The Delayed Reaction to Wells
Posted by Eddy Elfenbein on January 15th, 2014 at 5:31 pm

I wanted to make a brief comment on the recent price action of Wells Fargo ($WFC), and this is typical of how Wall Street behaves. The bank topped expectations by two cents per share yet the stock dropped yesterday morning after earnings.

But after a day passed, the market suddenly changed its made and decided that the earnings were good. WFC rallied today and hit a fresh 52-week high.

Let me be clear: There was no important info that came out between the earnings report and today. Nothing. The market simply reacted first with fear, and then became more rational.

Investing Is a Bottom-Up Activity
Posted by Eddy Elfenbein on January 15th, 2014 at 7:56 am

The longer I’ve worked as an investor, the more I’ve come to realize that successful investing is a bottom-up process. By bottom-up, I mean it starts with the very basics of a company (its products and markets) and gradually works upwards from there (i.e., balance sheet, cash flow, valuation ratios).

The problem is that most people are strongly averse to this approach. I don’t know exactly why, but there’s a natural propensity to view the investing world top-down. This clouds nearly every investment discussion. Heck, I’m guilty of it myself.

Here’s how it works. An investment discussion (particularly in the media) invariably starts with the Federal Reserve and the macro economy. Then it works its way down to partisan politics: the budget, taxes and the debt. Throw in a discussion of EMH and how bad hedge funds are (curiously, we’re never told the flip side of EMH—that it’s impossible to lose to the market consistently before fees), and maybe touch on CAPE. Then if we’re lucky, one or two comments about Apple. And we’re done.

This is a huge disservice to readers, and almost none of it matters to being a good investor. The skill set one needs to be a shrewd stock picker doesn’t involve complex math or defending your political party. Rather, it’s closer to that possessed by an investigative reporter or a private eye. Don’t laugh. Whenever I’m in a department store, I’ve gotten in the habit of asking the kid behind the counter, “What’s popular?” He’ll tell you. In fact, he’ll tell you a lot. Just by doing this, you can learn a lot more than what a stock screener will tell you.

Look, I love financial ratios as much as anyone, but the information they give you is very limited. I’ve long called the Balance Sheet the overlooked cute sister of the 10-Q report, but even that only says so much. Here’s an important generality in corporate finance: a good company isn’t usually transformed into a bad one by taking on too much debt. Sure, it’s possible, and certainly it has happened before. But what really happens is that companies take on too much debt precisely because they’re bad. They have a growing need to mask their deficiencies.

A few years ago, I stumbled across Nicholas Financial (NICK). I’ve probably written about this stock more than any other. NICK isn’t followed by any analyst. It rarely generates news. I visited a branch office and later called up the CFO. He patiently answered my many questions. With a little bit of work, I probably knew more about them than anyone outside HQ.

I remember when NICK dropped below $1.64 per share five years ago. It’s really hard to believe in efficient markets when your stock is trading at one-fifth book value and roughly one times earnings for the year after next. The market was offering me dollars for dimes, and I bought them. (NICK just agreed to be bought out at $16 per share.) Inflation, Obamacare, the euro—none of that mattered. To be fair, the Fed’s low rates played a role in helping NICK, but connecting that policy to being a NICK bull would be a stretch.

I also have a growing distrust and outright aversion to the tiresome bull-bear debate (Barry Ritholtz has led the charge on this for years). It’s a fun parlor game, but again, how does it help investors? Not much.

Another favorite game of the top-down view is to find a sector that ought to be big in the future. I know! Green Energy! Robotics! Biotech! China! Chinese robots producing green energy biotech!!

A basic fact about business is that money can be made just about anywhere. Your objective shouldn’t be finding the next so-and-so. You should try to find superior ROE. No top-down approach would lead anyone to Danaher (DHR), but it’s been one of the best-performing stocks of the last few decades. Their stable of businesses is pretty ordinary. That’s what they do, and they do it well.

My advice to investors is to grant yourself a healthy distance from those who view investing from 30,000 feet. It’s easy to wave your hand and say everything’s overpriced and the Dow could go to 1,000. Instead, if you’re interested in a company, start at the ground level and found out why it’s successful.

