Facebook
The other big story of the coming week is the long-awaited IPO of Facebook on May 16th.  The company plans to raise about $10 billion in the IPO, implying a valuation of nearly $100 billion for the entire company.  While recent reports indicate that the offering is substantially oversubscribed, more than a few professional investors have pointed out the lofty expectations built into a valuation of this range, as well as some troubling gaps in Facebook’s corporate governance.  We agree and would also point out that the durability of the company’s business model is unclear to us. As much as some of us enjoy staying in touch with friends and family using it, don’t expect to see shares of Facebook in your portfolio anytime soon.

Woodstock of Capitalism
May 5th marked the annual Berkshire Hathaway shareholder’s meeting in Omaha, Nebraska.  Berkshire’s chairman, 81 year old Warren Buffett, was recently diagnosed with early-stage prostate cancer in April.  Predictably, many of the audience questions this year centered on succession plans at the $200 billion dollar company.  Buffett downplayed concerns about his health, noting that the survival rate of his cancer was above 99%, and that he was more likely to be “shot by a jealous husband.”  Berkshire’s 88 year old Vice-Chairman, Charles Munger, had one of the better quips of the meeting when he deadpanned: “I resent all this sympathy and attention Warren is getting.  I probably have more prostate cancer.”  Even if you’re not a shareholder, these meetings are always full of insights about investing and business in general. For live blogs of the meeting’s Q & A session, click here or here.

When Mom & Dad help with housing
The kids have graduated and you think that you are finally off the hook financially. But wait! They now want to buy a house. Before deciding to help, “make sure that you have enough saved for retirement.” If you think you can still afford to help, read on for some advice by clicking here (Morningstar – free registration required).

Earlier this year, a major bond rating agency warned that California may not be able to repay $4 billion borrowed against the ten-year old class action settlement with tobacco companies that is paying states billions over a 25-year period to compensate for tobacco-related health care costs. The money was not guaranteed, but tied to tobacco sales, and the number of smokers is declining more rapidly than anticipated, resulting in lower payouts from Philip Morris et al.

Read the full commentary.

The good news is that the driving force behind the stock market recovery has been better news about the US economy. Job growth has resumed at a good pace and this has led to a stronger, more confident consumer. There have even been some positive signs emanating from the housing market. A stronger real economy is the best support for a rising stock market and a necessary pre-condition to address our nation’s fiscal imbalances.

As usual, Bristlecone’s perspective comes down to the question of valuation: how much are we paying for what we are buying? Although the S&P 500 has climbed back almost to within 10% of its all time high (1,565 in October, 2007), it is important to understand that corporate earnings have grown in the meantime, too. So whereas the S&P 500 traded above long-term valuation averages in 2007 (and way above long-term averages in 2000, the prior time it traded above 1,500), the current valuation is much closer to the long-term average of about 14x – 16x earnings. Comparing current prices to other measures such as cyclically adjusted earnings or GDP shows a market that is probably modestly overvalued. In the context of rock-bottom interest rates, though, the risk/reward tradeoff of stocks is somewhat attractive.

Investors should not be complacent, and we are busy re-balancing portfolios where appropriate and monitoring the individual stock holdings in the Large Cap Value portfolio, as many now have narrower discounts to our intrinsic value estimate.

This month’s articles:

Why I Am leaving Goldman Sachs

This resignation letter from former Goldman Sachs employee Gregg Smith has garnered lots of attention already, but it’s a good read if you haven’t seen it already. The message about the downward trajectory of that firm’s culture is an important one and a reminder to practitioners and consumers of financial services of the variable standards to which different companies hold themselves. Bristlecone’s standard is clear: we have a fiduciary duty to our clients and client interests come first, whereas brokers, investment bankers, and traders have a duty of loyalty to their employer.

A Financial Roadmap for Surviving Spouses

This video and the accompanying checklist are a good starting point to help a surviving spouse take over household finances.

Top 6 Tax Tips for Retirees

The video presents some tax tips related to managing distributions from savings accounts, property taxes, and medical expenses.

During the recent Super Bowl, Chrysler aired an extended 2-minute commercial starring Clint Eastwood, with the tagline “Halftime in America.”  The ad paid homage to generations of resilient Americans, and drew a parallel between the U.S. auto industry’s recent resurgence and that of the broader American economy and society.  Cynics saw the commercial as a form of covert electioneering by a company which benefited from a government bailout just two years ago, but recent macroeconomic data do support the case that the U.S. economy is improving.

To start with, January U.S. auto sales were up 11% over the prior year, to the highest annualized level since May 2008 (WSJ, 2/2/12).  General Motors, only two years removed from bankruptcy restructuring, is expected to report 2011 net income in excess of $8 billion.  The company has added 13,000 jobs since emerging from bankruptcy and now hopes to be earning as much as $10 billion annually by 2013 (WSJ, 2/6/12).

