The FOMC - Old News is No News!
(Guest Commentary by Rick Konrad – August 12, 2010)
Dear Subscribers and Readers,
For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in Mr. Rick Konrad for a guest commentary. Rick has been a regular guest commentator for several years and offers his unique insights to us in his twice-a-month mid-week commentaries. We highly appreciate your investment insights and general wisdom, Rick!
In this commentary, Rick will offer his views on the yesterday's adverse market reaction to Tuesday's FOMC “news,” as well as fears of a further slowdown in the U.S. economy – both of which are not really news at all. Rick then offers his macro views on the U.S. economy as well as Fed policies, and ends the commentary with a few individual stock picks, including a REIT and a business development company (BDC). Without further ado, following is Rick's biography:
Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on MarketThoughts.com (please see “Chasing Yields and Avoiding Taxes - Buybacks May Be the Only Answer” for his last guest commentary). Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years. You can view a more complete profile of Rick on his blog. You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary. Rick is a very genuine teacher of the financial markets and treats it very seriously. Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been involved with grading CFA examinations.
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
Well the Fed has spoken. As today's market indicates, the message has not gone over very well. It puzzles me why this message has been "accepted" so grimly.
What exactly was said? The FOMC decided to leave the Fed rate unchanged at the current 0-0.25% level. No surprise here. Hence, the previous stance of maintaining a low interest environment remains intact.
The FOMC also decided to reinvest principal payments from its MBS (mortgage-backed securities) portfolio in longer-term treasury bonds. What does this tell us? I think it indicates that the Fed is very strongly behind the yield curve, very staunchly behind the bond market, and willing to recycle MBS payments into long treasuries. The shift from mortgages into bonds without adding to the bloated Fed balance sheet in some ways is merely moving the deck chairs around, but I believe this is a signal to us to take on longer term risk. The Fed also indicated that it will continue to roll over its holdings of Treasury securities as they mature.
Remember too that at present, Fed holdings of MBS's (~$1.1 trillion) exceed their holdings of treasuries (~$0.8 trillion) and the need for some asset re-allocation is also prompting this move. Since the beginning of the financial market turmoil in August 2007, the Fed's balance sheet has grown to $2.3 trillion as of August 4, 2010, up from $869 billion on August 4, 2007.
The FOMC's views on recent economic conditions has weakened since last month. US output and employment recovery has slowed and though household consumption has risen, high unemployment, slow income growth, and continuing tight credit conditions restrain household spending. This is new news?? The FOMC statement and Fed Chairman Ben Bernanke's comments have taken a much more cautious tone over weaker signs of economic recovery with higher volatility in FX and capital markets as well as falling of economy into a liquidity trap.
Inflation remains subdued...the system continues to have a lot of capacity slack which should limit cost pressure and keep longer-term inflation expectations stable and subdued.
I believe that:
i) The upcoming worse-than-expected economic data would extend the period the Fed keeps its zero rate. The slowdown in employment, declining inflation rate, sluggish housing market and tight bank credit is expected to pressure the Fed to ease its monetary policy some or implement all of the market's suggestions mentioned above sooner or later, particularly for asset purchase and cutting interest paid on the Term Deposit Facility.
ii) The Fed may reconsider an exit strategy and raise its policy rate in late 2011. As they say in New Jersey, fuggetaboudit for a while until there is strong private-sector payroll employment, increases in income and accommodative higher inflationary pressure.
iii) The FOMC outcome will not block an upward interest rate cycle in Asian monetary policies
iv) For the bond and FX markets, the asset purchase program will continue to take the long-term US Treasury yield down. The US dollar should also be expected to weaken further against the euro to US$1.35/1.00 and weaken even more against Asian currencies.
There is absolutely no reason for the market's shock with the FOMC statement. Note some excerpts from Bernanke's before the Committee on Financial Services, U.S. House of Representatives, on July 22, 2010 which are essentially identical to much of yesterday's Fedspeak:
"...unemployment is now expected to be somewhat slower than previously projected...near-term inflation now looks likely to be a little lower...expect real GDP growth of 3.0-3.5% in 2010...the unemployment rate is expected to decline to between 7.0-7.5% by the end of 2012...most participants viewed uncertainty about the outlook for growth and unemployment as greater than normal...the risks to growth as weighted to the downside...inflation will average only about 1.0% in 2010 and remain low during 2011 and 2012...the risks to the inflation outlook are roughly balanced."
