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Being Optimistic Despite QE2

(Guest Commentary by Rick Konrad – November 7, 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 to pen a guest commentary.  Rick has been a regular guest commentator for several years and offers his unique insights to us twice a month.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick discusses the inability of QE2 to induce bank lending and employment without the participation of other actors, such as the Congress, regulators (corporations are hard-pressed to invest in labor or capital unless regulations are consistent and predictable), and the private sector.  Rick also emphasizes the importance of a buy-and-hold philosophy in a bull market, and ends his commentary with three promising individual stock picks.  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 “Mother Nature Sides with the Hidden Flaw” for his last commentary).  Prior to his founding Value Architects, Rick was a professional portfolio manager for institutional investors for over 25 years.  A more complete profile of Rick is available on his blog.  You can also email Rick at the following address if you have any questions or thoughts after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Rick has also run 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 graded 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.


Let me start off with an apology. It has been some time since I have posted here, not because of a shortage of things to say, but a scarcity of time. Once again, I have been on the road visiting with numerous brokers, and as always, listening to their views, and the views of our mutual clients.

A few observations. The election is out of the way. (Thank God.) After being bombarded with far too much negative or slick advertising, it does feel great to see that it is over. As a Canadian, I am used to an attenuated campaign with good reason. In Canada, corporations and trade unions now can no longer give money directly to political parties or candidates. Individuals are limited to donating no more than $1,100 in total per year to any of the political parties, “ridings associations” (equivalent to congressional districts), and individual candidates. Election spending is also limited according to the size and population of the district. For example, the largest “district” in Toronto had a spending limit per candidate of just over $100,000 in the last federal election. Political Parties must register with Elections Canada in order to issue tax receipts for donations, and in order to qualify for government funds which are paid to parties after an election. Major changes to election financing came into effect in 2004 and provide healthy reimbursements to both political parties and candidates.  If a party has received more than 2% of the national vote or 5% in the ridings it contested, then it may qualify for a payment equal to 60% of its election expenses. If a candidate wins at least 10% of the votes in his or her riding, they are also eligible for up to a reimbursement of up to 60% of their expenses. I think it's a rather clever way to keep the noise and rhetoric down.

The election is out of the way and QE2 is on its way. The rather lukewarm reaction to the FOMC statement regarding this additional monetary stimulus seems to imply that the scale of QE2 has been largely discounted if not dismissed. Thursday's Washington Post op-ed by Ben Bernanke seemed unprecedented. (please see: http://tinyurl.com/24kkktm) but contained little new justification for this move. In summary,

  • Chairman Bernanke reminded us of the Fed's dual mandate, to promote a low, stable inflation AND to promote a high level of employment..
  • Underlying inflation is low and could morph into deflation which would result in economic stagnation.
  • Asset purchases by the Fed in the past have had little effect of broad measures of money supply nor resulted in higher inflation. There is plenty of slack and excess capacity in the system…what, me worry?

In classical terms, what most of us think of as Keynesian economics, John Maynard Keynes suggested in his “General Theory” that a government treasury could print money to pay for infrastructure spending, railways, roads, and houses….a still familiar solution for many governments in the last two years. In one his more whimsical or radical moments, he also suggested that, as a way of boosting employment, new money could be buried in the ground and private companies could compete for the rights to employ workers to dig it up again. It seems to me that Keynes' joke is the only way that a central bank can achieve a direct impact on employment. Waiting for central bank purchases to persuade banks to lend rather than shore themselves up, and ultimately to reignite confidence and perhaps a consumption boom seems very indirect and inefficient…and, worse yet; isn't that how we got into this mess in the first place?

Somehow, it seems to me that the rather circuitous route to improved employment figures that QE2 navigates, has little chance of actually finding its target. Little wonder that in the last paragraph of Bernanke's op-ed he added very thoughtfully if not wistfully, “The Federal Reserve cannot solve all the economy's problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators, and the private sector.”

There is little doubt that the prospect of QE2 has had a positive impact on the market since September as well as some anticipation of an electoral message to Washington, particularly to Washington incumbents. Yet, in an economy that is saddled with debt, it still strikes me that QE2 will have little real economic effect.

That is not to say that QE2 may not still be a positive for the stock market in general. Investors' appetite for risk often depends on comparative valuations and returns offered by competing instruments and from my discussions with brokers during my roadshow, there is an increasing concern that investors' asset allocations need to shift back to equities.

Though the market has come a long way in the last couple of months, it is still difficult to argue that it is expensive. On the day post election when the market charged ahead by 200 points, I spoke to a major broker's operations head. By the end of the day, sell orders had outnumbered buy orders by more than six to one for their system…it seems that the vast majority could not stand prosperity, or at least wanted to “nail it down.”

Almost 100 years ago, Jesse Livermore observed,” the big money was not in the individual fluctuations but in the main movements, in sizing up the entire market and its trend…nobody can catch all the fluctuations. In a bull market your game is to buy and hold until you believe that the bull market is near its end.”

Despite my skepticism about the effectiveness of QE2 on the economy, the first order impact of a commitment to reflation is a rally in risk assets. The loose, borderline, and reckless monetary policy will continue to lift stocks in my view.