On the employment front, initial jobless claims dropped to 358,000 during the week of February 10th.  According to the blog Calculated Risk, this puts the 4 week moving average of initial unemployment claims at their lowest level since May 2008.

The Institute for Supply Management’s closely-watched U.S. manufacturing index increased to 54.1 in January, up one point from the previous month.  Readings above 50 on this index signal an expansion in manufacturing activity.  (WSJ, 2/2/12)

Last week also saw a landmark $25 billion settlement between the federal government and the country’s five largest mortgage-servicing companies, over alleged loan servicing and foreclosure abuses.  The agreement calls for approximately $20 billion of indirect financial relief to homeowners via principal forgiveness and loan refinancing, and about $5 billion of cash penalties payable to federal and state governments.  The average monetary benefit to homeowners from this settlement may prove relatively modest.  However, the resolution of this legal issue removes one of the key impediments to an orderly foreclosure process, which in turn is a necessary precondition for a housing market bottom.

In other news, civil strife in Greece continues over the latest round of austerity measures passed last weekend, as part of a deal for yet another EU bailout and debt restructuring package.  For those interested in a very accessible summary of how the European Debt crisis evolved, we would highly recommend a recent podcast from This American Life entitled “Continental Breakup.”

Finally, the SEC has issued a couple of bulletins on the topic of investor fraud in the social media sphere, prompted by the recent case of an Illinois investment adviser who attempted to sell fictitious securities to investors via LinkedIn.  You can read the bulletins here:

Investor Alert: Social Media and Investing – Avoiding Fraud

Investor Alert: Social Media and Investing – Understanding Your Accounts

Read the Full Commentary

The reason behind Vulcan’s positive stock performance in December was an unsolicited buy-out offer from its main competitor, Martin Marietta (MLM). The proposal currently on the table is to exchange each share of Vulcan for ½ share of Martin Marietta. Based on MLM’s current share price, VMC’s stock actually trades at a small premium, an indication that the market is anticipating that MLM might raise its offer. We do not expect submitting your shares at this point as the offering price is below our assessment of Vulcan’s value.  We will keep you posted.

The US stock market ended 2011 pretty much where it started, despite great volatility and investors’ anxiety over the financial system, Europe, and other bogeymen throughout the year. The Large Cap Value model portfolio ended 2011 underperforming the S&P 500 total return by a small margin, but was about in line with the Russell 1000 Value, a large cap value benchmark. Finally, the portfolio outperformed the average Large Cap Value mutual fund as reported by Morningstar. Overall, we give our investment results in 2011 a C+ grade.

In 2011, the 3 stocks that contributed most to investment returns were Pfizer (PFE), Apollo Group, and Cintas. Despite their good performance, none of those appear fully valued yet, and we remain positive about their potential going forward. The 3 stocks that hurt returns the most in 2011 (as most of your are probably aware) were Cemex (CX), Sprint, and Bank of America (BAC), . It is fair to say that each of these companies remains a work in progress, which is a polite way of saying that we vastly underestimated the challenges faced by all three. The key question is whether these companies are terminally wounded, or whether it’s likely that their future earnings potential is not reflected in the current stock price. Of the three, our confidence level is lower with Sprint; there is a possibility that its competitive situation will continue to weaken despite the sales potential of the iPhone. We’ll continue to monitor the situation, but it is fair to say that this investment is on a short leash.

Come January, it is traditional for clients, and media outlets, to ask financial advisers for their New Year outlook for stocks. It is also traditional for us to answer that we don’t have any. What experience has taught us is that we know what we don’t know. In other words, considering the experts’ dismal record at predicting the stock market (worse than a coin toss), we find it strangely fascinating that anyone would keep asking what prices will do in the short term.

Our goal is to make rational, sober assessments of the investments that we make on your behalf. The portfolio remains economically sensitive: the companies that comprise the biggest portion continue to be businesses that will typically outperform in an economic recovery. To clarify this statement, by “outperform” we do not mean the stock price but rather the company’s sales and profits. As previously stated, we confess to have no talent in predicting short-term prices. However, we’re confident that as sales and profits grow, the stock price should eventually follow, albeit in fits and starts.

Our greater representation in economically sensitive businesses is not due to our economic outlook, but rather the result of where we found investments at a discount to our assessment of their value in the past 3 to 5 years.  Examples of such companies include those in the construction industry (Cemex, Vulcan), technology (Dell, Cisco, Hewlett-Packard), power production (NRG), or even banking (Bank of America, Wells Fargo) due to the impact of the residential housing market on loans. Companies whose revenues and profits are less sensitive to the economic cycle tend to be less represented in the portfolio right now, yet we remain excited about the return potential for the ones we own: insurance companies (Progressive, Markel), and pharmaceuticals (Novartis, Pfizer) fall in this category.

