Gift Idea

When I was growing up the gift option of choice was federal savings bonds. When I was old enough to be allowed to make my own financial decisions I promptly sold them and invested the proceeds in the stock market, where my long term inflation-adjusted returns would be much higher. Among both my high school and college graduation gifts were shares of stock and the returns from those have been impressive, but the advantages of such gifts often go beyond dollars and cents.

Garnering interest in the markets was never a problem with me, but that was clearly the exception. Giving children shares of stock not only gives them a valuable financial asset, but it also allows one to expand the financial education process with them at an early age. At some point (perhaps not at first depending on how old they are), recipients are going to ask what that framed share of Disney stock is, and at that point you can explain it to them. Such a conversation might, at the very least, start them toward a path of being very educated when it comes to the responsibility of managing their finances.

Pulse of the Housing Market

Given that the housing market malaise is the prime culprit for our economic and market adversity, I decided to post some charts showing key indicators such as delinquencies, foreclosures, and inventories. Sources for this data are Countrywide Financial (CFC), which has the nation's largest mortgage servicing portfolio ($1.48 trillion), and the National Association of Realtors, which tracks home sales.

First up, Countrywide's mortgage delinquency rates and pending foreclosure rates for the last twelve months:

As you can see, delinquency rates have stabilized the last few months, with foreclosures still headed higher, but not severely. While certainly a good sign, we can not call it a trend just yet. After all, last summer we saw a leveling off, only to see another spike shortly thereafter.

The next chart is home inventories, I believe a key proxy for the future direction of home prices. We will not see stabilizing home values (and eventual gains again) until we work through very high inventory levels. Typical inventories levels are about 50% below current levels.

Again we see a curtailment of rising inventories in recent months, but I still do not think we can call it a long lasting trend of stabilization as of yet, given that we will not pass the peak in ARM rate resets for the next quarter or two.

But let's assume for a moment that these indicators do stop getting worse in coming months. Does that mean the housing market will stabilize also? Probably not. Inventories need to come down. The only way we get that is to increase demand. With home buyers now needing the "trifecta" to get a mortgage loan application approved (good credit, proof of steady income, and money for a down payment), demand won't outstrip supply unless prices come down further to get qualified buyers to pull the trigger in greater numbers.

More on Chesapeake Energy

"madhatter" writes:

After reading your old post, I'm just curious as to why you personally like CHK out of the bunch? Based on fundamentals alone, it seems like DVN or SJT might be a better play on nat gas (even though I realize the latter is a trust). Does CHK have something that I'm missing? Because their fundies seem to put them in the middle of the pack as just 'average' in terms of nat gas players. Thanks for your thoughts.

I neglected to expand very much on Chesapeake Energy (CHK), since I've written about it before (to read prior posts simply do a search for "chesapeake" from the left sidebar of this blog), but it has been a while so let me go into more detail. Here are four main reasons for my bullish stance on CHK:

1) Chesapeake is the largest independent domestic natural gas producer

This is beneficial for several reasons. They have a very large, diversified asset base from which to grow production and reserves. When you are such a big player and have extensive experience drilling in different areas of the country, it gives you an advantage that should lead to very high success rates with future drilling programs. Also, it means Chesapeake would be an ideal acquisition target for one of the big oil giants at some point in the future if and when management decides to consider an exit strategy.

2) Industry leading production and reserve growth

Indeed, the numbers back up the points made above. Chesapeake's organic production and reserve replacement rates are among the highest in the large cap natural gas sector (they might be the highest, but I do not have data in front of me to prove that, so I will include the "among" qualifier). In 2007, CHK increased gas production by 24% over 2006 levels and the company's reserve replacement rate was a staggering 369%. Company guidance for 2008 is for 21% gas production growth, followed by another 13% in 2009.

I think you will be hard-pressed to find large natural gas producers that are posting organic growth rates much higher than that (clearly small firms can have large growth rates due to a small starting base). As a result of past growth and the expected continuation of it for the foreseeable future, I feel Chesapeake's fundamental outlook is as strong as, if not stronger than, the competition.

3) Extensive Hedging Program

Chesapeake has the most extensive gas hedging program in the industry. The company has 70% of 2008 gas production hedged, as well as 33% of 2009 production. I like the hedging program because it reduces the commodity price risk the company faces, so its earnings stream is very predictable. The gas market is very volatile, and as a result, Chesapeake doesn't get hurt too badly when prices fall, but when markets are strong (or weather patterns cause temporarily sharp increases in prices) the company steps in and increases its hedges to lock in high prices that might not be realized otherwise.

