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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