrett and Harsco closed out the year with even strong year-to-date returns, but Arch Coals’ strong showing in the month made it a standout.

Doug May, President of Scout Partners, a Grand Junction-based registered investment advisor, noted that, "coal prices, like most commodities, are climbing as the value of the dollar falls,” May said. "Simply put, the U.S. dollar doesn’t go as far as it did before. To buy a barrel of oil or a pound of coal, buyers are having to give up more dollars because in the world economy the dollar currency won’t buy what it once did." Rising coal prices mean that those companies with sizable coal reserves are worth more, and stock prices are rising as the market factors that in.

Mesa Air (MESA) was the worst performer in the index for the second month in a row, falling -18.3% in December. The stock is now lost about two-thirds of its value during the year, closing the month at $3.09. The stock stabilized during the month of December, but fell sharply during the last few trading days of the month.

"Some of it may have been tax selling," May observed, "but more of it was the announcement at month-end that the company’s September 30 earnings announcements was delayed by the need to conduct a complete review of certain estimates and reserves that could affect it’s financial results."

Scout Partners equal weighted index of Western Colorado Stocks is comprised of 25 stocks that hope to reflect, to some degree, business conditions in Western Colorado. Reflecting the local economy, the index has a large (over 30%) concentration in the energy sector, which tends to drive index performance. The next largest sector concentration is in Industrial stocks, which comprise over 20% of the portfolio. Local stocks are up 10.7% for the year while the overall market has returned +5.5% over the same time period.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Why This Book? Why Now? (Part I)

Her-e-sy (n): 1. An opinion or doctrine at variance with established beliefs, especially denial of dogma by a believer. 2. Adherence to such controversial or unorthodox opinion or doctrine.

I am a student of money, thrilled to live in (as they say) interesting times. What passes for wisdom on Wall Street reeks of promotional zest. Money so thoroughly corrupts the judgment of man that wealth and knowledge are often confused, prudence and excitement compete for the same dollars, and truth is such a rarely glimpsed commodity that when it rises up to bless the world with insight, it is mocked and crucified as an imposter by the high priests of Wall Street whose power and fortunes are derived from skimming millions and millions off the billions of thousands. The inhabitants of the cathedrals of finance cannot afford to let truth interrupt the rather profitable status quo.

But I am about to tell the unvarnished God-awful heart wrenching truth about my friends at Wall and Broad because I can do no other thing. As Martin Luther said, “to go against conscience is neither right nor safe. Here I stand, I can do no other, so help me God.” Or, in the vernacular of risk takers everywhere, let the chips fall where they may.

Money flows. Like music, it can be creative and fruitful and result in goodness and peace. More often, it is discordant and artless and commercial and crass. It may be innocent, such as when a child empties his piggy bank to buy a game for a friend or sings a lullaby to help his little brother sleep. But more often money is a harsh clanging sound as harried and desperate people chase it through the tender tundra of relationships and integrity, sometimes failing and sometimes succeeding but always leaving an ugly pain in their wake.

I like money to make sense. I am frugal. Most would say cheap. Watching Wall Street rob its clients blind not only upsets my sense of right and wrong, it strikes me as wasteful. Imprudent. Inefficient. It is an out of tune piano that spoils the listener’s ability to enjoy any music at all. What makes it criminal is that the world has changed to give investors the ability to take control of their own financial affairs. They can’t all become little Warren Buffetts, but neither must they remain tied to the financial service behemoths who have been taking advantage of them year after year. Times have changed. Financial technology has advanced the cause and all investors need to do is plug in the electric guitar and leave the dark ages behind. Rock and roll.

Technology is the application of science (new knowledge) to commercial or industrial applications. Technology is responsible for yesterday's top choice becoming obsolete. Technology is not limited to the field of computers or medicine. Financial inventions, new technology applied to the area of finance, have revolutionized how we save money and invest for the future, although we rarely think of it in these terms.

For instance, when inflation ravaged savings account returns during the late 1970's, banks paying very low rates of interest on certificates of deposit competed with each other by giving away prizes, known as savings premiums. Instead of giving away bigger returns, they gave away toasters, clocks, 8-track players and other gadgets. These premiums were fun to have, but cash is better. At that time, however, federal regulations put a ceiling on what banks could pay depositors, so giving depositors more cash wasn't an option.

At the time, the OPEC oil embargo prompted inflation and interest rates to move higher. Elderly savers, living on interest from bank savings accounts, fell further and further behind each year as prices increased faster than their interest income. As inflation increased, unregulated money market mutual funds began paying higher and higher interest rates to investors. The funds invested in short-term certificates of deposit and commercial paper whose interest rates weren’t capped and they became a popular escape from the low yielding bank products. Although money market funds had been in existence for decades prior to this point in time, up to this point few investors used them or were familiar with them. Most investors still invested in individual securities. The concept of investing in a fund along with other investors and leaving the day-to-day fund management to professionals at a fund management company was foreign to most people.

But money market funds seemed pretty safe, and gradually these funds' higher yields began attracting investors. More knowledgeable savers, and eventually the investing masses, withdrew money from local banks and savings & loan institutions and deposited it instead into money market funds. Individual investors learned how to take more control over their own personal investing program.

Eventually banks did respond, of course. They pressured regulators to lift the interest-rate caps which had prevented them from offering competitive rates. They stopped offering investors blenders and mixers, and started offering more competitive yields. But it was too late. The cork was out of the bottle and the upstart mutual fund genie had escaped. What was once a poorly understood niche product, the super safe mutual fund designed to be a higher yielding alternative to a government guaranteed bank account, has subsequently evolved into a financial leviathan.

Now, nearly thirty-five years later, money still flows out of banks and into mutual funds. Banks continue to lose market share. The banking industry is consolidating and bankers are struggling to understand this not-so-new mutual fund competitor. In 1996 Pittsburgh's blue blood Mellon Bank purchased Dreyfus Corporation, the mutual fund giant whose money market funds once dominated the mutual fund landscape. Since the Glass-Steagal Act that separated commercial and investment banking was repealed in 1999, banks have acquired and ruined many mutual fund companies. What began as a heresy of sorts due to an advance in financial technology in the 1970's has become very mainstream indeed.

Next post: The Fund Supermarket Innovation

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Movable Beta

The Fed has cut rates by ¾ of a point to 4.5%, though the market wants more. Short-term T-Bill rates have fallen from 5% to 3%. Today’s lower rates will be a big factor in getting this economy moving again, but not until later next year. There is a lag to monetary policy.

For now, though, the Fed’s easy money policies won’t save Countrywide from itself. Big banks that used to funnel money to thousands of tiny mortgage lending companies have closed their loan warehouses down. They say that it’s to get a handle on loan quality, as if their own internal lenders were somehow exempt from the same sloppy lending practices that caused the housing bubble in the first place. In reality, the banks need every dollar they can get to prop up their own institutions.

Freddie Mac, the no longer government-backed company that became addicted to borrowing at rates just barely above treasury levels, is paying 8.375% to borrow $6 billion so it can continue purchasing mortgages that yield around 6.25%. Citigroup went hat in hand to the Middle East to borrow petrodollars from Abu Dhabi at 11%, though the prime rate for U.S. borrowers is 7.5%. Adding to the mix E-Trade sold its toxic collection of mortgages to a hedge fund for 27 cents on the dollar. With such stellar capital allocations moves as these, it’s unlikely that we have yet turned the corner on earnings disappointments in the financial sector.
 