If we were to make a prediction for 2012, it would be that there will be no shortage of potential issues to worry about, and that our biggest contribution to our clients’ portfolios will continue to be that of keeping emotions in check when making investment decisions. With Treasury bonds yielding 2% to 2.5%, and valuations reasonable in our view, our long-term outlook for large cap US equities remains positive. The shares of America’s biggest companies offer similar yields, but unlike the coupon from bonds, corporate earnings and dividends are expected to grow and offer investors some protection against inflation.

As 2012 begins, we wish you and your family a happy and healthy New Year.

Indeed, the great challenge facing investors today is no longer how to find good information.  Rather, the challenge is to filter out all the noise and put new information into a meaningful broader context.  Not only is there simply too much information to digest, news is also frequently sensationalized and purposefully de-contextualized in order to grab attention. While easier access to investment information is clearly a step forward, we have little doubt it can also contribute to pervasive short-term thinking and exposes investors to behavioral pitfalls.

This month we wanted to highlight an internet site that is a good source of economic news and, just as importantly, puts that information in a helpful longer-term context. We are not economists, and we don’t expect our clients to be, but we thought you might find this site useful in understanding what you hear on the news. The site is called Calculated Risk; take a look at these two posts from this week.

Weekly Initial Unemployment Claims Decline to 366,000

This figure is reported each Thursday and has been in the news regularly due to the prolonged employment slump. The post summarizes the key figures, but it also includes a chart showing the history of the figure for the last 40 years. From that, you can quickly put the 366,000 figure in proper context, well below the 600,000+ weekly claims at the height of the recession and not too far from the average over the last 40 years. That’s a good sign that the broad labor market is currently showing improvement. Elsewhere on the site (All Employment Graphs) you can quickly see how severe recent job losses were and how they compare to prior recessions.

Fed: Household Debt Service Ratio Back to 1994 Levels

Another headline that caught our eye this week related to household debt service levels. High consumer debt was a key cause of the 2007 – 2009 recession. Reducing that debt has been a key headwind slowing the recovery.  So it was interesting to see that some progress has been made toward reducing the amount the typical household has to budget to paying off debt. One big cause of this is rock-bottom interest rates; another is that lots of bad debt has been written off by lenders. But this news shows that American households are working toward getting their household budgets in order.

Together, these reports paint a picture today of a recovering economy, and indeed some economists have recently revised upward their GDP growth projections. It is important to remember, though, that these data only reflect current trends and are in no way a forecast of the future. Both laymen and economists have a poor record of forecasting, but that doesn’t diminish the usefulness of having a better understanding of the context and history of these numbers.

We at Bristlecone appreciate your trust in our services over the course of 2011 and we wish you and your families a wonderful holiday season.

The S&P 500 was down very slightly in November, but investors continued to experience wild swings throughout the month indicating that their answer to Soros’ question could change from “yes” to “no” on a daily basis. The Large Cap Value Model portfolio outperformed a little over the same period. As we approach the end of the year, the portfolio remains slightly in negative territory and is still lagging the market a bit.

Stocks that contributed positively to performance were EOG Resources (EOG), Pfizer (PFE), and Medtronic (MDT). The top detractors were NRG Energy (NRG), American Express (AXP), and Bank of America (BAC). During the month, our only trade was to dispose of our long-held investment in JP Morgan (JPM). JP Morgan is a bank that weathered the banking crisis here in the U.S. better than most, thanks to a greater emphasis on conservative underwriting for residential loans during the boom times. Management was also very shrewd and opportunistic in the acquisitions of Bear Stearns and Washington Mutual. However, we feel that developments in Europe have the potential to impair JP Morgan’s value more than that of our other bank portfolio holdings (Wells Fargo and Bank of America).

As we highlighted in a recent commentary, the European sovereign debt crisis creates a new set of issues for US banks, particularly for those that are very active overseas and in derivative markets. Our concerns stem from the fact that public disclosures about banks’ sovereign debt exposures are useless in order to ascertain the level of risk with a reasonable degree of confidence. Derivative hedges used to lower the gross exposure are only as reliable as the creditworthiness of the bank’s counterparties, and the ability to enforce the language embedded in the contract. Worryingly, some ideas recently floated by European officials raised doubts about the effectiveness of credit default swaps, a popular derivative instrument used in protecting against such default.

