After 7.5 highly adventurous years of bond investing, I decided it's time to take stock, or rather "bond". So, I went back to the beginning (2008), when I switched from my (frankly) disastrous stock / options style of investing to bonds: bonds, nothing but bonds, bonds all the time. I prepared a trade-by-trade listing of each purchase and redemption from May, 2008 until the present. My first purchase, Clear Channel 7.25% of 2027 was the very worst. I bailed out in September of 2011, with a nasty loss of $3100 on an original investment of $6800. Things soon got better though, a whole lot better.
From that start date to now, I bought a face amount of bonds to the tune of $2.88 million. The actual cost was $2.4 million. Since nearly all the bond positions have since risen well above par, that gain alone looks rich. In the meantime, I sold off positions worth $1.28 million, for a pre-tax profit of $176,000. The remaining positions are worth $1.35 million, with an unrealized profit of $304,000. On the taxable side, I used margin along the way, generally paying about 1.25% annually from Interactive Brokers. Starting with an initial total dollar outlay of $277,000 as of March 1, 2009, this portfolio is now worth $652,000. Adding back in $477,000 withdrawn over this period for living expenses, the adjusted value is $1.13 million, a return of 307%, or a compounded return of 20.5%! People praise Soros and Buffet for gains in the 18-20% annual range. Their calculations don't account for ANY withdrawals over the years; mine were nearly half a million! Had I reinvested those funds over the years, my results would have been substantially richer and I'd be looking down my nose at those amateurs.
So, where are MY acolytes, slavering for scraps from MY yearly press conference?
Of course, my IRA returns are far more modest: only 115% on an original outlay of $274,000. That's merely 12.5% annually over five years (my IRA bond investments were complete by July, 2010). Still, what bond maven wouldn't have killed for such returns (I'm talking to you, Bill Gross)?
Looking back, I am very inclined to fret. If I had only doubled, tripled, quadrupled down! Knowing what I knew, believing what I believed, why didn't I swing for the cheap seats? Well, to put it bluntly, I did, to the extent of my abilities. While it would have been technically feasible to be far more aggressive, I actually went to the farthest limits of my psyche. The risks I took (and they were considerable) were all I could handle. More and I might have exploded, imploded, or simply melted. Only the retrospective glow of success makes additional risk-taking look plausible. So, I simply have to pound the drum I have, not that bigger better one.
My disadvantages vis a vis Warren and his crowd are many: they have lots of insider information, they have huge sources of very cheap funds; they can command seriously favorable terms in buying and selling; they can influence management to do their will; and the pilot fish trailing in their shadow bid up the stuff they buy after the fact. I, however, am not without certain modest advantages as well: I can buy and sell without moving the market; I can overweight to my heart's content; I have no one riding my ass about last quarter's results and ... well, that's about it. But perhaps there is one additional advantage: it's MY money; I care a lot about it; and I watch it very carefully.
When I started this blog, I was sure I had useful advice, and this latest analysis bears me out. Folks, listen up! You'll thank me later!
Saturday, May 30, 2015
Saturday, February 7, 2015
What is cheap?
When you're thinking about investing in almost anything, you will, I guarantee, be plagued by the question of whether you're buying at the right price. Right price? Well, really, you need a cheap price. Essential to the investing dynamic is to buy low and sell high.
Well, I have bad news for you. Today's "bargain" price is tomorrow's "falling knife." The brutal truth is that there is no correct price for anything. There's only a price that is a compromise between a buyer (who is greedily looking for the lowest springboard to appreciation), and a seller (who is either afraid or is in turn seeking greener pastures for the same ultimate reason). Nobody buys because they truly think their purchase is overpriced, and few sell because they are convinced the item is extremely cheap. Notice, though, I said "few" in the prior sentence. And that's really important. People do, on occasion, sell things for tremendously low prices because they think they have little choice. They sell in despair ("I give up, this damn thing is headed for the toilet"), or they sell to raise cash to meet desperate needs (say the dreaded margin call).
In the broad flow of events, markets swing irregularly from euphoric highs to irritably dreary years of minor ups and downs, to occasional moments of sheer terror. When the market has risen inexorably for six years (hmm, remind you of any recent period?), people start thinking the abnormal is normal, and grasp for things that have already risen to the stratosphere. You hear variations of the greater fool theory underlying the purchase recommendations of market professionals ("yes, it's relatively high for the moment, but long-term dynamics will make today's price look trivial" - think of the endless flow of Amazon hype).
It is the moments of terror, though, that really interest me. While they seem like extreme outliers, I find them popping up fairly frequently: 2001-2, 2008-9, the euro crisis of 2010-11, and today's oil price collapse. If the crisis is severe enough, truly irrational behavior results. I've documented the extreme opportunities that occurred in the great recession and the euro kerfluffle. Now, lo and behold, they're on full display in the oil sector.
After trumpeting the "Case for $35 Oil", Barron's recently raised the ante ("The Case for $20 Oil"). If it hits that $20, what do you think Barron's next prediction will be? Of course, NOBODY (well, maybe a Saudi or two) makes money at $20/barrel, and very few at $35. So, those lows will disappear in the blink of an eye. In the last oil collapse (2008), oil plunged from $145 to $32 a barrel. So, it's pretty safe to say that $32/barrel is a VERY low price, as is the recent $44. The bulk of the world's producers have break-even somewhere around $50, so that too is a pretty low price. At $60, most folks start making money, but few make a whole lot. So, $60 is also a pretty low price. Fracked oil has a median break-even around $65. So, even $65 looks reasonably low.
The tug of war in the next few years will be between the low-cost producers who can make a buck below $60 and those who need to see $80 or more. Political winds will, at times, distort this struggle to the upside, while prolonged dips below $60 will dampen production. Frackers, after all, have no ideology; they'll postpone or halt drilling when they see no way to make a good buck. And, they'll jump right back in when they do see a way.
The quick response capabilities of frackers and other alternative producers (plus steady growth of wind and solar energy) pretty much guarantee that we won't see historical oil highs ($145 in 2008, $124 in 2010) any time soon. So, you can safely say that prices north of $100/barrel are high, just as $32 or $44 is low. So, that's what cheap and expensive are in the world of oil, at least for now. IMHO.