The market lost momentum in the financial and consumer cyclical sector a long time ago, but the lack of enthusiasm for equities has extended to most mid-caps and small-caps, telephone stocks, and even healthcare. Stalwarts like international, energy, technology, and materials had a tough month. Our fund portfolios purchased some long bonds this month. This effectively reduces what has been an above-market portfolio beta to roughly a market beta. There’s nothing wrong with boosting beta when markets are doing well. In some markets, however, it pays to be a risk manager.
 
Volatility (the kind where the market goes down) has for the third time this year again introduced itself to investors. Upside volatility is actually a good thing, but Wall Street typically uses the word volatility to avoid acknowledging the fact that sometimes markets go down. In their view, sometimes markets go up – and sometimes they are volatile. Beta is a term linking portfolio volatility to that of the overall market. A beta of 1.1 is 10% more volatile than the market. If the market rises 10%, a portfolio with a beta of 1.1 will rise 11%. If volatility inexplicably leads to a market decline to 10%, the higher beta portfolio will decline by 11%.
 
Since markets generally go up, some investors live mostly in a high beta world, hoping to outperform the market by taking greater risk (structuring a high beta portfolio). They can emphasize small cap stocks over larger names. They can focus on volatile sectors like technology or commodities. They might prefer companies with high debt ratios, or even use margin to leverage their own portfolios.In general, these always-aggressive portfolios are sort of a ticking time bomb. They work well, most of the time, but when the market goes against them they can lose most if not all that they gained on the way up. A lot of hedgers build these portfolios and given the pay structure of the hedge fund industry (tails I win, heads you lose), it makes sense (for the manager).
 
ETF Scout believes that portfolio beta ought to adjust to reflect current economic and market conditions. In a perfect world, investors want a high beta portfolio when the market is moving up, and a zero beta portfolio when the market is falling. While ETF Scout is not perfect, we see that the ability to adjust the beta, or risk, as one of the pillars of our investment strategy. From our standpoint if an investor is paying for active management they should demand a variable beta portfolio.Isn’t that what you are paying your managers to do? It makes sense to risk more when the markets are doing well, but risk less in times of trouble.
 
The epitome of this is the Will Rogers trading strategy. He said, “Trading is easy. Only buy stocks that are going up. If they don’t go up, then don’t buy them.” Easier said than done. But the idea that portfolio beta ought to move around, which is a more realistic version of the Will Rogers trading strategy, is considered heresy to Wall Street’s “buy and hold” convention.In recent years, the ETF Scout portfolio has done well partly because our portfolio has had an above average portfolio Beta during what has generally been a very kind five year period for investors.
 
In December, we once again re-introduced bonds to the portfolio. The effect will be to reduce overall portfolio beta. We are now less sensitive, at least for the time being, to what Wall Street calls “volatility.” If the market weakens further, we will reduce it even more. Happy Holidays.

 

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Falling market sends local index lower

The Scout Partners Index of Western Colorado stocks fell along with the market in November, -3.96% versus a -4.18% monthly decrease for the widely followed broad market S&P 500 stock index (total return including dividends). The 25 stock index focuses on large companies whose operations have a significant impact in Western Colorado. It includes major Mesa County employers such as Wal-Mart, Halliburton, Kroger (City Market), Exxon Mobil, StarTek, CRH (United Companies), and the Union Pacific Railroad.

Helping cushion the fall, Mesa Labs (MLAB), rose 10.5% during the month to close the month at $24.90. The stock is up +31.5% since the beginning of the year, putting it well ahead of the S&P 500 benchmark index.

Doug May, President of Scout Partners, a Grand Junction-based registered investment advisor, noted that, "Mesa Labs delivered a really solid quarter, with revenue increasing 16% year-over-year and earnings up 40%," May said. "With all of the difficulties that investors are experiencing in the financial sector, a stock with good earnings growth that isn't in any way tied to the sub-prime mortgage sector starts sounding more attractive."

Mesa Air (MESA) was the worst performer in the index, falling -18.7% in November and the stock is now -55.9% for the year, closing the month at $3.78 and traded as low as $3.10 on November 21.

"At the end of October, the company lost a significant court case," May observed, "and started the month of November by terminating their Chief Financial Officer. During the second week, they announced that air traffic was down. Merrill Lynch kicked off the third week of the month by finally recommending that clients sell the stock, now that the stock price was half what it was at the beginning of the year, and the company finished the month by posting a $90 million bond just in case it loses its appeal of that October ruling." On November 20th, the company's Board of Directors announced that they had approved certain ammendments to the employment agreements for several officers. "In Japan, this company's CEO would probably commit suidice," May said, "but in this country its ever vigilent board decided to give the management team a raise and extend their contracts. Investors should keep that in mind next proxy season."

Scout Partners equal weighted index of Western Colorado Stocks is comprised of 25 stocks that hope to reflect, to some degree, business conditions in Western Colorado. Reflecting the local economy, the index has a large (over 30%) concentration in the energy sector, which tends to drive index performance. The next largest sector concentration is in Industrial stocks, which comprise over 20% of the portfolio. Local stocks are up 9.3% for the year while the overall market has returned +6.2% over the same time period.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Strong numbers, but less so…

The housing crunch, sub-prime lending debacle, and real estate recession has unfolded pretty much as I forecast in my January meetings with clients. Neither the ferocity of the decline nor the size of the write-offs being taken are a surprise.

What is unexpected is just how strong the overall economy remains in spite of the huge losses being incurred in that part of the economy. It reminds me of the late 1980's when "rolling recessions" across the rust belt, then the financial industry, and finally the energy belt failed to KO the broad economic recovery that began in 1983. It wasn't until the junk bond and S&L crisis hit that the economy finally slowed to a crawl.

Last week's economic numbers suggest that the real estate bust is just another rolling recession that severely impacts one part of the economy without resulting in an nationwide slowdown. Growth in GDP (gross domestic production) and payrolls both suggest solid economic growth, even in spite of the blow-up in the housing sector.

Moreover, I wouldn't want today's comments to take away from the fact that I have been surprised by just how strong this economy remains. However, I think it might be a little less strong than last week's numbers suggest.

In "Pillow Talk," Barron's columnist Alan Abelson points out that last week's 3.9% 3Q GDP number was, shall we say, "enhanced" by the fact that according to this initial estimate of GDP, the GDP inflator rose only 0.8%, versus a 2.6% increase in the first quarter. To most of us, it seems that inflationary pressures are getting worse. However, since the GDP deflator barely increased according to the most recent calculation, the headline GDP number soared 3.9%, instead of a more modest 3% increase. "Save for the miraculous decline in the GDP 'deflator,' in the third quarter," Abelson writes, "growth in the economy would have barely topped 3%. So maybe this 3Q number is a tad bit aggressive, unless you actually believe in the 0.8% inflation number. I don't.

Similarly, the +166,000 job increase was helped a bit by the government's birth/death adjustment, which accounted for about 2/3 of the increase. Abelson write, "which means, pure and simple, they were the product of somebody's computer doodling; they were, in other words, made-out-of-the-whole-cloth phantom, phony."