4) Superior Management, Insider Buying

CEO Aubrey McClendon has been one of the most aggressive insider buyers of his company's stock that I know of. Given his superb track record of producing strong financial results, this is not surprising. McClendon has long been singing the praises of his company's stock, but unlike most executives who do so, he has been putting his money where his mouth is (and he's been right). He is the largest individual shareholder in the company he co-founded. In 2008 alone he has purchased more than 1.63 million shares of CHK on the open market at prices between 35 and 46 per share. That is ~$70 million of his own money! Investors should feel comfortable that they are investing right alongside him. Plus, with such a large stake in the company, you can bet that when he wants to retire, the company will be up for sale to maximize shareholder value.

The reader mentions Devon Energy (DVN) and San Juan Basin Royalty Trust (SJT) as other, potentially more attractive natural gas plays. I am actually a big fan of Devon. However, it's not really a pure play on natural gas (they are 50/50 between gas and oil). If you are looking for a well balanced domestic energy exploration and production company, I agree DVN should be near the top of your list.

Royalty trusts are interesting plays, given their high yields, but they tend to be less geographically diversified and have less financial flexibility. SJT, for instance, focuses on New Mexico, so their asset base is not diversified and they are much smaller than Chesapeake.

Also, while the high dividends of trusts are attractive, they really do not allow company management to be flexible in how they grow the business. When you pay out most of your income out as a dividend, you don't have much capital available to grow faster organically or make acquisitions. Rather, you are forced to sell debt to raise money, which isn't always an ideal funding mechanism (like now when credit markets are shaky).

So those are my thoughts on Chesapeake. Although I am a big fan of the company, there are definitely plenty of very good energy companies from which to choose from. Do you have other favorites? Let us know which ones and why you prefer them!

Full Disclosure: Long shares of CHK at the time of writing

Natural Gas Update

In July of last year I wrote that the United States Natural Gas Fund ETF (UNG) looked ripe for gains after a 30% drop from $54 to $38 per share. In recent weeks natural gas has become a hot commodity, with prices hitting $10 last week, up from under $6 last year. UNG shares have jumped 25% to $47 each and I think some profit taking is in order. Long term I still like energy in general and gas specifically, but at this point I think owning hedged exploration and production stocks makes more sense than owning the gas ETF after such a large increase in underlying commodity price.

Which gas stock would I point readers toward? Long time readers will be bored with this company, but Chesapeake Energy (CHK) continues to be my favorite domestic natural gas stock (newer readers can refer to my September 2006 piece entitled An Attractive Entry Point For Chesapeake Energy). Like UNG, CHK too has risen sharply (from $29 to $44 since that bullish article), but they have the advantage of being able to hedge prices for their ever-growing production, so they will get hit much less than UNG during the next natural gas sell off, which will surely come despite the recent renewed enthusiasm for the commodity.

Full Disclosure: Long CHK at the time of writing

Browsing the Sale Rack for Technology

One of the great things about blogging about the market is that while I can't possibly buy every stock that looks attractive, I can post some ideas online and readers can make money if any of them spark their interest. With the technology sector among the worst performers so far in 2008, I thought I would present six stocks that look awfully cheap for long term investors who have no problem waiting out current economic conditions. All of these names have extraordinarily strong balance sheets, so there is even more value than the P/E ratios indicate. Feel free to make the case for any favorites you may have on this list.

Full Disclosure: Long DELL and MSFT but like the entire list to some degree

Differentiating Between Trading and Investing

John writes:

Hi Chad,

How do you differentiate between "trading" and "investing"? I'm always curious to hear what people think is the difference.

Thanks for the question, John. I don't think there is too much of a debate over the difference, and my views likely aren't much different than most, but I'm happy to give my personal thoughts on the topic.

The main difference between "trading" and "investing" is time horizon. Investors are long term players. They are investing in a business and are making an optimistic bet about the fundamentals of that business in the future. If they pay a reasonable price, and their analysis of the business prospects are correct, they will make money over time (regardless of overall market environment) because over the long term both valuation and earnings determine the value of a business, and thus the per share price of a company's stock.

Furthermore, since investors are willing to take a long term view (years rather than days, weeks, or even months) on an investment, they are likely to buy more shares as a stock drops in price. The main goal is to minimize one's cost basis in order to maximize profits over time. Temporary drops in share price aren't likely to change an investor's opinion of a stock's long term investment merit, unless of course the fundamental outlook changes in a meaningful way.

Conversely, traders are short term oriented. They tend to care very little about valuation or the long term earnings power of a business. Since they won't own the stock long enough for future business fundamentals to influence share price, they are more likely to use chart patterns and follow the momentum when buying stocks.