In writing about this sector absolutely flattened by recent oil price drops, one company in particular interests me: the maritime driller Transocean. It recently bottomed (maybe) at around $15, and is now hovering around $18. Are these low prices? Well, there's a fair amount of ink arguing that it's too high. A Motley Fool investor just threw in the towel (after a 62% drop in his holdings of Transocean), and hints that others should too (even though he admits the company will probably trade sharply higher in the near future). As with the price of oil itself, though, I think it's fairly obvious that the company's price is cheap. The blood in the water helps me see this.
So, forget the bottom, just focus on the essentials: will the company survive the present crisis, and will it ever have a future in the future? I've think Transocean (symbol RIG) will survive short-term (adequate cash, fairly modest demands on that cash). Long term, the question relates to whether oil drillers, as a group, will be needed. Well, much as people are focused on fracking as a direct threat to ocean drilling, it's also quite clear that frackers represent incremental production. Their costs are relatively high (probably break-even north of $65), and relatively short well-life requires constant (and probably ever more expensive) replacement of supply.
Ocean drilling is targeted to the largest and relatively least exploited sources of big-time supply. Roughly half of world production comes from offshore drilling at various depths. While exploration and development is expensive, lifting costs (simply pumping the stuff) are quite low, on average $10/barrel, with total upstream costs around between $41 for offshore shelf, $51 for deepwater and $56 for ultra deepwater oil. Even the expensive rigs therefore compare favorably to highly-hyped fracking. So ... is there a future for the sector? Of course there is. When oil returns to $60, new business will start trickling in, while there will probably be a rush once $80 is reached.
Right now, the balance of fear and greed is overwhelmingly on the side of fear. Taking action is hard, things might get even cheaper. True enough, but do you seriously think oil will STAY at $20, or $30, or $40? So, I think doing SOMETHING makes sense. I'm buying Transocean calls (10 of January, 2017) for astonishingly small time premiums (around $.50 per share for a two-year leap). I've already locked in some spreads (selling calls 18 of 2017), with a maximum profit to expiration of 140%. That profit will be realized if the stock closes at or above $18 in January 2017. Will it? Heck if I know. But I think the odds are heavily in my favor, as the stock closed at $18.51 yesterday.
I'm also nibbling at the bonds, particularly an issue of Global Marine (7%, 6/1/28) now yielding over 10% to maturity. This issue is actually an obligation of Transocean, but apparently the folks considering buying it don't know. The bonds yield a full point higher than similar Transocean bonds, even though the two are actually the same entity, with the same credit rating (Baa- Moody's, subject to possible downgrade). I wrote about the math of buying such bonds in my last post: a four to five year doubling of the investment is entirely feasible.
Update: one week later, 2/9/15. Busy week. The stock has moved from about $18.50 to $20.44. I have bought, in total, 65 call options, most 10's of 2017, at prices varying from $7.37 to $9.80. As RIG rose, I began selling call options, first at 18, then at 20 (all of 2017). All but 10 options are now spread-paired, with a maximum profit potential of $29,000 if the stock stays at or above $20 by January of 2017. Today's close of $20.44 makes the prognosis highly favorable.
My sense is that RIG is will approach some version of "normal" valuation around $30, so I intend to keep the process up until it approaches that level. As during the past week, I'll try to buy call options with the minimum possible time premium (perhaps $.50 or so), and pair then pair them with a short call at the money, as the stock rises. Each two point rise allows for a 150% profit on the spread, so I might get five more chances to ride this wave. The reason I'm selling calls at the money is, I hope, obvious: to limit risk while still allowing for fairly huge gains over a two-year period.
Update: February 18. Transocean has cut the dividend by 80%, and fired the idiot who let Carl Icahn bully the company into an unsustainable $3.00 rate in the first place. This is good news. A new sense of urgency and common sense will lead the company to cut back on buying hugely expensive new drilling rigs, and thus conserve enough cash to maintain the company's investment grade credit rating. So, the bonds, will, I am fairly sure, start rising sharply. As will the company's stock. At today's $19/share, my call positions are in the money, but only slightly. Any number of things could cause crude to rise sharply from today's levels, and the stock will float with that tide. Is this the sure thing of 2008-9? No, but it's not a whole lot removed from it.
There is a huge range of opinions about Transocean, with one Chicken Little predicting a bottom of $6/share, and other folks projecting $25-30. So, this is the exact moment when predicting things can, or should, establish soothsaying credibility. I'm doing frequent updates to document, here and now, what I am expecting to see down the road. By the way, when I edit older posts (and I do so, frequently), it is always to correct word choice and thought flow. I don't believe in modifying predictions based upon subsequent events. So, if future events make my Transocean thread look witless, then so be it.
Update: February 26. Another adventurous week, this time to the downside. Transocean has sagged to just under $16/share. While my overall options position is showing a small loss, I am comforted by the observation that the position would, ultimately, result in a decent profit by January, 2017, assuming the stock stayed right where it is now. That is due to the fact that the short options (18 and 20) are both out of the money, and would expire worthless in 2017 at today's price. The long calls, however, are still solidly in the money, and would be worth the final 2017 price less $10. The upside I outlined above continues unchanged: roughly 150% if the stock closes at or above $20 in January of 2017. By the way, Moody's just downgraded the debt to Ba1, just into junk territory. S&P and Fitch are still rating it investment grade. While all three might fall into line, I wouldn't be surprised if the split rating continued awhile. Such tag-teaming is not unusual, as it often influences a company to fall into line financially. So, let's see what transpires next.
Update: 5/14. Even more action, now on the upside. After tottering just below 16 (which brought out a wave of sell-side advice, with the above-cited Chicken Little now predicting a bottom of 3!), the stock has since shot up to 21. Yesterday's pundit? "Transocean is 20% undervalued." My spreads are in the pink, needing no further up movement to achieve their maximum profit in January 2107. Upon reflection, I decided to stop establishing spreads and sold back a few unpaired calls for a $2000 profit. Instead, I intend to focus on the bonds. I've repositioned my IRA, selling some mature (and richly priced) positions to make room for the Global Marine 7% bonds of 28, average purchase price around 77. I have also used margin to buy a fairly substantial number of bonds in my taxable accounts. The margin ratio is roughly 50%, so the yearly return with IB's 1.25% margin rate is roughly 16%.