So...is there a surprising amount of strength in this economy, particularly given the horrific state of the residential real estate industry? Yes. But, is it as good as this market seems to be thinking? I doubt it.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Arch Coal leads local index higher

The Scout Partners Index of Western Colorado stocks rose along with the market in October, +4.30% versus a +1.59% monthly increase for the widely followed broad market S&P 500 stock index (total return including dividends). The 25 stock index focuses on large companies whose operations have a significant impact in Western Colorado. It includes major Mesa County employers such as Wal-Mart, Halliburton, Kroger (City Market), Exxon Mobil, StarTek, CRH (United Companies), and the Union Pacific Railroad.

Leading the index higher, rising 21.5% in the month, Arch Coal (ACI) ended the month at $41.00. The stock is up +36.5% since the beginning of the year, putting it well ahead of the S&P 500 benchmark index, though it has been a particularly volatile year for the stock.

Doug May, President of Scout Partners, a Grand Junction-based registered investment advisor, noted that, "Arch Coal announced a weaker than expected quarter, only 19 cents per share instead of the 27 cents that Wall Street was expecting, but they tempered that news with a positive outlook for the rest of the year and for 2008, and more importantly with the price of crude oil gaining more than 10% on the month, the outlook for pricing in 2008 looks solid, which should lead to upward estimate revisions."

Qwest (Q) was the worst performer in the index, falling -21.6% in October and the stock is now -14.4% for the year, closing the month at $7.16. The stock is now down more than 30% from its recent high of $10.45 last May.

"It looks like Richard Notebaert got out just in time," May observed, refering to Qwest's former CEO who retired in mid-August. "Revenues were lower, they had to cut the earnings forecast, and any talk of restoring some sort of dividend payout to investors has been set aside until they can get a handle on things," May said.

Scout Partners equal weighted index of Western Colorado Stocks is comprised of 25 stocks that hope to reflect, to some degree, business conditions in Western Colorado. Reflecting the local economy, the index has a large (over 30%) concentration in the energy sector, which tends to drive index performance. The next largest sector concentration is in Industrial stocks, which comprise over 20% of the portfolio. Local stocks are up 13.9% for the year while the overall market has returned +10.9% over the same time period.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Strange Quarter

Who knew, on the 1st hot day of July, that the mortgage market was on the verge of collapse, highly leveraged hedge funds were going to be forced to dump assets at fire sale prices in a desperate attempt to de-lever, that rumors of a rebound in residential construction would die such a swift death, that thousands of mortgage lenders would soon be out of a job, that Citibank would be writing off over a billion dollars of sub-prime loan exposure at quarter-end, or that Swiss banking giant UBS would be writing off more than $3 billion, or that nearly a half dozen announced and ostensibly already financed leveraged-buyout deals would be cancelled because liquidity in the junk bond market would evaporate in a heartbeat?

And if you had known these events would transpire, who would have guessed that the S&P 500 would rise 1.5% during the quarter?

Had we known these events were on deck, we certainly would not have guessed that our ETF portfolio would be up +4.3% during the tumultuous 3-month period to follow. Had we perfect foresight and known that the Fed’s response would be to cut interest rates, causing the dollar to implode, we might have surmised that our heavy international exposure and commodity oriented investments would benefit from that particular consequence. At least that part makes sense. But how do you explain an up market when the fundamentals are being battered and bruised on a daily basis?

One day in August, the market fell 285 points, only to rebound by 250 points the day after that. It’s a tough way to lose 35 points! To be sure, this year has been rough, but also rewarding. The ETF Scout portfolio is closing in a gain of almost double the market. In spite of such performance, this market has been unnerving to us as it has been to many of you.

Headline news aside, the market continues to climb the proverbial “wall of worry.” Perhaps we ought to be rejoicing each calamity as it unfolds. We are not. Neither, however, are we full of panic. Instead, humbled once again by our inability to precisely predict the future, we are trusting our instruments and letting our investment disciplines guide us.

A limber mindset and a flexible portfolio remain critical elements of investment success.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Mesa Labs replaces LaFarge in Index

The Scout Partners Index of Western Colorado Stocks rose along with the market in September, +3.63% versus a +3.74% monthly increase for the widely followed S&P 500 stock index (total return including dividends). The 25 stock index focuses on large companies whose operations have a significant impact in Western Colorado. It includes major Mesa County employers such as Wal-Mart, Halliburton, Kroger (City Markets), Exxon Mobil, StarTek, CRH (United Companies), and the Union Pacific Railroad.


Leading the index higher, rising 14.4% in the month, Arch Coal (ACI) ended the month at $33.74. The stock is up +12.4% since the beginning of the year, putting it slightly ahead of the S&P 500 benchmark index, though it has been a particularly volatile year for the stock. Mesa Air Group (MESA) was again the worst performer in the index, falling -21.3% in September and the stock is now down -48.2% for the year.

“Mesa is experiencing both internal and external problems,” observed Doug May, a Grand Junction-based registered investment advisor, “there are increasing signs that we're heading into a recession, or at least very close to one, and fuel prices are rising, which will boost Mesa's cost structure. In addition to that," May added, "they are in the middle of a lawsuit as a result of a Hawaiian Airlines lawsuit which alleges that Mesa conducted some due diligence on Hawaiian Air in 2006, and then turned around and used that confidential information to go start up their own interisland carrier." Mesa Air Group received an unfavorable ruling in September as the judge determined that evidence that Mesa intentionally destroyed can be used in trial.

Mesa Labs (MLAB) replaced LaFarge in the index. LaFarge applied for a delisting from the New York Stock Exchange but retains its Euronext listing, where 99% of its stock trading takes place. Lakewood, Colorado-based Mesa Labs manufactures and markets electronic instruments and systems for industrial applications and hemodialysis therapy. "Adding Mesa Labs to the index helps bolster representation of the health care sector in the index," May notes, "which is an important contributor to the local economy and one that was under-represented in the index."

Scout Partners equal weighted Index of Western Colorado Stocks is comprised of 25 stocks that hope to reflect, to some degree, business conditions in Western Colorado. Reflecting the local economy, the index has a large (over 30%) concentration in the energy sector, which tends to drive index performance. The next largest sector concentration is in industrial stocks, which comprise over 20% of the portfolio. Local stocks are up +9.16% for the year while the overall market has returned +9.13% over the same time period.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Fed Cuts Rates by 1/2%

I'm disappointed, how about you?

The market has risen about 400 points since Ben Bernanke cut the Fed Funds rate by 1/2%, but that's not what bugs me. Who doesn't like it when their investments are worth more one day than they were the previous day?

And it's not that I don't think the rate should be decreased. I think it was a mistake that short-term rates were increased to 5% at the start of 2006. We had a dozen consecutive increases raising rates from just over 1% to nearly 5%, and it would have made sense to me to wait a few months to see what impact rates above 4.5% were going to have on the economy. Instead, we kept raising rates and it's no surprise that today we're wringing our hands wondering if he didn't go too far.

A 4.5% Fed Funds rate, plus or minus 25 basis points, is probably where rates ought to be. I'm not disappointed that the short-end of the curve came down.

What disappoints me is that the Fed has been on this anti-inflation campaign and William Poole, the Chairman of the Fed Bank of St. Louis, said in mid-August that, "No one has called up and said the sky is falling." He intimated that it would take some sort of calamity to get the inflation hawks to change course.

Two days later, the Fed cut the discount rate and this week the Fed Funds rate came down. What do they know that we don't know?