The history of financial crises around the world teaches us that creditors never come out unscathed. JP Morgan shares have been a rewarding investment throughout our ownership, providing us with positive returns in excess of the market. We felt, however, that with the deepening crisis across the Atlantic, the opacity of the bank’s real exposure to the European situation was a risk that we were no longer willing to take.

Of course, the main reason for this once-in-150-years event is that yields on these bonds decreased from the mid-teens level in the early 1980s to slightly over 2% today. As yields dropped, bond prices rose and investors enjoyed significant capital appreciation in addition to their regular interest payments.

With interest rates just above 2% today, it is mathematically impossible for bonds to match their performance of the past 30 years. Even if one expects the current slow-growth economic environment to last for a few more years, rates on government debt are more likely to rise over the long term, and fixed income investors can expect to face headwinds at times.

Should We Care About Europe?
The events of the past few months in Ireland, Portugal, Greece, and now Italy should concern U.S. investors as well. It is not clear that politicians in Europe will be able to resolve the crisis in a timely manner, and the next few months could see another crisis of confidence with financial institutions. We’ve already witnessed the failure of Dexia (a Franco-Belgian bank) and MF Global (a U.S. investment bank), both due to over-leveraged positions in European sovereign debt. 

Most concerning to us is that the lessons of the Great Depression seem to have been forgotten. Historians now agree that the effects of the stock market crash in 1929 were compounded by economically restrictive policy decisions around the world at the time. In Europe today, fiscal deficits and debt servicing burdens are made worse by repeated austerity measures. The lesson from the Great Depression is that Europe should first kick-start its economies with growth-inducing cyclical measures, and address the structural deficit issues once economic growth provides a tail wind in tax revenues and job creation. Unfortunately, there is little prospect of this happening, as public opinion in the wealthier countries of the European Union does not support such measures.

If the situation in Europe deteriorates further, we see significant risks of contagion to the U.S.  Despite assurances to the contrary, American banks are both directly and indirectly exposed to European sovereign debt. As we saw in the last financial crisis, the derivative contracts that are designed to hedge a bank’s exposure to troubled debt are only as reliable as the creditworthiness of the bank’s counterparties.  Should these counterparties also find themselves in dire financial straights, the value of derivative hedges then rests on the assumption that the EU would ultimately backstop those troubled institutions.  This is far from a foregone conclusion.  Moreover, the largest American corporations now derive half of their profits from foreign operations. Europe is a large economy; if it slows, U.S. corporations are bound to feel the effects.

Whether one looks at bonds or equities, there is no shortage of potential risks today and we expect continued volatility for the near future.  But with CDs and money market funds currently yielding less than inflation, most investors need exposure to stocks and bonds in order to meet their long-term goals.  While we may advise adjustments to lower portfolio volatility or prepare for an inevitable rise in bond yields, we believe that it is best to use these market fluctuations to our advantage.  By diligently monitoring and rebalancing your holdings around your target asset allocation, we enforce a discipline of buying low and selling high, while keeping overall market exposure to a minimum level consistent with your investment goals.

On a different note, if you’re retired, don’t miss reading the article below. 

ARTICLES OF INTEREST
(Free registration might be required)

Medicare Enrollment Checklist
Morningstar, September 29
“It’s important for seniors to re-shop their coverage every year–especially this year.”
>>Read the Article

It’s Time to Occupy Your Checkbook
New York Times, November 2
“Perhaps it’s time to talk openly about past mistakes we’ve made. Time to take responsibility for our own financial situations and make plans to improve it.”
>>Read the Article

It is somewhat difficult to explain what brought this renewed optimism: expectations for 3^rd quarter corporate earnings and economic growth were probably too pessimistic going into October. As companies reported throughout the month, investors appeared relieved. Late in the month, the announcement that Europe might finally have a plan to deal with the aftermath of the Greek tragedy (pun intended) had a favorable impact as well, as did the news that the American economy grew at 2.5% annualized during the 3^rd quarter, a pace that beat expectations and seems to indicate that another recession is not in the cards, at least for now.

We did not make any trades during October.  Stocks that contributed positively to performance were Cisco (CSCO), Apollo Group (APOL), and Dell (DELL). The only detractor was Sprint (S), as all other stocks increased during the month. The company spooked investors following some poorly disclosed information about their network technology strategy and the cost of subsidizing the iPhone. Once the dust settled, it became clear that Sprint could not sell millions of iPhones, meet its debt repayment obligations, and continue investing in its business without raising cash.

After being our worst performer last month, Cemex was our best performer in October, rising by more than 38%. The company reported 3^rd quarter earnings, showing a modest improvement in revenues and cash flow. Expectations were low and the stock price reacted positively to the increased likelihood that the company will meet its debt covenants by year-end without any drastic steps. News of stronger than expected economic growth in America helped support the stock as well.