My shift in emphasis is based on the consideration that I have little idea of what the "correct" price is for Transocean (yeah, 15 is very low, 60 is very high). I do, however, have a very clear idea of what is sensible for the bonds: par, or better yet, 110% of par. That's based on a simple comparison of their present yields with a broad spectrum of high level junk bonds. Even considering the risk, they are wildly underpriced. Now trading around 83 (up from the very low 70's), the bonds still have a long way to go. If they regain their investment status (very very likely, as the company seems to be weathering the oil crisis quite well), the bonds will probably go up to 120 or so. I intend to be along for the ride.
Update: 11/9/15. Movement in both the stock and bonds has been very negative, although both are now slightly above their lows. Moody's rating has ticked down one notch further, to Ba2. I took the the opportunity, following a spurt in the stock price to the mid 16 level to close out my option positions, with an overall profit of $7500. Not great considering the risk, but I won't complain. The bonds continue to sag, with my Transocean 7% of 28 positions hovering around 60. So that bargain price of 77 mentioned above now feels more like a falling knife. Global Marine's implied yield of 13.5% to maturity is a full 2% higher than its Transocean sisters, a persistent and illogical disparity. It stands out like a sore thumb, as other companies with similar yields are well down the junk ladder from Transocean. It is also, of course, a temptation for the brave. I have, however, temporarily reached my limit for bravery. I won't sell, but would rather wait for the bandwagon to roll forwards before jumping back on.
Still, there is plenty of reason for good cheer. Of paramount importance is the way Transocean has responded to the turn-down. They've cut the dividend entirely, delayed the delivery of multiple rigs and cold-stacked a bunch of other units. Better yet, though, from the point of view of a bond investor, they have attacked debt with a vengeance. In the last three quarters alone, they have retired $.9 billion of current debt, as well as $.4 billion of longer term debt, a 13% reduction of total debt. Since 2011, Transocean's liabilities have shrunk from $19.4 billion to $11.8 billion. That's a 39% reduction and bodes very well for the company's survival down the road. To sum up: from a cash management point of view, Transocean does not look like a junk-rated company at all.
Will this strict attention to finances be good for the company in the long run? That's hard to tell. Those delayed next generation drilling rigs might be sorely missed in a couple of years, hurting long-term growth. But, one of the great things about being a bond investor is that we don't need to worry so much about long-term growth. The stock-holders can gnaw on that. Our concern is more basic: will Transocean honor its debts long enough for us to cash them in at par? Ask the holders of Transocean's 4.95% of November 2015 what they think!
11/16/15. One additional note: a Motley Fool article "Transocean's Recent Earnings Show a Company on Track to Survive" dated 11/14/15 reads the figures far more positively than I did. The article states that Transocean has reduced its total liabilities by $2.6 billion in the last year. Its net debt / EBIDTA ratio of 2.03 and current ration of 2.68 compare very favorably to fellow driller Ensco. But Ensco has a Moody's investment grade rating of Baa2, three levels higher than Transocean! Ensco's debt trades at a maximum yield to maturity of 9%, compared to Transocean's present 14% for Global Marine bonds. As I said above, something is seriously out of whack here. Transocean doesn't look at all like a junk-rated company.
12/14/2015. WHEEEEEE! The roller coaster (I hope that's what this is) hurtles down! My Transocean bonds (7% of 2028) have cracked 50 on the downside! That's a yield to maturity of nearly 18%! Why, in light of the fairly benign third quarter results cited above, is this happening? I think I know, or at least, I hope I know. The ratings cut into junk-land has put pressure on funds of various kinds to offload the Transocean/Global Marine bonds. It's now December, and I think the year-end deadline is causing a sharp imbalance in the supply/demand ratio. So, even though I'm fairly terrified, I've started buying ... again! Transocean's mere survival will make these bonds soar, and I suspect the ascent will start in January. I promise an update then, even though my chin might be smeared with egg. You can take a picture to scare your kids.
2/26/16 UURRRPP! Still down! Most recent trades for the Global Marine bonds are just below 40! And yet ... full year results are in for 2015. Despite retiring $1.5 billion in debt, and buying new ships to the tune of $2 billion, the company's cash is actually up for the quarter, to $2.3 billion. With the line of credit, that's $5.3 billion, cash in hand, to cover future expenditures of $3 billion in debt maturities and $2.4 billion in new builds between now and 2020. So, the company just has to earn $100 million in the next three years to keep afloat. With a backlog of $16 billion, that's a no-brainer.
About the backlog: a lot of commentary goes into cancellations, treating them as a disaster for the company. From a cash-flow point of view, that's simply wrong. What really happens is that Transocean gets a hefty payment, right now, to compensate for the loss it suffers for not doing future work. These contracts were written back in the days when deep drilling rigs were in peak demand, and so the penalties are severe. In effect, Transocean books an immediate profit, gets an immediate infusion of cash, and is still perfectly free to hire the rigs out at any price they can get. Sure, it will be a pitiful day rate, but even that represents additional cash flow.
So, allow me a moment of sheer speculation, as I have no knowledge of the contracts Transocean has made with its many clients. The company's gross margins are somewhere in the 50% range: ie, $1 in earnings for every $2 in billings. At present, I think it's better than that. So, a penalty clause for early cancellation will certainly be designed to compensate the company for a substantial percentage of that profit. I'm gonna guess $25% of the contracted amount. If that's right, then cancelling the entire backlog would still bring in $4 billion, for which the company would perform zero work.
So, the 2016, 2017 and 2018 bonds look totally safe, even though some are trading to yield 20% to maturity. This is the surest bet I've seen since the US government basically guaranteed the banks' debt in 2008. The bonds with maturities past 2018 are another story, but still a good one, I think.