We already know, for example, that loan defaults have recently doubled. We know that residential building permits fell to below 1 million starts, the lowest level since June of 1995. In fact, the August number was the worst non-Winter report since April of 1990, during the nadir of the Savings & Loan debacle. We already know that retail sales growth is anemic, and that Wall Street's money machine is having trouble selling the big LBO buyout loans to which it committed over the Summer. But what don't we know yet? (One thing we don't know is what is the "clearing price" for those junk bonds that need to be issued, which will determine just how big of write-offs will Wall Street banks be taking at year-end.)

We already know that the Fed's announcement caused gold and oil prices to soar as global economic players discount, yet again, the value of a dollar. Travel overseas, lately? It used to be that New York was the expensive part of the trip. Now it's "over there" that you can't afford to shop. But we already know that. We know that we're increasingly dependent on overseas investors funding our deficits, and this week's 10-year Treasury auction was practically boycotted by foreign investors. But we already know that. What, besides "what is the clearing price of a U.S. Treasury Bond if foreign investors don't participate in our auctions," what don't we know?

Something that we don't know yet, but the Fed does, has them scared enough to turn policy on a dime and turn almost overnight from policy hawks into rate cutters.

The reason I'm disappointed is that I've been saying for awhile that we're headed into a recession in 2007, and it looks like the Fed has finally come around to my views.

Last time around, the first Fed cuts came in the Spring of 2001. The party didn't last too long. 2001 and 2002 were awful years for stock investors. The market's aren't as overpriced as they were then, so we don't have as far to fall, but things don't look too good out there. If you don't believe me, just ask Ben Bernanke.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Welcome to September

Barron's wrote up XTO Energy (ticker XTO) and interviewed Andrew Pilara who likes related energy investments in Key Energy Services (KEGS), Spectra Energy (SE), and Taliman Energy (TLM). The most interesting this to me, though, was page 48 of the Market Week section.

It happens almost every year, but it's still noteworthy when Equity flows into mutual funds reverse, as they do about this time every year. Outflows hit municipal and taxable funds, and last week AMG reported that stock flows out of stock funds reached $2.7 billion.

When new money is flowing into the market, it's easy for the bid side to carried away investing its' money, forcing the price of stocks up higher than fair value. When the party is over and the money starts flowing the other direction, the trading desks are left with a need to raise funds and forced to ask the question, "sell to whom?" At these times, values fall to a level where new money can come into the market and stabilize the buy/sell equilibrium. No longer will buyers tolerate overvalued merchendise. Stocks are likely to keep falling until either equilibrium is restored or, courtesy of the calendar, money flows reverse direction and buyers once again need to hustle to get money put to work.

It's a supply and demand world out there, and it's time for the annual calling to account.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Mesa Air drags down local stocks

The Scout Partners Index of Western Colorado Stocks fell in August, losing -0.73% versus a +1.5% monthly increase for the widely followed S&P 500 stock index (total return including dividends). The 25 stock index focuses on large companies whose operations have a significant impact in Western Colorado. It includes major Mesa County employers such as Wal-Mart, Halliburton, Kroger (City Markets), Exxon Mobil, StarTek, CRH (United Companies), and the Union Pacific Railroad.

Leading the index higher, rising 8.2% in the month, Wells Fargo (WFC) ended the month at $36.54. Large diversified financial service companies led the month-end market recovery.

“With all the independent mortgage companies going bankrupt, many investors are looking for the survivors like Wells Fargo to benefit from picking up market share,” said Doug May, President of Scout Partners, LLC, “What makes no sense to me, however, is that we are seeing real problems - nationally - in the real estate market, and I don't see why the big banks like Wells Fargo and BofA are going to be immune to these problems. I think that all the big banks are going to have to increase loan loss reserves before this thing is over, and that is likely to hurt companies like Wells Fargo going forward.” Wells Fargo is up +2.8% since the beginning of the year, which lags the S&P 500 benchmark index.

Mesa Air Group (MESA) was the worst performer in the index, falling -15.2% in August and is down -34.2% for the year.

“Mesa reported a decrease in both available seat miles and revenue passenger miles,” May said, “though passenger enplanements increased year-over-year.” MarketWatch reported mid-month that all U.S. airline shares were being hurt by rising oil prices and that investors had concerns about how deteriorating credit market conditions would impact this traditionally heavily leveraged sector.

Scout Partners equal weighted Index of Western Colorado Stocks is comprised of 25 stocks that hope to reflect, to some degree, business conditions in Western Colorado. Reflecting the local economy, the index has a large (over 30%) concentration in the energy sector, which tends to drive index performance. The next largest sector concentration is in industrial stocks, which comprise over 20% of the portfolio. Local stocks are up +5.3% for the year while the overall market has returned +5.2% over the same time period.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Booyah Barron’s - Part 2

Alan Abelson, whose weekly column is the main reason people subscribe to Barron’s, was missing in action this week - probably out celebrating the sell-off that he’s been predicting for lo these many years. However, his responsibilities were ably filled by Randall Forsyth whose column, though not particularly humorous, was rich in other ways.

His “On Borrowed Time” article described the wrenching adjustments being made in the subprime mortgage industry as even the good players find themselves forced to the edge of solvency, and possibly over it, as the capital markets reject an entire industry. He borrows his description from an un-named hedge fund who describes the financial alchemy used to magically convert junk bond low-quality investments into something AAA rated, and available for sale to, according to that writer, Asian, German, French and U.K. banks who are running massive trade surpluses with the US. This is no way to treat your lenders, on whose kindness your national solvency depends.

The letter writer concluded “This will go down as one of the biggest financial illusions the world has EVER seen.” Forsyth adds, and “to think it’s all played out is even more laughable. Borrowers in Grand Junction, Colorado are having difficulty getting their loans approved because of the madness perpetrated by these Wall Street Masters of the Universe in their never ending quest for a bigger year-end bonus.

Barron’s also wrote about “A Gusher of Opportunities” in the energy service sector, highlighting Nabors Industries (NBR) in particular, a stock which Scout Partners custom wealth (individual stock) clients currently own. Though the offshore drillers like Diamond Offshore (another Scout Partners’ long position) have performed reasonably well, the dry land rig renters like Nabors have seen more pricing pressure and concerns mount about the sustainability of their earnings stream, estimated at $3.45 in 2007 and $4.01 in 2008. The stock trades at only 8 times earnings, for an inflation protected return of over 12% on investment.

The nay-sayers on Nabors worry that the industry boom will go bust, but global industrial production is on the rise, which typically requires a corresponding boom in oil production. Instead, oil production has flat-lined, despite increasingly frenetic attempts to find the liquid gold (i.e. higher and higher drilling rig counts). Until we start turning up more of the oil we need, as long as the global economic boom lasts, we would expect the energy service industry to continue to have pricing power and robust top line growth. We’re glad to see Barron’s profile this company.

Finally, Barron’s weekly Mutual Fund Cash Track continues to show strong inflows into equity mutual funds. More typically, this is the time of year when fund flows turn negative. Year-end bonuses have all been paid, tax refunds are all back in the market, and Summer vacationers are selling investments in order to pay off travel and lodging expenses on their credit cards. August and September are typically months where there are net outflows from mutual funds, but the AMG data in Barron’s is reporting strong inflows instead. This was a bit of a surprise because last Thursday the TrimTabs mutual fund cash flow tracking reported a swing to the negative on equity fund flows. In fact, the market acted like it was funding $19 billlion in outflows, as TrimTabs reported, rather than receiving $4.9 billion in inflows, as AMG reported.