Anecdotally, investors are clearly not as bearish as they were just in August or earlier in the year, but they are far from optimistic. The experience of the last couple of years has resulted in anguish and a tendency to hammer out short term gains. Markets have a way of creating pain, of finding the vulnerabilities and punishing them. I suspect that sellers may well find themselves trying to get back into this market at higher levels.

Corporate profitability continues to provide some positive surprises. Though the political clouds will take some time to part, it seems that many executives are somewhat relieved by the November 2nd outcome. As we all realize, the only sector of the economy with a healthy balance sheet at the moment is corporate America. I think we will be seeing some helpful capital management as 2011 progresses.

For example, one of our insurance holdings, Harleysville Group (HGIC) announced an extra dividend to be paid later this month:

“… we are going to pay a special cash dividend of $1.44 per share -- which represents the amount of our current annualized dividend -- on top of our regular quarterly cash dividend of $0.36 per share. This special dividend is another example of our commitment to managing capital efficiently. With limited opportunities to reinvest cash in our investment portfolios due to historically low interest rates, we feel it is appropriate to distribute some of our excess capital to “our shareholders.”

All told, we have returned more than $325 million of our capital to our shareholders since June of 2007 via dividends and the six stock repurchase programs that have amounted to 20% of our outstanding shares. We believe our balanced capital management strategy continues to differentiate us from many of our competitors. At the same time, we are well positioned for profitable growth, and we have plenty of capital to fund the right acquisition or other growth opportunities as they emerge.”

Later in the week, another one of our insurance companies, Alterra Capital (ALTE) announced their version of capital management:

“Turning to our balance sheet and capital management, we ended the quarter with over $3 billion in shareholders' equity. Book value per diluted share was $25.88 at the end of the quarter, up 5.4% from June 30, 2010. Including the unrecognized change in fair value on our health and maturity portfolio, book value would have increased by an additional $0.47 in the quarter or resulting in a growth of 7.4% over the prior period number”

“Year to date including yesterday's dividend declaration, we've declared $351 million in dividends and have repurchased $113 million of our common shares. In aggregate we have returned capital shareholders of over $460 million or more than 15% of our pro forma opening shareholders equity.”

“Going forward we believe that share repurchase will continue to be our primary tool to manage excess capital levels. With that yesterday our Board authorized an additional $200 million for share repurchases, bringing our outstanding share repurchase authorization up to $223 million.”

Corporations face an embarrassment of riches at this point. With opportunities to roll cash at the same miserable yields that are barely positive, and with a reluctance to commit to much in the way of capital spending, and with the likely carryforward of the Bush tax cuts, we may see a lot of additional capital management activity. The corporate balance sheet may well be the incremental buyer of equities.

The last two years have seen a great deal of corporate restructuring on the operational side. Productivity gains have come at the heavy cost of cutting jobs. Accessing debt markets for corporate America is very easy at this point--plentiful credit at very low yields is readily available. The ability to lower the weighted average cost of capital by issuing low yielding debt and buying back cheap equity I think will be an important factor in keeping equity markets moving north or at least providing support.

I continue to like both Harleysville and Alterra Capital as reasonably valued holdings in the insurance area at current prices.

Here is another idea that we find appealing currently:

Finish Line (FINL) operates about 570 mall-based stores carrying all of the major athletic wear brands. In its most recent quarter, the stock was penalized because the stores were under-inventoried and failed to participate as well as consensus had expected in the toning shoe craze. While it may well have missed a golden opportunity to optimize on a hot footwear cycle, FINL has adjusted its deliveries to meet what ought to be a strong back half demand in athletic footwear. Strength in lightweight running shoes, and strong launch schedules in: Under Armour , Reebok Zig and Air Jordan basketball should help traffic and raise average selling prices for FINL. FINL has started to roll out a new store within a store concept for Nike called the Nike Track Club which may also positively impact sales. This concept should be present in about 50% of all stores by the holiday season.

Finish Line's management was fortunate in pulling out of a deal to acquire Genesco just prior to the Great Recession by utilizing what is known in investment banking as a MAC clause (material adverse change). Though the company avoided what would likely have been a horrendous $1.5 billion acquisition, the termination extracted a $200 million penalty and I believe, a valuable lesson in capital allocation and leverage. The former founder and CEO who had engineered the deal (as well as extricated the firm from it) has retired and it seems that management is back to basics.

Looking at FINL versus its larger rival, Foot Locker (FL) draws some interesting comparisons for the trailing twelve months:

  Finish Line Foot Locker
Price to FCF 5.2 X 15.4 X
EV/EBITDA 3.8 7.3
ROE 14.7% 4.0%
ROIC 13.2 3.3

Last fiscal year, FINL bought back about $14 million of stock net of about $2 million in issuance. Including dividends, roughly $20 million of FINL's $157 million in operating cash flow was returned to shareholders, or about 12%.

The company is down to about 2.4 million shares left on its repurchase authorization having bought 1.4 million shares in the first half of this year. We certainly expect more down the road.

I like the relative value of Finish Line as compared to its retail peers given its strong position, it excellent free cash flow characteristics and high profitability.

Disclaimer: I, my family, or clients have a long position in Finish Line, Harleysville Group, and Alterra Capital.

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