So, let's look at 2019. Assuming the company has tapped its line of credit to pay off bonds maturing in 2018, Transocean would need to come up with $3 billion to pay off that line. Since I am hypothesizing a minimum of $4 billion in backlog revenue going forward, that would result in $1 billion in positive cash. With capex complete, the company would have a year of breathing space, with no debt due. Then, between 2020 and 2022, there will be an additional $2.7 billion of debt to repay, say a little over $3 billion with debt interest. Over that four years, therefore, the company needs to come up with roughly $2 billion of cash to stay afloat. Transocean could sell stuff, at a loss probably, but $2 billion is entirely possible. OR, the company could resume selling its product, deep and mid-water drilling, once demand recovers. Will that recovery occur?
While things look bleak right now, is it reasonable to assume they will be equally (extremely) bleak in 2020, 2021, 2022? With the world gulping 35 billion barrels of oil a year, while replacing a modest fraction of that in exploration, will the demand for drillers never recover? While the demise of oil is touted frequently, how will the hundreds of millions of new Chinese, Indian and Brazilian middle class entrants fuel their new automobiles? With hydrogen or electricity? Ha! Oil demand will rise, inexorably, while supply will be challenged, inexorably.
Update: March 23, 2016. There are signs the worst is over. Crude oil prices have soared from about $26/barrel to a present $41. That's a fat 57% rise! Of course, who would have been wise enough to start buying at $26? Not I. However ... Those 7.375% Transocean bonds of April 2018 sold down briefly to below 75, an annual yield to maturity of nearly 25%. While one might have legitimate concerns about bonds maturing past 2019, it appeared absolutely obvious to me that Transocean's cash hoard of $2.3 billion and line of credit of $3 billion made the redemption of the 2018 bonds nearly certain. So, I started buying. Just a day or two later, the idea seemed to percolate widely. The price jumped quickly from 74 to 90, and is now hovering between 92 and 95. At 95, the yield to maturity is still juicy (11% or so), so I've continued loading up along the way. With one-to- one margin, the two-year return will still be 40%! To make the story even sweeter, Transocean just announced a delay of up to four years in the delivery of five new drilling rigs. This means the company will have an additional $500 million cash in hand (in addition to its present $2.3 billion cash hoard and $3 billion line of credit). So, that's $5.8 billion available to pay off $2.7 billion of debt and $1.3 billion of capex between now and the end of 2018. Even if the company didn't earn a dime in 2016, 2017 and 2018, there would still be a cash cushion of $1.8 billion. But a considerable amount of revenue (as discussed above) is nearly certain. A mere $1 billion yearly would enhance the cushion by 50%
Update: July 2016. The uptrend continues, with bumps. Oil is now hovering around $45 per barrel, having peaked recently at $50. Transocean's stock has been on a roller-coaster. It plunged to $8.50, only to soar to today's $12.14, a rise of 42%! Across the board, the bonds have risen sharply from drastic lows. The action has been particularly robust in the near maturities: 2018 and 2020. The 7.375% 2018 bonds are now trading above par. The 6.5% bonds of 2020 are now at 94.
Two things account for this sharp improvement. One is the delay Transocean negotiated in delivery of new-builds into 2020-21. A second step was just announced: the company will issue new bonds in the amount of $1.25 billion, maturing in 2023. At the same time, they announced a tender offer of $1 billion to redeem bonds maturing in 2020, 2021 and 2022. Since the 6.5% bonds of 2020 represent $910 million by themselves, it is reasonable to assume that they will absorb most of the buybacks. The bonds now trade at roughly 94 because the tender offer is at 94.5. The discounts on the other two issues are sharper, so they will probably not be tendered in bulk.
So, why target 2020? Well, there is a large challenge then. In addition to approximately $.9 billion of bonds coming due, the company also needs to pay out $1.9 billion for new ships. If the company's core business continues to languish over the next four years, it would be challenged to come up with that nearly $3 billion in cash. The new bond issue is precisely targeted to address this cash flow problem. It gives the company an additional three years to handle its debt concerns. Make no mistake: the tender means that Transocean is expressing high confidence in its ability to weather the period from 2016-2019.
What does the tender plus new bond issue portend for later issues (2021, 2022, 2027, 2028, 2029, 2031, 2038, 2041)? Well, according to Moody's, it's a near-catastrophe. Their rating was promptly cut to Caa1, a stomach-churning two notches below their prior rating of B2. Their reasoning is that the new bonds will have provisions ensuring they are favored over the company's other senior debt. Fair enough, but ... really? On the narrowest front, the net increase in debt is only $250 million, quite modest in comparison to total outstanding debt of over $7 billion. And, let's be clear, delaying the grim reaper might mean he doesn't visit at all. Companies, unlike people, don't necessarily die at all.
Particularly curious is that the downgrade applies equally to the specific issue that is most likely to be retired: the 6.5% bonds of 2020. Even if a holder doesn't tender, it seems nearly guaranteed that the remaining scraps will be paid off upon maturity in 2020. These bonds aren't weaker than before; they are virtually as safe as the equally dismally-rated 2018 bonds.
I regard Moody's downgrade as a hissy-fit, addressing a real, but narrow risk. Sure, in default, the post 2023 bonds would suffer. But guys, the likelihood of a default is substantially lower now than it was before the new issue. The company's near-term cash crunch has been alleviated, while the cushion increases by $.25 billion.
A Caa1 rating shrieks doom, and doom soon. That's simply wrong for a company responding to a threat four years down the road. Sure, bad things might happen after 2020, but even then, Transocean has a variety of alternatives. It could issue more debt, issue more stock, further delay delivery of new ships (with penalties, to be sure) and/or sell off the very new-builds that created the cash crunch in the first place. At a fire-sale of fifty cents on the dollar, Transocean would pull in up to $3 billion to toss to circling p(c)reditors. None of these steps merits rave reviews, but each could keep the wolf from the door.
Caa1 also proclaims that today's abysmal environment is unlikely to change within the next four years. Well, that might be true, but linear projections of short-term trends are usually stupid. The path of oil prices has been repeatedly marked by sharp declines followed by equally sharp up-turns. Most experts point out that total oil consumption is destined to rise steadily, regardless of Western conservation efforts. At the same time, replacement of existing oil reserves continues to lag drastically. Bottom line, I think a supply crunch is far likelier for 2020 than continued slump.