This discrepancy bears watching, and my guess is that the TrimTabs reports are right. I don’t see retail investors buying back into this market. This recent bubble was financed by brain-dead pension fund fiduciaries who were too stupid to see the garbage that passes for a hedge fund manager these days. When all is said and done, it will be pension funds that pay the price for most of the subprime and leveraged buyout stupidity that has sent the market reeling in recent weeks. Look for corporate profits and defined benefit plan retirees to pay the price for these less-than-wise investment decisions.

- Go to Booyah Barron's, Part 1 -

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Booyah Barron’s! - Part 1

This week's Barron's issue is full of tasty financial morsels, not least of which is the cover story on Booyah's Jim Cramer, wondering why his trademark cry, "Booyah!" rhymes with "fooled ya!" as they report on the media hound's less than stellar performance. It took awhile, but the elves at YourMoneyWatch.com finally listened to what Cramer said on-air, followed up on whether the advice was profitable or hip deep in booyah, and found that Cramer's picks have generally underperformed the market.

The Cult of Cramer has quite a following, but long-time observers see a media megalomaniac who will say and do just about anything to make a buck, for himself. At his hedge fund, he took advantage of the razor thin journalistic integrity of the CNBC talking heads in order to pump up stocks in which his day trading desk had long positions, and passed along negative rumors in positions he was short. A madman in his own company, much like the persona he displays on television, he was a difficult person to work for and I still marvel at the decision he made to walk away from a successful hedge fund in order to become a TV celebrity.

If he really loved the markets and was truly a successful hedge fund manager, I don’t see how he came to that decision. As an insufferable megalomaniac with a less than incredible hedge fund track record, however, it’s a bit easier to understand the trade-off he made. That he did so while feasting off of the internet bubble, trying to get his share of the booty while there was easy money to be made, might just be a coincidence.

If, for some strange reason, you still want to follow Cramer’s Mad Money picks, rather than listen to the daily filter free self aggrandizement which he parades in the somewhat faded threads of financial journalism, just log onto http:MadMoney.theStreet.com and follow the facts without the booyah. Be sure to keep a record, and you might want to stash your money in an index fund and just keep a paper portfolio for awhile. When the market was making new highs in July, Cramer was talking about how much higher each of the Dow components would be at year-end.

After the market turned down and broke through 13,000 on the downside, he spoke as an experienced bear, about how he has loaded up with cash because it will be cash-rich vultures like him who will take advantage of others by buying assets at (precisely, no doubt) the bottom. Cramer’s 20/20 hindsight is as good as it gets. On the other hand, most investors’ hindsight is 20/20. But Cramer’s advice usually parallels the tape. He is as manic as the internet in rising markets, and as skeptical as a banker (oops, bad analogy) when the tape is running red. He’s a vulture, alright, preying on a media-mad culture which seems incapable of doing the math that’s required to separate the successful investors from the crowd that peddles nothing but booyah.

A few weeks back, Cramer showed yet again that his moral compass drifts off course by about 180 degrees from the direction of true north when he advised New Yorkers who bought a home in 2006 to walk away from it and let the bank (or sub-prime mortgage holder, probably a hedge fund managing money for a pension fund) take a bath on the property. Can you imagine Warren Buffett giving anyone that advice? Only in New York would that be considered financial wisdom.

To members of the Cult of Cramer, caveat emptor. Buyer beware! With P.T. Barnum ethics (there’s a sucker born every minute) and an obviously selective recollection of his own track record, doesn’t it make sense for investors to ask themselves the most basic investing question there is, which is “would I trust this person with my money?” Cramer is more than just annoying. He’s a personification of most of what is wrong with Wall Street today. All brand name, and no substance. Thanks, Barron’s, for putting him on the front cover.

- Go to Booyah Barron's, Part 2 -

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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“Opportunity” in a mortgage bond

Do you know anyone about to die who wants to make a fast buck on the way out the door? I just saw an interesting opportunity to buy some Countrywide Financial 5% bonds due 12/15/09 at only $88.33. (A buyer would pay $883.30 for the bond, which returns $1,000 at maturity.)

I wouldn't want to own these Countrywide bonds very long, since CFC may or may not be around for much longer. It's supposed to be the only mortgage lender who survives...but what if they don't? The bonds are selling at 88 cents on the dollar, but apparently they have a "death put," where the holder can put the bonds back to the issuer (for 100 cents on the dollar) if the holder dies.

That's a quick 13% (plus accrued interest!), and all you have to do is kick the bucket!

Anyone who thinks that Countrywide will last longer than them, and admittedly it's a horse race, ought to take a look at these!


Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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July roughs up local company index

The Scout Partners Index of Western Colorado Stocks fell in July, losing 3.9% versus a 2.9% monthly decline for the widely followed S&P 500 stock index (total return including dividends). The 25 stock index focuses on large companies whose operations have a significant impact in Western Colorado. It includes major Mesa County employers such as Wal-Mart, Halliburton, Kroger (City Markets), Exxon Mobil, StarTek, CRH (United Companies), and the Union Pacific Railroad.

Leading the index higher, rising 4.3% in the month, Halliburton Co. (HAL) ended the month at $35.96. The company announced strong profits, with operating earnings growing 28% and reported earnings almost tripling over year-ago levels due to one-time gains reported as a consequence of the sale of its KBR unit.

“Oil prices continued higher throughout the month,” said Doug May, President of Scout Partners, LLC, “which encourages drilling activity, which is benefiting many companies in the energy sector. After announcing strong earnings, the Jeffries analyst raised his target price and had positive things to say about Halliburton's presence in the Eastern Hemisphere and Latin American operations.” Halliburton is up nearly 16% since the beginning of the year.

Arch Coal (ACI) was again the worst performer in the index, falling -14.1% in July after an equally dismal -13.8% decline during the month of June. The stock, which was up almost 40% at the end of May, has given up all those gains and now sits $0.13 below where it began the year.

“Utility companies have been stockpiling coal, so on the 23rd of July the company acknowledged that production levels would come down and pricing is still soft,” May said. “They cut the earnings guidance to $1.00 to $1.30 for the year, which is well below the Street consensus of $1.53 per share.”

Scout Partners equal weighted Index of Western Colorado Stocks is comprised of 25 stocks that hope to reflect, to some degree, business conditions in Western Colorado. Reflecting the local economy, the index has a large (over 30%) concentration in the energy sector, which tends to drive index performance. The next largest sector concentration is in industrial stocks, which comprise over 20% of the portfolio. Local stocks are up 6.1% for the year while the overall market has returned +3.9% over the same time period.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Retirement Calculations

Are you paying active management fees to invest in a bunch of index funds? Why does that make sense for anyone except your financial advisor, who is spared the burden of having to do something to earn his keep?

In some (rare) cases, maybe your financial advisor is actually helping you develop and monitor a financial plan for your retirement years. I mean, a real plan. One with financial projections to help you see whether you've saved enough money to retire in the way you've imagined. A plan that examines any estate tax liability with options in place that prevent you from paying anymore to the tax man than is necessary. You know, a real working document that makes it clear how much you need to be saving so that you've truly saved "enough."