The market's reaction to the uncertainty seems to be complete risk aversion. We continue to believe that we will garner good returns by bearing others' fears at fat risk premia. It is easy to get lost in the labyrinth of paths where anxiety and dread meet opportunity and value.
Let's go through some of our recent bargain hunting. Here's a few ideas.
Government Properties Income Trust- GOV
Welcome the federal government into your building as a tenant. Here is your opportunity to be a landlord to what still should be regarded as a decent tenant. This REIT yields 6.4% at its current price. The federal government or one of 5 state governments is on the lease for 96.8% of the properties. Occupancy rate...let's say, there's still a few broom closets left to rent. The portfolio is about 99.7% leased with on average five years remaining lease term. Renewal rates are also north of 90%.
Contrast this with Corporate Office Properties Trust- (OFC), a REIT with a focus around Washington DC. The Feds represent about 18.6% of the rental income. Decent occupancy too for a commercial property REIT but at 90.7% currently on the owned property. There are some joint ventures with considerably more vacancy. Yield significantly lower at 4.10%. The balance sheet here is decent with interest coverage of almost 3 times. But GOV has even less leverage with interest coverage of 9 times.
There is room for GOV to lever itself up and considerable opportunity with many states in a position to consider sale/leasebacks of their property.
Golub Capital BDC- GBDC
Business development corporations have been through the wringer. Essentially, these are portfolios of financings for middle market (i.e. smaller) private companies. Consequently, the quality of the portfolio is dependent on the asset quality of the loans backing the portfolio, an honest assessment of risk and valuation (Check David Einhorn's Fooling Some of the People All of the Time for some great insight), and funding.
GBDC appears to have decent credit quality and from checks that I have run on management, a decent reputation among the middle market crowd. The company recently went public after a long history of growth as a private vehicle. Management has skin in the game both from the standpoint of its majority ownership and its below industry norm participation in incentive rewards. Finally, the company successfully develoiped a new funding source, securitization that they just completed in the most recent quarter.There is also a SBIC, a Small Business Investment Company, a structure which permits co-funding by the Small Business Administration. About 40% of the GBDC portfolio is in relatively low yielding loans which could easily be redeployed as they are repaid or sold.
Yielding 8.60%, perhaps at the low end of many BDCs, the higher quality of the portfolio and the management should provide some relative sanctuary in this market.
Forest Labs- FRX
The iconoclastic chairman and CEO, Howard Solomon speaks his mind. The letter to shareholders is a "thing of beauty" beginning:
"Perhaps it was always that way, but it does seem today that we are inundated with bright young men and women, and some not so young, who are delirious to get as rich as possible as fast as possible. And they are incorrigible-as soon as the balloon breaks, they blow up a bigger one-"
With $8.2 billion in market cap that includes $3.3 billion in cash, Howard is thumbing his nose at those who keep waving high priced acquisitions at him. The company was born of licensing agreements and partnerships and relationships. Though it loses exclusivity for its major league Lexapro product in 2012 and a lesser product, Namenda in 2015, the company continues to build a pipeline of products that as Howard says, "will replace and exceed the sales of those products."
The company is in many ways an ideal partner: small enough to focus on a product without an array of competing products of its own, and big enough to have the scale to market effectively.
No yield...Howard reinvests the cash flow stream in its R&D and heavy share buybacks. We like this at current levels and are buying along with the company.
None of us knows exactly when the market or individual stocks will rise or fall. However, using some fundamental disciplines will improve the odds of success. Fundamental ideas are often in sharp contrast to popular ideas. As the late John Templeton said, “Bull markets are born in pessimism, grow on skepticism, mature on optimism, and die of euphoria”. We hope to take advantage of the pessimistic backdrop.
Though the likelihood of the economy to come roaring back to life is a low probability bet, the most likely scenario to me is a "muddle through" economy with meandering growth of 1 to 2% for some time. The prospects for a significantly improving unemployment picture in 2010 remain poor.
I, my family, and clients currently have a long position in all of the securities mentioned in this post.