As long as the 2020 bonds trade below par, I think they're a screaming bargain. Don't tender them; instead collect the income till maturity, along with that extra five point gain to par. Without leverage, that's a 36% gain. With 50% leverage, it jumps to 65%. Better yet, wait until the tender premium of 3 points passes (July 18). The bond price will probably fall to 91, or less, once the tender period has ended. That will represent a huge buying opportunity: a $900 gain to par on ten bonds plus $2925 in interest makes for an unleveraged 42% return to maturity (77% with 50% margin). That's the kind of highly favorable risk/reward you can find only rarely in bonds.
Once the 2020 bonds approach maturity, it will be time for the new 9% bonds of 2023. Since they will have status senior to later Transocean bonds, they too have very nice potential. Of course, pricing will be critical: it would be nice to pick them up at or below par. Considering that the later bonds now yield in the 13% range, that should be distinctly do-able. (Update 3/13/17. Or not. Looks like these bonds are not - yet - available for public trading. Dunno why.)
To prepare for this pivot, I've been selling off part of my large position in the 7% Global Marine bonds of 2028. Since I bought a large slice of them at prices as low as 41 (yes, 41!), these trades have been cash-neutral. At 66, I can pair the sales against bonds bought at at higher prices to establish tax losses, but mentally match them against my rock-bottom purchases. As long as prices hold up for the Global Marine bonds, I can continue the pivot with only nominal losses, while substantially enhancing the safety of my overall Transocean exposure.
As to the 6.375% notes of 2021 and the 3.8% notes of 2022, well they'll require more fortitude. Their potential returns are large, though, and the risk is significantly lower today than it was before Transocean issued the new bonds. Absent an early default, they will be long-gone before the post-2023 holders are possibly savaged by their drop in priority in bankruptcy court. Even so, I think these longer bonds are a better bet than they were a week ago.
Moody's, perversely, has in general started being super cautious after its criminally negligent treatment of mortgage securities leading up to 2008. Over-reacting now, Moody's, won't make up for those catastrophic errors eight years ago. I'm just itching to revisit this issue in a couple of years. I'll bet Moody's present stance will look just as stupid then as it clearly was in 2008.
Well, I have bad news for you. Today's "bargain" price is tomorrow's "falling knife." The brutal truth is that there is no correct price for anything. There's only a price that is a compromise between a buyer (who is greedily looking for the lowest springboard to appreciation), and a seller (who is either afraid or is in turn seeking greener pastures for the same ultimate reason). Nobody buys because they truly think their purchase is overpriced, and few sell because they are convinced the item is extremely cheap. Notice, though, I said "few" in the prior sentence. And that's really important. People do, on occasion, sell things for tremendously low prices because they think they have little choice. They sell in despair ("I give up, this damn thing is headed for the toilet"), or they sell to raise cash to meet desperate needs (say the dreaded margin call).
In the broad flow of events, markets swing irregularly from euphoric highs to irritably dreary years of minor ups and downs, to occasional moments of sheer terror. When the market has risen inexorably for six years (hmm, remind you of any recent period?), people start thinking the abnormal is normal, and grasp for things that have already risen to the stratosphere. You hear variations of the greater fool theory underlying the purchase recommendations of market professionals ("yes, it's relatively high for the moment, but long-term dynamics will make today's price look trivial" - think of the endless flow of Amazon hype).
It is the moments of terror, though, that really interest me. While they seem like extreme outliers, I find them popping up fairly frequently: 2001-2, 2008-9, the euro crisis of 2010-11, and today's oil price collapse. If the crisis is severe enough, truly irrational behavior results. I've documented the extreme opportunities that occurred in the great recession and the euro kerfluffle. Now, lo and behold, they're on full display in the oil sector.
After trumpeting the "Case for $35 Oil", Barron's recently raised the ante ("The Case for $20 Oil"). If it hits that $20, what do you think Barron's next prediction will be? Of course, NOBODY (well, maybe a Saudi or two) makes money at $20/barrel, and very few at $35. So, those lows will disappear in the blink of an eye. In the last oil collapse (2008), oil plunged from $145 to $32 a barrel. So, it's pretty safe to say that $32/barrel is a VERY low price, as is the recent $44. The bulk of the world's producers have break-even somewhere around $50, so that too is a pretty low price. At $60, most folks start making money, but few make a whole lot. So, $60 is also a pretty low price. Fracked oil has a median break-even around $65. So, even $65 looks reasonably low.
The tug of war in the next few years will be between the low-cost producers who can make a buck below $60 and those who need to see $80 or more. Political winds will, at times, distort this struggle to the upside, while prolonged dips below $60 will dampen production. Frackers, after all, have no ideology; they'll postpone or halt drilling when they see no way to make a good buck. And, they'll jump right back in when they do see a way.
The quick response capabilities of frackers and other alternative producers (plus steady growth of wind and solar energy) pretty much guarantee that we won't see historical oil highs ($145 in 2008, $124 in 2010) any time soon. So, you can safely say that prices north of $100/barrel are high, just as $32 or $44 is low. So, that's what cheap and expensive are in the world of oil, at least for now. IMHO.
In writing about this sector absolutely flattened by recent oil price drops, one company in particular interests me: the maritime driller Transocean. It recently bottomed (maybe) at around $15, and is now hovering around $18. Are these low prices? Well, there's a fair amount of ink arguing that it's too high. A Motley Fool investor just threw in the towel (after a 62% drop in his holdings of Transocean), and hints that others should too (even though he admits the company will probably trade sharply higher in the near future). As with the price of oil itself, though, I think it's fairly obvious that the company's price is cheap. The blood in the water helps me see this.
So, forget the bottom, just focus on the essentials: will the company survive the present crisis, and will it ever have a future in the future? I've think Transocean (symbol RIG) will survive short-term (adequate cash, fairly modest demands on that cash). Long term, the question relates to whether oil drillers, as a group, will be needed. Well, much as people are focused on fracking as a direct threat to ocean drilling, it's also quite clear that frackers represent incremental production. Their costs are relatively high (probably break-even north of $65), and relatively short well-life requires constant (and probably ever more expensive) replacement of supply.