Morning News: January 15, 2014
Posted by Eddy Elfenbein on January 15th, 2014 at 6:30 am

World Bank Is Expecting Widespread (if Still Possibly Turbulent) Growth for 2014

EU Lawmakers Seal Deal on Financial Market Rules Overhaul

German Economy Grows at Modest Pace

China Bank Lending Slows as PBOC Walks Policy Tightrope

Why Trying to Hurt China in the Trade Game Could Backfire

Japan Approves Tepco Turnaround Plan

Tullow Finds More Kenyan Oil Boosting East Africa Export Plans

Senate Hearing Set to Press for Quicker Commodity Bank Curbs

What Stanley Fischer Did at the IMF

China’s Huawei Profit Jumps on Smartphones, U.S. Asks Hua-Who?

Charter Woos Time Warner Cable Holders

Bernard Madoff Haunts JPMorgan’s Earnings

General Motors to Resume Paying Dividend After 6 Years

Edward Harrison: Privacy and the Ubiquity of Embedded Technology

Epicurean Dealmaker: A Fine Disregard for the Rules

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Babcock & Wilcox
Posted by Eddy Elfenbein on January 14th, 2014 at 11:33 am

One of these days, I should start a Boring Portfolio of good stocks that are as dull as dirt. Sometimes I really wonder if people understand that the stock market is more than Google, Apple, Facebook and Twitter.

The truth is there are lots of great companies out there, and many of them barely make a peep. Some of them like Moog ($MOG-A) make it on to the Buy List. Harris ($HRS), a former member, is another good example. If you’ve read me for a while, you may recognize other boring standouts like ACE Limited ($ACE) or Raven Industries ($RAVN). International Flavors & Fragrances ($IFF) is another good example.

Here’s another boring stock to put on your radar, Babcock & Wilcox ($BWC). BWC has a noble history going back nearly 150 years. They developed boilers that were used on early steamships and Teddy Roosevelt’s Great White Fleet. They also helped develop the first nuclear-powered subs.

BWC was eventually forced into bankruptcy as a result of asbestos litigation. The company eventually merged from bankruptcy and was spun-off by McDermott International. BWC started trading on the NYSE three years ago.

Here’s the company’s profile via Yahoo Finance:

The Babcock & Wilcox Company operates as a specialty constructor of nuclear components for various customers in the power and other steam-using industries worldwide. Its Power Generation segment designs, engineers, manufactures, supplies, constructs, and services utility and industrial power generation systems, including boilers used to generate steam in electric power plants, pulp and paper making, chemical and process applications, and other industrial uses. This segment also offers technologies to control nitrogen oxides, sulfur dioxide, fine particulate mercury, acid gasses, and hazardous air emissions; and construction services to steam generation or environmental equipment projects, and cogeneration and combined cycle installations, as well as provides environmental equipment and components, and related services. The company’s Nuclear Operations segment manufactures naval nuclear reactors for the U.S. Department of Energy/National Nuclear Security Administration’s Naval Nuclear Propulsion Program, which in turn supplies them to the U.S. Navy for use in submarines and aircraft carriers. Its Technical Services segment offers services to the U.S. Government comprising uranium processing, environmental site restoration services, and management and operating services for various U.S. Government-owned facilities. The company’s Nuclear Energy segment fabricates pressure vessels, reactors, steam generators, heat exchangers, and other auxiliary equipment. This segment also offers engineering services, such as structural component design, 3-D thermal-hydraulic engineering analysis, weld and robotic process development, and metallurgy and materials engineering. In addition, it provides power plant construction, management, and maintenance services; and services for nuclear steam generators and balance of plant equipment, as well as nondestructive examination and tooling/repair solutions. The company was founded in 1867 and is headquartered in Charlotte, North Carolina.

The company also has zero long-term debt and trades at 14 times next year’s earnings.

Wells Fargo Earns $1 Per Share
Posted by Eddy Elfenbein on January 14th, 2014 at 9:45 am

Fourth-quarter earnings are out for Wells Fargo ($WFC). The big bank earned $1 per share which beat estimates by two cents per share. For Q4 of 2012, Wells earned 91 cents per share. For the quarter, net income was up 10% and for the year, it was up 16% to $21.9 billion.

Chief Executive Officer John Stumpf, 60, is trimming staff and expenses as rising interest rates curtail demand for home refinancings. Wells Fargo had vowed to reduce overhead after expenses surged above its target in the previous three months.

(…)

Revenue slid 6 percent in the quarter to $20.7 billion from a year earlier and 3 percent for the full year to $83.8 billion, while profit before taxes and provisions fell 5 percent. Non-interest expense dropped 6 percent and the efficiency ratio, which measures costs as a percentage of revenue, improved to 58.5 percent from 59.1 percent in the third quarter and 58.8 percent a year earlier.