Since traders are more like speculators (making educated guesses as to short term price movements) than investors are, they are likely to use stop loss orders to limit downside risk. If a trade goes against them, they cut their losses quickly and look for other opportunities. Even if the market reaction in the short term is illogical and unsubstantiated, since they aren't willing to hold the stock long term and wait for the inefficient market to correct itself, they can not afford to wait things out until cooler heads prevail.

Here is an analogy for you; investors are the casinos, whereas traders are the gamblers. Investors have the odds stacked in their favor, just as the casinos are guaranteed winners over time because the games they offer have a win percentage built-in. Over time, the economy grows and corporate earnings grow, hence stock prices rise over long periods of time. Thus, investors (who by definition are long term players) have the odds stacked in their favor.

Traders, on the other hand, are trying to win big on short term trends, much like a blackjack player hopes for a hot shoe and then cashes out his/her chips. The gambler knows that they don't have a statistical advantage but they play nonetheless, trying to make some money and getting out before they give it all back. Now, I grant you that traders aren't at a statistical disadvantage, so the comparison isn't perfect, but whether or not the market goes up or down tomorrow is pretty much a coin flip, so traders' odds are about 50/50, although they try and boost those numbers with technical analysis, momentum trading, etc. Much like a trader's stop loss order will limit losses in the market, many gamblers will come to a casino with a certain amount in their wallets, to ensure they don't incur severe losses.

Casinos and investors know very well that in the short term they might lose money to a hot table or an analyst downgrade, but over time they feel comfortable because they know the odds are in their favor to make money. They are patient enough to wait for their payout, whether it comes from the 5% edge at the roulette table they operate, or long term earnings growth generated by a publicly traded company they have invested in.

Traders Bracing for Retest of January Lows

Regular readers of this blog know that I am a fundamental-based investor. As a result, over the long term the two key determinants of future stock price performance that I focus on are earnings and valuation. Although I strongly believe that technical analysis only works over short periods of time, in the absence of new material information, enough people read charts (especially traders, as opposed to investors) that they can predict near term market movements due to thousands of people acting on them in the same manner simultaneously.

I bring this up because when we got the huge leg down in January, which served as a short term bottom after the Fed temporarily rescued us with an emergency rate cut, traders were adamant that we did not see capitulation (Bernanke didn't let that happen) and would have to retest the lows after an oversold bounce. Sure enough, we got a bounce up toward 1,400 on the S&P 500, moved along in a narrow 1300-1400 band for a little while, and now are moving back down to the lows, as the chart below indicates.

Let's give the chartists credit for their call. Market bottoms often look like the letter "W" on a chart, a pattern I have noticed since I started following the markets. The next step is to see if we in fact retest the lows (we are a few points on the S&P away from the closing low of 1310 as I write this, but still a few percentage points away from the intra-day lows of 1270).

If we get a retest, followed by buying interest sparked by all those chartists salivating at a potential double bottom formation, we could certainly have another bounce in coming months. Depending on the economic and earnings picture at that point, it could very well give investors a chance to take some chips off the table. That is only one possible scenario, but it is the one bulls should be hoping for.

UPDATE: 12:20PM CT
The S&P 500's closing low was 1310.50 on January 22nd. Today the index hit an intra-day low of 1310.49 and has since bounced about 4 points.

Sifting Through Buffett's Annual Shareholder Letter

Warren Buffett's annual letter is always a good read and the recently released 2007 version is no different. There are a couple points that Buffett mentions this year that I think are worth pointing out and commenting on regarding the current market environment; corporate creditworthiness and sovereign wealth funds.

Buffett is often criticized for speaking out against the widespread use of derivatives and at the same time, initiating derivatives positions for Berkshire. However, just because certain derivatives are extremely risky and may pose a serious threat to our financial system, that does not mean that every single derivative contract is bad. There are many derivatives that do not use tons of leverage and pose little threat, and those are the ones Buffett is using.

In the letter, Buffett points out that Berkshire has entered into 94 derivative contracts which fall into two categories; credit default swaps and long term short put positions on several equity indices. The former is interesting because corporate credit spreads have widened dramatically recently, and investors are worried that default rates are set to spike in coming years.

Buffett has decided to insure bondholders against default over the next five years, and in return has received more than $3 billion in premiums for these contracts. He is betting that actual corporate defaults are less than the rates currently implied by the market prices of credit default swap contracts. Given that current prices are artificially high for credit protection, due to the unstable credit markets, the implied default rates right now are well above typical historical loss rates at the end of an economic cycle.