Ocean drilling is targeted to the largest and relatively least exploited sources of big-time supply. Roughly half of world production comes from offshore drilling at various depths. While exploration and development is expensive, lifting costs (simply pumping the stuff) are quite low, on average $10/barrel, with total upstream costs around between $41 for offshore shelf, $51 for deepwater and $56 for ultra deepwater oil. Even the expensive rigs therefore compare favorably to highly-hyped fracking. So ... is there a future for the sector? Of course there is. When oil returns to $60, new business will start trickling in, while there will probably be a rush once $80 is reached.
Right now, the balance of fear and greed is overwhelmingly on the side of fear. Taking action is hard, things might get even cheaper. True enough, but do you seriously think oil will STAY at $20, or $30, or $40? So, I think doing SOMETHING makes sense. I'm buying Transocean calls (10 of January, 2017) for astonishingly small time premiums (around $.50 per share for a two-year leap). I've already locked in some spreads (selling calls 18 of 2017), with a maximum profit to expiration of 140%. That profit will be realized if the stock closes at or above $18 in January 2017. Will it? Heck if I know. But I think the odds are heavily in my favor, as the stock closed at $18.51 yesterday.
I'm also nibbling at the bonds, particularly an issue of Global Marine (7%, 6/1/28) now yielding over 10% to maturity. This issue is actually an obligation of Transocean, but apparently the folks considering buying it don't know. The bonds yield a full point higher than similar Transocean bonds, even though the two are actually the same entity, with the same credit rating (Baa- Moody's, subject to possible downgrade). I wrote about the math of buying such bonds in my last post: a four to five year doubling of the investment is entirely feasible.
Update: one week later, 2/9/15. Busy week. The stock has moved from about $18.50 to $20.44. I have bought, in total, 65 call options, most 10's of 2017, at prices varying from $7.37 to $9.80. As RIG rose, I began selling call options, first at 18, then at 20 (all of 2017). All but 10 options are now spread-paired, with a maximum profit potential of $29,000 if the stock stays at or above $20 by January of 2017. Today's close of $20.44 makes the prognosis highly favorable.
My sense is that RIG is will approach some version of "normal" valuation around $30, so I intend to keep the process up until it approaches that level. As during the past week, I'll try to buy call options with the minimum possible time premium (perhaps $.50 or so), and pair then pair them with a short call at the money, as the stock rises. Each two point rise allows for a 150% profit on the spread, so I might get five more chances to ride this wave. The reason I'm selling calls at the money is, I hope, obvious: to limit risk while still allowing for fairly huge gains over a two-year period.
Update: February 18. Transocean has cut the dividend by 80%, and fired the idiot who let Carl Icahn bully the company into an unsustainable $3.00 rate in the first place. This is good news. A new sense of urgency and common sense will lead the company to cut back on buying hugely expensive new drilling rigs, and thus conserve enough cash to maintain the company's investment grade credit rating. So, the bonds, will, I am fairly sure, start rising sharply. As will the company's stock. At today's $19/share, my call positions are in the money, but only slightly. Any number of things could cause crude to rise sharply from today's levels, and the stock will float with that tide. Is this the sure thing of 2008-9? No, but it's not a whole lot removed from it.
There is a huge range of opinions about Transocean, with one Chicken Little predicting a bottom of $6/share, and other folks projecting $25-30. So, this is the exact moment when predicting things can, or should, establish soothsaying credibility. I'm doing frequent updates to document, here and now, what I am expecting to see down the road. By the way, when I edit older posts (and I do so, frequently), it is always to correct word choice and thought flow. I don't believe in modifying predictions based upon subsequent events. So, if future events make my Transocean thread look witless, then so be it.
Update: February 26. Another adventurous week, this time to the downside. Transocean has sagged to just under $16/share. While my overall options position is showing a small loss, I am comforted by the observation that the position would, ultimately, result in a decent profit by January, 2017, assuming the stock stayed right where it is now. That is due to the fact that the short options (18 and 20) are both out of the money, and would expire worthless in 2017 at today's price. The long calls, however, are still solidly in the money, and would be worth the final 2017 price less $10. The upside I outlined above continues unchanged: roughly 150% if the stock closes at or above $20 in January of 2017. By the way, Moody's just downgraded the debt to Ba1, just into junk territory. S&P and Fitch are still rating it investment grade. While all three might fall into line, I wouldn't be surprised if the split rating continued awhile. Such tag-teaming is not unusual, as it often influences a company to fall into line financially. So, let's see what transpires next.
Update: 5/14. Even more action, now on the upside. After tottering just below 16 (which brought out a wave of sell-side advice, with the above-cited Chicken Little now predicting a bottom of 3!), the stock has since shot up to 21. Yesterday's pundit? "Transocean is 20% undervalued." My spreads are in the pink, needing no further up movement to achieve their maximum profit in January 2107. Upon reflection, I decided to stop establishing spreads and sold back a few unpaired calls for a $2000 profit. Instead, I intend to focus on the bonds. I've repositioned my IRA, selling some mature (and richly priced) positions to make room for the Global Marine 7% bonds of 28, average purchase price around 77. I have also used margin to buy a fairly substantial number of bonds in my taxable accounts. The margin ratio is roughly 50%, so the yearly return with IB's 1.25% margin rate is roughly 16%.
My shift in emphasis is based on the consideration that I have little idea of what the "correct" price is for Transocean (yeah, 15 is very low, 60 is very high). I do, however, have a very clear idea of what is sensible for the bonds: par, or better yet, 110% of par. That's based on a simple comparison of their present yields with a broad spectrum of high level junk bonds. Even considering the risk, they are wildly underpriced. Now trading around 83 (up from the very low 70's), the bonds still have a long way to go. If they regain their investment status (very very likely, as the company seems to be weathering the oil crisis quite well), the bonds will probably go up to 120 or so. I intend to be along for the ride.