Your advisor isn't doing that? I didn't think so. Most don't. It is a lot of work, which tends to get in the way of the advisor's true calling - which is to lower their golf handicap as much as possible, which takes a lot of practice. Real work, the kind that benefits clients, kind of gets in the way.

So some folks might want to go online and try out a "retirement calculator" to do what their advisor should be doing for them, but can't or won't because his swing developed a hook that is just ruining his long game, and the only way to get rid of it is practice, practice, practice.

In fact, CBSMarketWatch just reviewed several calculators in a recent article titled Retirement by the numbers.

Online calculators can help you get a sense of whether you've saved enough money to live the life to which you would like to become accustomed after you hang up your canary and say good-bye to your friends in the coal mine. These calculators can only provide a general answer, but that's true of the most sophisticated planning programs available on the market. They all need to be used with a giant sense of skepticism. Though they calculate answers to the penny and draw charts and illustrations that extend out until the investor reaches the ripe old age of 119, in reality the investment markets rarely perform as expected, on cue, and the assumptions that go into a plan are usually quite different than the reality that one experiences as the plan unfolds and real life takes root. How many planning programs took the technology crash into account? (Answer: none. It's the planners job to try to avoid "garbage in / garbage out.")

On the other hand, unless you've got a sixth sense that gives you an innate sense of the time value of money and the ability to discount cash flows to net present value over a 30-year time span, remembering to factor in Social Security income, a calculator is the only way to get your arms around the question.

Will I have enough to live on in retirement? Can I afford to retire at all, or will I be singing with the canaries down in the shaft until the day I finally bite the dust and go to meet my maker?

And when you do finally cash in your chips and pass on to that big worldwide web in the sky, you might want to ask the big guy why we can't know more precisely just how long we need to plan for when we're using these retirement calculators. It would certainly make the job a lot easier.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Comparing Long-term Care Policies

One of the best things about the investment business is that you get paid to read. A lot. A recent Investment Advisor article included some very helpful comments about how to compare long-term care policies.

One important difference between policies are the "benefit triggers" that enable the policyholder to begin collecting benefits. Better policies will cover cognitive impairment such as Alzheimer's, senility, irreversible dementia and mental dysfunction caused by stroke.

Benefit periods also differ between policies. Be certain the policy covers at least 3-5 years, the length of a typical nursing home stay.

The elimination period is the period of time before benefits can begin to be paid. Are the policies you're comparing comparable, with each having 30, 60, or 90 days? Longer elimination periods reduce premium costs, but comparing two policies with different periods is difficult.

Look for a "guaranteed renewable" clause as well as inflation protection, and for policies that cover all levels of care, both skilled and non-skilled. Finally, compare the financial stability of the company offering the policy.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Money Market Funds

Back in the days when mutual fund companies used to focus on ways to help consumers - before the marketing guys took over and start pushing bad product out the door - money market funds were, at one time, an innovative product that enabled investors to get higher yields than were available on bank savings products. In the early 1970's, when the Federal Reserve was still in the habit of regulating interest rates - capping what banks could pay depositers - the money market mutual funds allowed investors an entry into the commercial paper marketplace, where corporate and financial borrowers were paying much higher rates of interest on short-term paper. By bundling savers' moneys together into a mutual fund, the mutual fund companies made it possible for investors to benefit from those higher yields.

These days, however, the mutual fund companies are replacing innovation with exploitation. The major financial services companies switch customers into new accounts with ongoing fees, regardless of activity, and then hope that these customers just let their money sit so the "financial advisor" can enjoy the best of both worlds, recurring fees with no actual work to do for the client. The financial services companies call this "annuitizing the book of business" because it turns a client into a constant fee source, though I can think of other names that better describe what the client is getting.

In recent years, several large brokerage firms have taken exploitation a step further. Noting that many brokerage accounts sit uninvested in anything except money market funds, brokerages like Charles Schwab, Citigroup (Smith Barney), Wachovia, and more recently Wells Fargo, have realized that they can do a lot more than merely scrape a 1/2% annual fee off money sitting in a money market fund. Now they are starting to automatically sweep uninvested cash into deposit accounts with their bank affiliated subsidiaries.

Investors, instead of receiving a fair market interest rate (currently 4.5% to 5.0% in a taxable account) receive only a fraction of that amount. Many investors will receive less than 2% on the money, while the bank subsidiary has the opportunity to turn around and lend that money out at a "prime" rate of interest (above 8% at the moment). You can see why the bank subsidiaries are salivating at the chance to earn 6% on the spread, instead of a 1/2% fee for managing the money market fund. What is less clear, of course, is why investors shouldn't be hopping mad at their broker once again giving them the short end of a conflict of interest.

There is already at least one class action suit levied on behalf of investors for this practice. But it is no wonder that investors place do not trust their brokers. Given practices like this, the brokers do not deserve their trust!

Schwab used to be a very customer-centric firm. It is really a shame to see them adopt this practice. I expect it from the wirehouse and bank firms. But really, Mr. Schwab, as long as this is your modus operandi, the housecleaning at Schwab isn't over yet.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Exxon Mobil added to Index

The Scout Partners Index of Western Colorado Stocks fell in June, losing 1.2% versus a 1.7% monthly decline for the widely followed S&P 500 stock index (total return including dividends). The 25 stock index focuses on large companies whose operations have a significant impact in Western Colorado. It includes major Mesa County employers such as Wal-Mart, Halliburton, Kroger (City Markets), StarTek, CRH (United Companies), and the Union Pacific Railroad. During the month, Exxon Mobil (XOM) was added to the index to replace Kinder Morgan following a management led buyout which took the company private and resulted in it being de-listed from the stock exchange.

Leading the index higher, rising 12.3% in the month, Airgas (ARG) ended the month at $47.90. The company pre-announced stronger than expected same store sales and raised its earnings estimates. “Management says that expected earnings from operations should be in the range of $0.61 to $0.63,” said Doug May, President of Scout Partners, LLC, “which is about 17% higher than the old estimates and the Street earnings estimates for the company. The next day, all the analysts raised their estimates and a couple of them raised their target price as well.” Airgas is up more than 18% since the beginning of the year. Arch Coal (ACI) was the worst performer in the index, falling -13.8% during the month of June, though the stock had spiked higher in May and is still +16.2% since the beginning of the year. “Utility companies have been stockpiling coal, so there are some concerns about the earnings impact of that going forward,” May said. “It also didn’t help that Goldman Sachs downgrade Arch Coal to a sell on June 18th. Wall Street almost never issues a ‘sell’ rating, so Goldman’s call really caught investors’ attention.”

The addition of Exxon Mobil helps maintain the index’s heavy weighting toward industrial material sector stocks, which now represent 21% of the index, which reflects the considerable impact of the energy sector on the local economy. Scout Partners equal weighted Index of Western Colorado Stocks is comprised of 25 stocks that hope to reflect, to some degree, business conditions in Western Colorado. Reflecting the local economy, the index has a large (over 30%) concentration in the energy sector, which tends to drive index performance. The next largest sector concentration is in industrial stocks, which comprise over 20% of the portfolio. Local stocks are up 10.4% for the year while the overall market has returned +7.0% over the same time period.


Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Saving for healthcare costs

Fidelity Investments estimates that retirees need to save about $215,000 just to pay for healthcare costs during retirement.