Segment Results

Profit rose in all three operating segments, with the greatest percentage gains coming in wealth, brokerage and retirement, the unit run by David Carroll. Mortgage originations fell to $50 billion, a 38 percent decline from the third quarter, and mortgage-banking income fell by almost half from year-earlier levels to $1.57 billion.

Net interest margin, the difference between what the bank makes on lending and pays for funds, fell to 3.26 percent from 3.38 percent in the third quarter.

The annual profit represents the fifth straight record year for the lender, which doubled its size with the 2008 purchase of Wachovia Corp. It was the first year since 2009 that profit surpassed New York-based JPMorgan Chase & Co., the biggest U.S. lender by assets, which earned $17.9 billion for all of 2013 — a 16 percent drop.

Wells Fargo, which ranks fourth by assets, gained 33 percent in New York trading last year, trailing the 35 percent return for the 24-company KBW Bank Index. The stock closed at $45.56 yesterday and declined to $45.43 at 8:19 a.m. in New York.

(…)

Wells Fargo, responsible for about 1 in 5 U.S. mortgages last year, has profited from Federal Reserve policies that lowered mortgage rates and sparked a refinancing wave. As rates have risen, applications have slowed and cut into originations. Rates on 30-year mortgages averaged 4.51 percent last week, up from 3.35 percent in early May, according to Freddie Mac.

Stumpf announced 5,300 job cuts in the third quarter, and another 925 in October. The impact began to take effect in the fourth quarter, according to a Nov. 7 presentation and may reduce costs by as much as $750 million annually, Deutsche Bank AG analysts wrote in a Jan. 3 report.

The bank is also facing fewer costs tied to litigation and legal expenses than its peers. Through the first nine months of 2013, those expenses fell 1.2 percent to $413 million, according to regulatory filings.

Legal settlements and other costs related to mortgage lending and sales should continue to decline, Stumpf said during a Dec. 10 investor conference. The bank began an internal ethics review this month that could last as long as two years, with plans to examine standards for how employees should act and procedures for handling conflicts of interest across more than 80 business lines.

Morning News: January 14, 2014
Posted by Eddy Elfenbein on January 14th, 2014 at 6:39 am

Eurozone Industrial Output Surges in November

Japanese Stocks Suffer Worst Day in Five Months After U.S. Jobs Report

India Considers Lifting Ban on Airbus Superjumbos

ECB’s Nowotny Would Like Better Financing for SMEs

U.S. Lawmakers Leave IMF Resources Request Out of Spending Bill

Consumers Vent Frustration and Anger at Target Data Breach

Time Warner Cable Rejects $61 Billion Bid From Charter

Suntory Overseas Thirst Drives Higher Beam Deal Value

Volvo Cars Recorded Profits in 2013, Unlike 2012

AstraZeneca Sees 2017 Revenue in Line With 2013 Level

McKesson May Pursue Celesio Joint Venture After Failed Bid

Ranbaxy Falls on USFDA Concerns; Brokers Downgrade

Lamborghini Plans SUV in 2017 in Luxury Push Into Segment

Jeff Carter: Be Like Bill Murray

Joshua Brown: Technical and Fundamental Arguments Against the Secular Bull Thesis

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Ford is the Talk of the Auto Show
Posted by Eddy Elfenbein on January 13th, 2014 at 9:43 pm

I discussed this before, but Ford‘s ($F) new F-150 is making waves at the Detroit Auto Show. The new line’s trucks are made out of alumuninum. They’re more expensive, but they are more fuel efficient.

From the AP:

Ford Motor Co. unveiled the 2015 F-150, whose body is 97-percent aluminum, on Monday. The lighter material shaves as much as 700 pounds off the 5,000-pound truck, a revolutionary change for a vehicle known for its heft and an industry still reliant on steel. No other vehicle on the market contains this much aluminum.

“It’s a landmark moment for the full-size pickup truck,” said Jack Nerad, editorial director for Kelley Blue Book.

The change is Ford’s response to small-business owners’ desire for a more fuel-efficient and nimble truck — and stricter government requirements on fuel economy. It sprang from a challenge by Ford’s CEO to move beyond the traditional design for a full-size pickup.

(…)

Ford is taking a big risk. F-Series trucks — which include the F-150 and heavier duty models like the F-250 — have been the best-selling vehicles in the U.S. for the last 32 years; last year, Ford sold an F-Series every 41 seconds. Ford makes an estimated $10,000 profit on every F-Series truck it sells. Michael Robinet, the managing director of IHS’s automotive group, says the trucks account for about a third of the company’s revenue in North America — $80 billion in 2012.