Update: 11/9/15. Movement in both the stock and bonds has been very negative, although both are now slightly above their lows. Moody's rating has ticked down one notch further, to Ba2. I took the the opportunity, following a spurt in the stock price to the mid 16 level to close out my option positions, with an overall profit of $7500. Not great considering the risk, but I won't complain. The bonds continue to sag, with my Transocean 7% of 28 positions hovering around 60. So that bargain price of 77 mentioned above now feels more like a falling knife. Global Marine's implied yield of 13.5% to maturity is a full 2% higher than its Transocean sisters, a persistent and illogical disparity. It stands out like a sore thumb, as other companies with similar yields are well down the junk ladder from Transocean. It is also, of course, a temptation for the brave. I have, however, temporarily reached my limit for bravery. I won't sell, but would rather wait for the bandwagon to roll forwards before jumping back on.
Still, there is plenty of reason for good cheer. Of paramount importance is the way Transocean has responded to the turn-down. They've cut the dividend entirely, delayed the delivery of multiple rigs and cold-stacked a bunch of other units. Better yet, though, from the point of view of a bond investor, they have attacked debt with a vengeance. In the last three quarters alone, they have retired $.9 billion of current debt, as well as $.4 billion of longer term debt, a 13% reduction of total debt. Since 2011, Transocean's liabilities have shrunk from $19.4 billion to $11.8 billion. That's a 39% reduction and bodes very well for the company's survival down the road. To sum up: from a cash management point of view, Transocean does not look like a junk-rated company at all.
Will this strict attention to finances be good for the company in the long run? That's hard to tell. Those delayed next generation drilling rigs might be sorely missed in a couple of years, hurting long-term growth. But, one of the great things about being a bond investor is that we don't need to worry so much about long-term growth. The stock-holders can gnaw on that. Our concern is more basic: will Transocean honor its debts long enough for us to cash them in at par? Ask the holders of Transocean's 4.95% of November 2015 what they think!
11/16/15. One additional note: a Motley Fool article "Transocean's Recent Earnings Show a Company on Track to Survive" dated 11/14/15 reads the figures far more positively than I did. The article states that Transocean has reduced its total liabilities by $2.6 billion in the last year. Its net debt / EBIDTA ratio of 2.03 and current ration of 2.68 compare very favorably to fellow driller Ensco. But Ensco has a Moody's investment grade rating of Baa2, three levels higher than Transocean! Ensco's debt trades at a maximum yield to maturity of 9%, compared to Transocean's present 14% for Global Marine bonds. As I said above, something is seriously out of whack here. Transocean doesn't look at all like a junk-rated company.
12/14/2015. WHEEEEEE! The roller coaster (I hope that's what this is) hurtles down! My Transocean bonds (7% of 2028) have cracked 50 on the downside! That's a yield to maturity of nearly 18%! Why, in light of the fairly benign third quarter results cited above, is this happening? I think I know, or at least, I hope I know. The ratings cut into junk-land has put pressure on funds of various kinds to offload the Transocean/Global Marine bonds. It's now December, and I think the year-end deadline is causing a sharp imbalance in the supply/demand ratio. So, even though I'm fairly terrified, I've started buying ... again! Transocean's mere survival will make these bonds soar, and I suspect the ascent will start in January. I promise an update then, even though my chin might be smeared with egg. You can take a picture to scare your kids.
2/26/16 UURRRPP! Still down! Most recent trades for the Global Marine bonds are just below 40! And yet ... full year results are in for 2015. Despite retiring $1.5 billion in debt, and buying new ships to the tune of $2 billion, the company's cash is actually up for the quarter, to $2.3 billion. With the line of credit, that's $5.3 billion, cash in hand, to cover future expenditures of $3 billion in debt maturities and $2.4 billion in new builds between now and 2020. So, the company just has to earn $100 million in the next three years to keep afloat. With a backlog of $16 billion, that's a no-brainer.
About the backlog: a lot of commentary goes into cancellations, treating them as a disaster for the company. From a cash-flow point of view, that's simply wrong. What really happens is that Transocean gets a hefty payment, right now, to compensate for the loss it suffers for not doing future work. These contracts were written back in the days when deep drilling rigs were in peak demand, and so the penalties are severe. In effect, Transocean books an immediate profit, gets an immediate infusion of cash, and is still perfectly free to hire the rigs out at any price they can get. Sure, it will be a pitiful day rate, but even that represents additional cash flow.
So, allow me a moment of sheer speculation, as I have no knowledge of the contracts Transocean has made with its many clients. The company's gross margins are somewhere in the 50% range: ie, $1 in earnings for every $2 in billings. At present, I think it's better than that. So, a penalty clause for early cancellation will certainly be designed to compensate the company for a substantial percentage of that profit. I'm gonna guess $25% of the contracted amount. If that's right, then cancelling the entire backlog would still bring in $4 billion, for which the company would perform zero work.
So, the 2016, 2017 and 2018 bonds look totally safe, even though some are trading to yield 20% to maturity. This is the surest bet I've seen since the US government basically guaranteed the banks' debt in 2008. The bonds with maturities past 2018 are another story, but still a good one, I think.
So, let's look at 2019. Assuming the company has tapped its line of credit to pay off bonds maturing in 2018, Transocean would need to come up with $3 billion to pay off that line. Since I am hypothesizing a minimum of $4 billion in backlog revenue going forward, that would result in $1 billion in positive cash. With capex complete, the company would have a year of breathing space, with no debt due. Then, between 2020 and 2022, there will be an additional $2.7 billion of debt to repay, say a little over $3 billion with debt interest. Over that four years, therefore, the company needs to come up with roughly $2 billion of cash to stay afloat. Transocean could sell stuff, at a loss probably, but $2 billion is entirely possible. OR, the company could resume selling its product, deep and mid-water drilling, once demand recovers. Will that recovery occur?
While things look bleak right now, is it reasonable to assume they will be equally (extremely) bleak in 2020, 2021, 2022? With the world gulping 35 billion barrels of oil a year, while replacing a modest fraction of that in exploration, will the demand for drillers never recover? While the demise of oil is touted frequently, how will the hundreds of millions of new Chinese, Indian and Brazilian middle class entrants fuel their new automobiles? With hydrogen or electricity? Ha! Oil demand will rise, inexorably, while supply will be challenged, inexorably.