Assuming that a couple, age 65, retires in 2007 with no employer sponsored coverage, the husband will have a life expectancy of 17 years while his wife's life expectancy will be 20 years - to age 85. The study excluded such variable costs as over-the-counter medications, most dental services, and long-term care. The 2007 estimate is a +7.5% increase over last year's estimate.

Health Savings Accounts (HSA's) are one tool that can be used to manage this expense. Because healthcare expenditures are not spread out evenly throughout retirement, those lucky enough to go several years without a significant expense can save money tax-free in a HSA account. Families can set aside $5,650 annually. Unused funds can accumulate, tax-free, for later-year obligations. An HSA is paired with a high-deductible insurance policy to insure against the risk of major medical expenses.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Market Digesting rate rise

The economy, though continuing to struggle in many areas, has remained remarkably resilient on the jobs front. This has been a blessing for consumer spending, since few Americans monitor business and market events and set their confidence levels and spending habits accordingly. Most consumers gauge their spending to their immediate job market. They don't cut back until they, or someone they used to work with, loses their job. At the moment, even in spite of a continued decline in the housing sector, very few workers are experiencing that hardship.

With consumer confidence still strong, consumer spending has held up. This week's retail spending numbers were legitimately strong. In fact, most of the economic releases in the past couple of weeks suggest that those who fear a recession is around the corner (and that has included me) may be in for a pleasant surprise.

The downside of all this good news is that the bond market, too, has been expecting a recession. A short while ago, short-term rates stood higher than long-term interest rates, which is unusual, except as a foreshadowing of a recession. As recession fears lift, the shape of the "yield curve" resumes a more normal structure. Long-term rates have increased precipitously and short-term rates have dropped a little.

So far, the stock market loves this latest development. Inflation sensitive energy and materials stocks are leading the market higher. Higher interest rates, however, send bond prices lower. Conservative investors, who have shunned high-risk stocks for the safety of bonds, are losing money and purchasing power. So far, the stock market has the upper hand. It will be a real test of this economy, though, to see if consumers can withstand record high gas prices, rising mortgage payments, and a continued decline in the residential construction sector. That's a lot of bad news for any market to digest.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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More Red Flags for Yield Hogs

The market loves "high yield" stocks, which used to mean cautiously picking a few real estate investment trusts with 10% yields, but now means loading up on those same names with 4 - 6% yields. Looking at energy sector stocks a few days ago, the most expensive stocks in the sector seemed to be Master Limited Partnership (MLP) assets with a 20 multiple (Price/Earnings ratio) versus traditional companies in the sector which regularly sport valuations half that level. The draw, of course, is that the MLP's pay out huge dividends, sometimes in excess of their true earnings power, while the traditional "C" Corporations have lower dividend yields. Today's post-Enron investors have learned not to trust earnings statements - which are frequently be re-stated back several years as a result of option dating scandals and other derivative-based shenanigans. Given the sad state of the corporate suite, where the CEO supported by his hand-picked directors is systematically looting the company, being skeptical about the true state of earnings is a lesson well learned. However, the notion that dividends are an infallible indicator of stock market opportunity is a stretch, to say the least.

Barron's "The New Math of Oil and Gas" article by Dimitra DeFotis gives a close look at Denver-based Forest Oil (FST). Commenting on the disparate valuations between the MLPs and traditional companies, DeFotis writes that, "in the limited partnership market, a company's daily energy production usually is valued at about $200,000 per barrel. But Forest Oil's production is valued at just $60,000 per barrel." The MLP's pay out all their earnings (and them some, at times) so investors don't mind paying more than 3 times the going rate for those assets. Overpaying in "market B" for assets that cost less than as third as much in "market A" is not a great strategy for making money, but investors chasing yield are taking that risk.

The real estate market is in a similar conundrum. Barron's Andrew Bary wrote "High-Risk Realty" about how the national REIT market has been bid up to interesting levels. Writing about the sector's most recent buyout - of Archstone-Smith (ASN), a national company with many tight-market apartment properties, the buyout group is buying properties with a yield of 4% on the real estate assets being acquired, and will be paying 6% on the debt used to acquire the properties. Negative cash flow is sometimes a fact of life in the world of real estate. It can be offset by price appreciation of the underlying assets. But in today's world of fast-growing foreclosure rates, rising residential housing inventories, and falling real estate valuations - such a leveraged bet on future price appreciation might not be a good deal. Chances are, the buyout group may have an idea of where they are going to lay off these properties and pay down that debt. In a recent Equity Office Properties buyout, some of the target properties were turned around and re-sold even prior to the EOP deal closing. Just hope that those Archstone apartment buildings aren't being turned around and sold to some private real estate syndicated deal that's going to end up in your portfolio, courtesy of your local bank or wirehouse broker, whose marketing departments are cooking up these "new" diversification strategies and plugging them into client portfolios just as the real estate market is beginning to turn down.

Keep your real estate deals local. Western Colorado is in the midst of an energy led boom that is contra-cyclical to the rest of the country.

And don't pay too much, just to chase a high-yielding security. Earnings yield is just a portion of the total return equation. Don't forget to keep a close eye on your principal as well!

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Leuthold Group downshifts to Neutral on stocks

Steve Leuthold is the Chief Investment Strategist for the Leuthold Group, a research boutique and mutual fund manager who charges pension fund and hedge fund managers thousands of dollars for his research. In business since 1981, his "green book" is a combination of original, thematic oriented technical and quantitative analysis, and some of the best jokes in town (for good measure). His core mutual fund (LCORX) was launched in 1987 and since 2000 has outshined its category average in 7 out of the last 8 years. It beat 98% of its peer group over the pat 3-year, 5-year, and 10-year time periods. Leuthold's Core Investment Fund has a very flexible investment mandate. It is a balanced fund, so it typically has some bonds in it to reduce risk, but Leuthold is willing to commit money to a wide variety of investment ideas, and typically looks nothing like the Vanguard Index 500 Fund, so Morningstar has it classified as a "high risk" fund.

I think manager flexibility is a good thing, particularly when your manager's insights are good enough that other fund managers will pay him thousands of dollars for his insights, so it doesn't bother me that the portfolio refuses to be a closet index fund. I figure that clients are paying him a fee to exercise discretion, but the Morningstar analysts see things differently.

(This wouldn't be the first instance where I have rejected conventional wisdom in setting Scout Partners investments discipline.)

In last weekend's Barron's interview, Leuthold notes that as a result of the recent run-up in the stock market, against a backdrop of rising interest rates and a slowdown on the consumer side of the economy, Leuthold lowered its stock allocation to neutral. Defensive a year ago, late last year the strategists warmed to stocks so they were able to benefit from 2007's run-up in the market.

More recently, though, he has written in his Green Book about some parallels to 1987. In 1987, leveraged buyouts were taking shares out of the public market, so Wall Street was talking about a "shortage of stocks" as valuations ran higher. Interest rates, too, were rising in 1987, although at much higher levels than at present. Inflation was rising, and the economic expansion was getting long in the tooth.

Leuthold notes that Leveraged Buyout (LBO) teams are paying 33% to 40% more to take over companies in 2007, based on cash flow, and commented wryly that "everybody and his brother is running screens as to who the next likely leveraged buy-out candidate will be." He wasn't so concerned that these private equity deals will cause a problem, but they represent a lot of potential equity issuance in the future that could cap any sort of future market recovery.