What does this mean to individual investors? It means that high yield bonds are extremely depressed right now and many smart investors are betting that the market for corporate debt has swung too far into the pessimistic camp. If you agree and believe that although earnings might fall in coming years for certain companies, they will still be able to repay their debt, then high yield bonds and credit protection are interesting areas for investment. Investors can play this two ways.

First, you can simply buy high yield corporate bonds or bond funds. High quality managers are salivating at some of the yields currently available in the corporate bond market and are more than willing to wait out this economic downturn, collect interest payments, and get repaid several years down the road if their financial analysis proves accurate.

You can also invest in a company like Primus Guaranty (PRS), a small publicly traded writer of credit default swap contracts. Essentially, Primus is doing exactly what Buffet has done, but they do it for a living. As credit spreads widen and premiums rise for selling credit protection, Primus will do more business at more lucrative prices.

Another point Buffett raises in his letter that I think is interesting is the rise of sovereign wealth funds. For those of you who are unfamiliar with the term, these are simply government owned investment funds of foreign countries. As the global economy has expanded and the developing world sees increased economic prosperity, foreign governments are flush with cash, and like anyone else in that situation, are looking for places to invest it.

As the world's biggest market, it is not surprising that the U.S. has seen China buy a 10% stake in the Blackstone (BX) IPO and Abu Dhabi invest in Citigroup (C). Of course, some on Capitol Hill are worried about foreign money being invested in U.S. companies. Although these are passive investments, and bring with them no control of operations, national security concerns are being voiced by many.

Buffett makes the point that this trend is largely the product of our own doing. The U.S. is racking up huge deficits, issuing debt to any foreign country who will buy it, and the resulting weak dollar is prompting foreign investors to invest in U.S. equities. They are simply diversifying their investment portfolio. After a while, you can only buy so much U.S. debt without getting a little worried about our country's financial health. Many U.S companies, although navigating through tough times, look more attractive than the government does for investment dollar allocations.

As a result, foreigners want to buy equities as well as bonds. Buffett points out we certainly can't blame them for buying stocks rather than more bonds. And it is much easier for them to do so now because so many financial institutions are trying to raise capital after sub-prime mortgage blunders. In my view, as long as these remain passive investments, we really can't complain. When operational decision making becomes as issue, as it was when an Abu Dhabi firm wanted to run our ports here in the U.S. (the deal was squashed), then it makes sense to talk about national security threats, but only when a real threat is apparent.

Full Disclosure: No positions in the companies mentioned at the time of writing

Citigroup Break-Up Analysis - Part 3

I posted my extremely conservative valuation on Citigroup (C) last week and promised a more aggressive version in order to try and quantify not only a potential floor in the stock ($22?) but also a reasonable ceiling ($41?). Below in graphic form are three scenarios; my first one (conservative) as well as a moderate and more aggressive case. I will revisit these projections after Citi reports first quarter numbers, which might shed some light on their normalized earnings power.

Full Disclosure: Still no position in Citigroup at the time of writing

Related Posts:

Citigroup Break-Up Analysis - Part 1

Citigroup Break-Up Analysis - Part 2

Beware of Phrases Like "Cheapest in 20 Years"

This week's Barron's highlighted shares of entertainment giant Disney (DIS) as being the cheapest they have been in 20 years. I just wanted to remind people that arguments like this in general don't really make much sense. This is not about Disney itself (it is not an overvalued stock) but rather the whole idea that bulls on certain stocks like to look at one particular period in the past, and assume that those conditions should apply today.

These days you hear people say that certain stocks or sectors (or the market for that matter) haven't been this cheap since the early 1980's, and thus conclude they should be aggressively bought. What they fail to mention is that the period from 1982 through 1999 was the greatest bull market the U.S. stock market has ever seen, and P/E ratios were in a historically high range during that time. Therefore, investors should not assume that those valuations were "normal" and therefore should and will always be applicable.

The Barron's piece suggests that Disney's current forward P/E of more than 14 (the current market multiple) is too low because the stock typically trades at a 30% premium to the market. Again, just because a stock traded at a 30% premium a long time ago, that multiple does not stay relevant forever. P/E ratios are largely based on future growth expectations. If Disney is going to grow earnings less robustly over the next two decades than it did over the last two, it stands to reason its P/E should be lower.

My point is not to bash Disney specifically (no meaningful opinion there), but to remind investors that current valuations are based on investor expectations of the future, not historical data. Surprisingly, many people still look at average P/E ratios from the past 10 or 20 years to determine where a stock should trade today, but I would caution you to pass on that type of valuation methodology.

Full Disclosure: No position in Disney at the time of writing