“Anytime you make a change with that vehicle, it’s got to be well thought out, because you are really playing with the crown jewels of that company,” Robinet said.

(…)

The 2015 F-150 goes on sale late this year. As for cost, Ford wouldn’t reveal prices, but its truck marketing chief Doug Scott says the F-Series will stay within its current price range even though aluminum costs more than steel. F-Series trucks now range from a starting price of $24,445 for a base model to $50,405 for a top-of-the-line Limited.

Pete Reyes, the F-150’s chief engineer, said Ford expects to make up the premium by reducing its recycling costs, since there will be less metal to recycle, and by slimming down the engine and other components, since they won’t have to move so much weight.

Aluminum is widely used on sporty, low-volume cars now, like the Tesla Model S electric sedan and the Land Rover Evoque. U.S. Postal Service trucks are also made of aluminum.

(…)

Improvements in aluminum are also driving the change. Three years ago, for example, Alcoa Inc. — one of Ford’s suppliers for the F-150 — figured out a way to pretreat aluminum so it would be more durable when parts are bonded together. Carmakers can now use three or four rivets to piece together parts that would have needed 10 rivets before, Alcoa spokesman Kevin Lowery said.

And Ford is able to take more risks. When the F-150 was last redesigned, in the mid-2000s, Ford was losing billions each year and resources were spread thin. But by 2010, when the company gave the green light to an all-aluminum truck, Ford was making money again. Mulally, a former Boeing Co. executive who joined Ford in 2006, encouraged his team to think bigger. After all, it was Mulally who led early development of Boeing’s Dreamliner, which replaced aluminum with even lighter-weight plastics to be more efficient and fly further.

(…)

Ford is convinced truck buyers will accept the change. The company says the new truck will tow more and haul more. The frame — which does most of that work — is still made of high-strength steel, and the engine doesn’t have to account for so much weight. It can also accelerate and stop more quickly. Aluminum doesn’t rust, Ford says, and it’s more resistant to dents.

Reyes says the company planted prototype F-150s with three companies — in mining, construction and power — for two years without revealing they were aluminum. The companies didn’t notice a difference.

The S&P 500 Drops -1.26%
Posted by Eddy Elfenbein on January 13th, 2014 at 4:35 pm

Ugly day today. At noon, the market was mostly unchanged, but then Dennis Lockhart, the president of the Atlanta Fed, said he supports more tapering (he’s not a voting member this year). The market started to head south. By the closing bell, the S&P 500 had dropped down to 1,819.20 which is its lowest close since December 20th. For the day, the index lost -1.26%.

My take: I don’t think there’s any real news here. The Fed will most likely continue with tapering this year but hold off on any rate increases.

Breaking down the market, the biggest damage today came among cyclical stocks. The energy, consumer discretionary, and financials got hit the most while utes, healthcare and staples were down least. Bonds were up, but not by much. The 10-year yield fell to 2.83% which is 21 points below its peak from December 31.

Our Buy List had a rough day. We lost 1.27% on the day which was almost the same as the S&P 500. Eighteen of our 20 stocks lost ground; only Ford ($F) and eBay (EBAY) made money. Ford made a lot of headlines with the unveiling of its new F-150 at the Detroit Auto Show. The new pickups are made out of aluminum. Although they cost more, they’re more fuel efficient.

Our worst performers today were Microsoft ($MSFT), Bed Bath & Beyond ($BBBY) and Cognizant ($CTSH). Next up, we get the earnings report from Wells Fargo ($WFC).

CADY
Posted by Eddy Elfenbein on January 13th, 2014 at 12:40 pm

There’s been a lot written lately on the Cyclically Adjusted Price/Earnings Ratio (or CAPE). I highly recommend what Josh and Jesse have written.

CAPE is the Price/Earnings Ratio but based on the last 10 years of earnings instead of the last one year. I’ve never been much of a fan of CAPE. My reasoning is pretty basic — valuations are cyclical so there’s no need to adjust the earnings side of the P/E Ratio.

I went to look at the data on Prof. Shiller’s website, but I made one small adjustment. I changed the earnings input to dividends.** So instead of the trailing 10 years of earnings, this is what the trailing 10 years of dividends looks like, or as I’m calling it, CADY (Cyclically Adjusted Dividend Yield):

We see much the same as the CAPE graph, the current market is vastly overpriced. In fact, with CADY it’s even more so. But this underscores the point Josh makes—it’s not different this time, it’s different every time. According to CADY, the market has been priced above its long-term average every month over the last 28 years. The current stock market would have to drop 64% before CADY reached its long-term average.