From my point of view, the LBO teams are making a classic end-of-cycle mistake, loading up on equities using borrowed money, just because market and economic conditions, at present, remain positive. Buying on margin after the market has already appreciated 50% isn't how the smart money gets rich, typically.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Encana Leads Local Stocks Higher

The Scout Partners Index of Western Colorado Stocks rose in May, gaining 4.8% versus a 3.5% monthly gain for the widely followed S&P 500 stock index (total return including dividends). The 25 stock index focuses on large companies whose operations have a significant impact in Western Colorado. It includes major Mesa County employers such as Wal-Mart, Halliburton, Kroger (City Markets), StarTek, CRH (United Companies), and the Union Pacific Railroad. Though Encana led the energy sector higher, Arch Coal, Halliburton, Williams Companies, and Royal Dutch Shell all saw their stock prices beat the market during the month of May.


Rising 17.0% in the month, Encana (ECA) ended the month at $61.40 and rose to above $63 about 10 days before month-end, the first business day after natural gas prices peaked for the month at $7.88/MMbtu. “In addition to being a great company in a rising sector,” Doug May, President of Scout Partners, LLC observed, “Southeastern Asset Management’s Mason Hawkins, manager of the Longleaf Partners Fund, disclosed that he had started adding Encana shares to his portfolios. He runs a concentrated portfolio and a lot of people watch what he’s doing, so that helped the stock.” A few days later, an analyst from Citibank’s Smith Barney brokerage unit upgraded Encana from a “sell” recommendation to a “hold.” Encana is up 35% since the beginning of the year.

Safeway Stores (SWY) was the worst performer in the index, returning -4.99% during the month of May in spite of comments at the end of April that earnings would be on the upper end of previous guidance, and despite efforts by the company to boost the stock price by raising the dividend 20% to 6.9 cents per share in an attempt to make the stock more attractive to income oriented investors. “Its contract negotiation time,” May said. “Wall Street is worried that management will have to give away the store to avoid another strike like they had in 2004.” Some 65,000 members of the United Food and Commercial Workers union (UFCW) have been negotiating since early March. The companies are negotiating an extension of the 2004 contract which was signed after a 141-day-long strike, the longest supermarket strike in history. The 2004 agreement had left some workers feeling betrayed by the UFCW negotiators who were representing them.

Scout Partners equal weighted Index of Western Colorado Stocks is comprised of 25 stocks that hope to reflect, to some degree, business conditions in

Western Colorado. Reflecting the local economy, the index has a large (over 30%) concentration in the energy sector, which tends to drive index performance. The next largest sector concentration is in industrial stocks, which comprise over 20% of the portfolio. Local stocks are up 11.7% for the year while the overall market has returned +8.8% over the same time period.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Advisors Focus on Income Goals

The May 21 issue of Investment News reported that a recent survey of advisors at an Allianz summit showed that 88% of the advisors at the meeting believed that clients' major priority has now shifted to creating income at retirement. In earlier surveys, advisors priority had been to help clients accumulate wealth.

Of those advisors surveyed, 69% believed that purchasing an annuity was the best way to meet that particular need. "I think retirement income will be the market for the 21st century," said Robert MacDonald, chief executive of Allianz Income Management Services. "The companies that can solve this problem will emerge as the leaders."

Shocking, isn't it, that the CEO of an annuity provider would make such an outlandish statement?

In this case, however, there might actually be some truth to it. Annuities are good products for those earning mega-incomes who just can't put enough away in a traditional retirement plan. Good options for many of those people might include opening Simplified Employee Pensions (SEPs) or, for a few, even creating their own personal Defined Benefit Plan. But many high earners who don't control the business structure they work in may not be able to create these tax preferred structures. For them, rolling a big bunch of money into a tax deferred annuity and letting it grow tax deferred for a long time (to offset the relatively high fees in this products) can make sense.

The other folks who ought to be looking at the annuity products, however, are on the opposite end of the spectrum. In retirement, with not a lot of money and little tolerance for taking risk, these investors ought to consider a plain vanilla "immediate annuity" that will pay them an income stream for life.

These annuities take a lump sum investment and each year pay a portion back to the annuitant, for life. The risk facing the elderly is that they outlive their financial resources. An annuity transfers that risk to an insurance company, which can better afford to take the risk because they can spread the risk out among millions of customers.

Other tools in the planning kit include reverse mortgages and better comprehensive financial planning. A good plan should separate income oriented investments from "growth" oriented investments. The income oriented investments are all about wealth preservation and income generation. These include bank CD's, money market funds, bond portfolios, and annuities.

Growth portfolios ought not focus primarily on income generated. Long-time market commentator Ray DeVoe of The DeVoe Report wrote many years ago that, "more money has been lost 'reaching for yield' than at the point of a gun." Many high yield investments provide great current income, until you realize that what you thought was "income" was really "return of principal," and not even all of your principal was ultimately returned.

It is interesting to me that in the energy industry, some of the most expensive assets are those paying the highest dividends. They may only pay 6% now, versus 10% a few years back before their stock prices rocketed skyward, but 6% is still better than a Treasury bond so it sounds good, even if you will lose principal in the long run. That 6% dividend may represent 110% of earnings, but we like dividends because they are a "sure thing," at least until they're cut in half.

"Income" is the ultimate goal for most retiree portfolios. Annuities are a simple approach. Many of the closed-end funds being marketed to income oriented investors are high-risk high-fee products developed primarily in order to scoop up retiree assets while the scooping is good.

Caveat emptor. Buyer beware. Don't confuse a "return on equity" with a return OF equity. Watch out for the business end of a slick high yield packaged product. It could kill you.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Markets On High Alert

When we said, two months ago, that the February 27 sell-off would ultimately prove to be a “non-event,” we honestly didn’t expect to be quite so right…quite so quickly.

Now, 1120 points later (to the upside) where does this market stand?

The typical bull market doubles in price off the market bottom in a rally that lasts, on average, 2 years and 9 months from beginning to end. This rally, now almost 4 ½ years young, is the fourth longest in U.S. history since 1900. However, in percentage terms the rally has been sub-par, which suggests more upside opportunity ahead. So is the rally almost over, as the calendar suggests, or is there more money to be made?

Two key variables will likely determine the outcome. In spite of many traditional signs of a slowing economy, the job market is strong so workers remain confident of their future, willing and able to keep spending. Jobs are a lagging indicator, though, with cutbacks usually a result of Corporate America tightening its belts in the face of declining profits. Each week’s unemployment claims news release may soon take on the same significance that money supply numbers held for the market 25 years ago, particularly as the Presidential campaign season progresses.

The other thing to watch is whether weakness in the dollar will ever result in foreign investors, particularly in China, Japan, and the United Kingdom, reversing their willingness to continue funding our government and trade deficits. They don’t need to sell their current holdings, which are massive, to impact our interest rates. They just need to stop buying, which would likely force our long-term interest rates much higher, make bonds a more attractive alternative to stocks, and cause some of the private equity folks (and their bankers) to re-think their “let’s leverage this thing to its eyeballs” mode of doing business.

Neither one of these indicators currently suggest that it’s time to step to the sidelines. April was certainly a fun month to be fully invested, and so far the year has been kind to investors. The bull market lumbers on. But it would be a particularly bad time to be complacent.


Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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