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Buyouts, Bifurcation, Bailouts and Bankruptcy


Artificially delaying the natural business cycle will create a more horrific final event.

I write this piece on the way home from the annual Minyanville Festivus in New York, a gathering of some of the country's greatest investment minds. I am honored to be part of the Minyanville community and to contribute whatever knowledge I have gained during my career.

At Festivus the hot topic was the sub-prime bailout, which was crafted jointly by Treasury Secretary Paulson and President Bush last week. It is this very topic which inspired me to write this piece. Many people I have come across recently are questioning the sub-prime bailout. As a proud American, I am always there to pay taxes that take care of basic social programs. But I wonder if we are crossing the line of democracy into the land of socialism. This is a tough subject to address, but running from the truth isn't right either.

1) Buybacks

When I started in the securities industry way back in 1981, there were a few important investing "rules" we were taught. One such rule was that the stock market was "cheap" when dividend yields were as high as 6% for the S&P 500 and considered "expensive" when yields were as low as 3%. In fact, if you look at a chart from 1900 to 1995, this relationship actually held true. Then, suddenly, in 1995, the range of 3 to 6% dividend yields suddenly broke down. We have not seen dividend yields anywhere close to 3% since 1995.

At the peak of the stock market bubble in March 2000, dividend yields fell below 1%. I remember this vividly, because as a value-oriented hedge fund manager, 0.95% got my attention. We must keep in mind that the S&P 500 is a capitalization weighted index and at the peak in 2000, the largest market cap stocks were Microsoft (MSFT), Cisco (CSCO), etc.- those stocks with dividend yields of 0. One would conclude then, that since the tech bubble broke apart and tech stocks proceeded to fall by 80% into the October 2002 low that the dividend yield would climb steadily as these tech titans had less impact on the index, but no! Alas, they have stayed stubbornly between 1% and 2% since 1995 (please note, however, that the Dow Jones Industrial Average has recently climbed all the way to 2.25%).

For those new to the game of investing, you should know that nearly half of all stock market returns since 1900 have come from dividends. Yes, dividends. So, the way I see to properly analyze the balance between stocks versus bonds is to look at what we can earn in bonds. Lately, I have added Freddie Mac (FRE) and Fannie Mae (FNM) Trust preferred shares in the 7 to 8% annualized dividend range. Because their dividends qualify for the 'dividends received deduction', the tax equivalent yield is nearly 11.5%. If I am paid a paltry 1.75% to own stocks, stocks must therefore gain almost 10% per year just to keep up with the Trust Preferred Stocks.

Investors in stocks normally demand to be paid a 'risk premium' or some spread over lower risk securities. Please don't misunderstand me-Freddie Mac and Fannie Mae preferred shares aren't without risk, but I believe they have less risk than the S&P 500. Given this relationship and a risk premium of around 3%, stocks need to earn 14% including dividends. This means that 12.25% would have to come from capital appreciation. This is double the rate that stocks have appreciated over the past century. And this would have to happen every year.

Since I doubt a 12+% annual appreciation rate can be sustained, I can only conclude that the great debt induced buyback experiment has backfired, and explains my cautious view (even more cautious than usual) towards equities based on simple risk/reward analysis.

The excuse for low yields generally goes like this. Rather than returning cash to shareholders in the form of cash, or dividends, we are being 'rewarded' by companies plowing money into share buybacks. Is this "new math"? Because dividends are taxed at the capital gains rate of 15%, I would like more income. What a great time to reward people that own your company. Send them a check with low tax consequences. It sure beats earned income with tax rates approaching 40%.

Why then, do companies buy back stock with cash, often borrowed cash, instead of sending me a check? It is an earnings manipulation and financial engineering in a simple form. Company insiders reward themselves with stock options and dilute the interest of shareholders. They then buy back the shares, offset the dilution, which enhances earnings per share.

The acceleration in money supply and credit growth that has now gone parabolic started in 1995, the same year that the 3%-6% stock market dividend rule broke down. The sum of the financial engineering is that we create more money for companies to 'reward' shareholders by buying shares with borrowed money. All I can say is "Where is my dividend check?"

2) Bifurcation

The split between the "haves" and the "have not's" seems to be accelerating, and the bifurcation takes on many forms.

The stock market is bifurcated when some of the stocks are doing well and some of the stocks are doing poorly. This is occurring now as the shares of financial companies, retailers, homebuilders, investment banks and REIT's get hammered while shares of energy companies, like Exxon (XOM) and Schlumberger (SLB), and infrastructure companies, like Jacobs Engineering (JEC) and Fluor (FLR) are doing very well. This is due to the fact that countries that used to be considered 'emerging markets' have now turned into 'developing nations', like India, Vietnam and China, to name a few. These countries are developing at the very time that the USA is suffering through a credit crisis, the depth of which is still unknown, and will likely be far worse that anyone imagines before it is all over.

The weakness of the U.S.' overleveraged asset-based economy is just beginning to surface. This helps to explain the fact that financial companies are under the most pressure. Developing economies like China continue to build out infrastructure which could slow when the U.S. goes into a recession. The shares of the companies in many of these countries already discount growth, so while I see the economic strength of these countries and acknowledge the bifurcation, it is hard to commit money to these markets at such stretched valuations.

Another bifurcation is growing between those that have significant wealth and those that have little wealth at all. Many people tell me that "it is different this time" (I seem to have heard that before…), and that the growth in countries like China are insulated from the problems in the U.S. When looking at the developed countries that China relies on to export their cheap goods to, we see that these countries are losing economic momentum and may even already be in recession. I can only wonder what will happen to these over-heated markets. Will they win in the long run? It is possible, but it will take many years for the U.S. to get its financial house in order and clean up the leveraged mess that Americans now call their financial system. The bifurcation train is rolling down the tracks and is accelerating in my view, which leads to B #3 - Bailouts.

Continued on Page 2.
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Positions in FNM, FRE Trust Preferreds.

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