Sounds crazy? I would argue that CADY has a major advantage over CAPE in that we don’t have to dig through all the accounting issues (Jesse does a great jobs on this). A dividend payment, after all, is a dividend payment.

Some of you might object to CADY by noting that dividend payout ratios have fallen so the yield should be less. But that’s my point exactly. The nature of stock ownership has changed over the decades, so the valuations metrics have also changed. By looking at CADY, I hope it highlights the problems of looking at CAPE. I love looking at old stock data, but be leery of drawing too many conclusions when looking at stock data before 1960.

** For the excel file, I changed the J’s in column K to I’s, and divided by the H cell factor instead of vice versa.

GoodBrokas
Posted by Eddy Elfenbein on January 13th, 2014 at 11:59 am

Over the weekend, I saw “The Wolf of Wall Street.” I thought it was an entertaining albeit flawed movie. It’s disappointing to see a movie by one of your favorite directors about a subject you’re familiar with fall short of what you had hoped for. (I should mention that in the early 1990s, I was a cold-caller for a shady brokerage outfit in Boston, but rest assured gentle reader, it was a far cry from the buffoonish culture of Stratton Oakmont.)

I’m not in the habit of reviewing movies, so take my comments as the views of an amateur. For one, I though the movie was far too long. There’s nothing wrong with a movie going on for three hours, but so much of the “The Wolf of Wall Street” was redundant. We see similar scenes over and over again.

For example, Martin Scorsese’s attempt to capture the over-the-top lifestyle of Stratton Oakmont was itself over-the-top. We get it—there were drugs, prostitutes and debauchery, but does that has to be shown repeatedly?

But what troubled me most was that once you peel away the drug-coated layers of Jordan Belfort, there’s nothing particularly interesting about him, his character or his crimes. He’s just a petty thief, but on a larger scale. The guys at Stratton Oakmont aren’t smart or interesting.

I can’t help but think what a movie about the Great Salad Oil Swindle of 50 years ago would be like. Now those guys were smart.

I’ve never seen a movie where another movie, in this case, Goodfellas, ghostly floats through each scene. From Belfort’s rise and fall to his tempestuous marriage, so much of the Wolf of Wall Street strives to catch Goodfellas. Leonardo DiCaprio even sounds like Ray Liotta. But there’s a critical difference. We see behind the worldview, character and motivations of Henry Hill and his gangster associates. Consider this famous line:

Hundreds of guys depended on Paulie and he got a piece of everything they made. And it was tribute, just like in the old country, except they were doing it here in America. And all they got from Paulie was protection from other guys looking to rip them off. And that’s what it’s all about. That’s what the FBI could never understand. That what Paulie and the organization does is offer protection for people who can’t go to the cops. That’s it. That’s all it is. They’re like the police department for wiseguys.

That’s a brilliant line and it tells us so much. There’s nothing in the Wolf of Wall Street that comes close to that one line. Jordan Belfort? He’s just a dumb crook. He even distorts the famous 1991 Forbes article. For one, no one ever called him the Wolf of Wall Street. Belfort made up his own nickname. The Forbes article is one of disdain and it was clear that he was going to be caught eventually.

Even the oleaginous Gordon Gekko in “Wall Street” has a larger (but damaged) worldview. Remember that he closes his famous “greed is good” speech by saying that greed will save “that other malfunctioning corporation called the USA.” It’s that movie’s flaw that Gekko is finally done in by breaking the law instead of the consequences of how he sees the world. Chalk that up to Oliver Stone’s heavy-handedness.

A movie covering the misdeeds of Wall Street could be fascinating. But despite Mr. Belfort’s self-given nickname, Stratton Oakmont has little to do with the real Wall Street. The workings of Goldman Sachs or Morgan Stanley might as well be in another universe as some bucket shop on Long Island.

Last year, Leonardo DiCaprio played another Long Island-based fraudster who threw big parties:

If personality is an unbroken series of successful gestures, then there was something gorgeous about him, some heightened sensitivity to the promises of life, as if he were related to one of those intricate machines that register earthquakes ten thousand miles away.

There’s nothing gorgeous about Jordan Belfort. Instead of Jay Gatsby, the Wolf of Wall Street gives us a bunch of drug-addled bros.