Update: March 23, 2016. There are signs the worst is over. Crude oil prices have soared from about $26/barrel to a present $41. That's a fat 57% rise! Of course, who would have been wise enough to start buying at $26? Not I. However ... Those 7.375% Transocean bonds of April 2018 sold down briefly to below 75, an annual yield to maturity of nearly 25%. While one might have legitimate concerns about bonds maturing past 2019, it appeared absolutely obvious to me that Transocean's cash hoard of $2.3 billion and line of credit of $3 billion made the redemption of the 2018 bonds nearly certain. So, I started buying. Just a day or two later, the idea seemed to percolate widely. The price jumped quickly from 74 to 90, and is now hovering between 92 and 95. At 95, the yield to maturity is still juicy (11% or so), so I've continued loading up along the way. With one-to- one margin, the two-year return will still be 40%! To make the story even sweeter, Transocean just announced a delay of up to four years in the delivery of five new drilling rigs. This means the company will have an additional $500 million cash in hand (in addition to its present $2.3 billion cash hoard and $3 billion line of credit). So, that's $5.8 billion available to pay off $2.7 billion of debt and $1.3 billion of capex between now and the end of 2018. Even if the company didn't earn a dime in 2016, 2017 and 2018, there would still be a cash cushion of $1.8 billion. But a considerable amount of revenue (as discussed above) is nearly certain. A mere $1 billion yearly would enhance the cushion by 50%
Update: July 2016. The uptrend continues, with bumps. Oil is now hovering around $45 per barrel, having peaked recently at $50. Transocean's stock has been on a roller-coaster. It plunged to $8.50, only to soar to today's $12.14, a rise of 42%! Across the board, the bonds have risen sharply from drastic lows. The action has been particularly robust in the near maturities: 2018 and 2020. The 7.375% 2018 bonds are now trading above par. The 6.5% bonds of 2020 are now at 94.
Two things account for this sharp improvement. One is the delay Transocean negotiated in delivery of new-builds into 2020-21. A second step was just announced: the company will issue new bonds in the amount of $1.25 billion, maturing in 2023. At the same time, they announced a tender offer of $1 billion to redeem bonds maturing in 2020, 2021 and 2022. Since the 6.5% bonds of 2020 represent $910 million by themselves, it is reasonable to assume that they will absorb most of the buybacks. The bonds now trade at roughly 94 because the tender offer is at 94.5. The discounts on the other two issues are sharper, so they will probably not be tendered in bulk.
So, why target 2020? Well, there is a large challenge then. In addition to approximately $.9 billion of bonds coming due, the company also needs to pay out $1.9 billion for new ships. If the company's core business continues to languish over the next four years, it would be challenged to come up with that nearly $3 billion in cash. The new bond issue is precisely targeted to address this cash flow problem. It gives the company an additional three years to handle its debt concerns. Make no mistake: the tender means that Transocean is expressing high confidence in its ability to weather the period from 2016-2019.
What does the tender plus new bond issue portend for later issues (2021, 2022, 2027, 2028, 2029, 2031, 2038, 2041)? Well, according to Moody's, it's a near-catastrophe. Their rating was promptly cut to Caa1, a stomach-churning two notches below their prior rating of B2. Their reasoning is that the new bonds will have provisions ensuring they are favored over the company's other senior debt. Fair enough, but ... really? On the narrowest front, the net increase in debt is only $250 million, quite modest in comparison to total outstanding debt of over $7 billion. And, let's be clear, delaying the grim reaper might mean he doesn't visit at all. Companies, unlike people, don't necessarily die at all.
Particularly curious is that the downgrade applies equally to the specific issue that is most likely to be retired: the 6.5% bonds of 2020. Even if a holder doesn't tender, it seems nearly guaranteed that the remaining scraps will be paid off upon maturity in 2020. These bonds aren't weaker than before; they are virtually as safe as the equally dismally-rated 2018 bonds.
I regard Moody's downgrade as a hissy-fit, addressing a real, but narrow risk. Sure, in default, the post 2023 bonds would suffer. But guys, the likelihood of a default is substantially lower now than it was before the new issue. The company's near-term cash crunch has been alleviated, while the cushion increases by $.25 billion.
A Caa1 rating shrieks doom, and doom soon. That's simply wrong for a company responding to a threat four years down the road. Sure, bad things might happen after 2020, but even then, Transocean has a variety of alternatives. It could issue more debt, issue more stock, further delay delivery of new ships (with penalties, to be sure) and/or sell off the very new-builds that created the cash crunch in the first place. At a fire-sale of fifty cents on the dollar, Transocean would pull in up to $3 billion to toss to circling p(c)reditors. None of these steps merits rave reviews, but each could keep the wolf from the door.
Caa1 also proclaims that today's abysmal environment is unlikely to change within the next four years. Well, that might be true, but linear projections of short-term trends are usually stupid. The path of oil prices has been repeatedly marked by sharp declines followed by equally sharp up-turns. Most experts point out that total oil consumption is destined to rise steadily, regardless of Western conservation efforts. At the same time, replacement of existing oil reserves continues to lag drastically. Bottom line, I think a supply crunch is far likelier for 2020 than continued slump.
As long as the 2020 bonds trade below par, I think they're a screaming bargain. Don't tender them; instead collect the income till maturity, along with that extra five point gain to par. Without leverage, that's a 36% gain. With 50% leverage, it jumps to 65%. Better yet, wait until the tender premium of 3 points passes (July 18). The bond price will probably fall to 91, or less, once the tender period has ended. That will represent a huge buying opportunity: a $900 gain to par on ten bonds plus $2925 in interest makes for an unleveraged 42% return to maturity (77% with 50% margin). That's the kind of highly favorable risk/reward you can find only rarely in bonds.
Once the 2020 bonds approach maturity, it will be time for the new 9% bonds of 2023. Since they will have status senior to later Transocean bonds, they too have very nice potential. Of course, pricing will be critical: it would be nice to pick them up at or below par. Considering that the later bonds now yield in the 13% range, that should be distinctly do-able. (Update 3/13/17. Or not. Looks like these bonds are not - yet - available for public trading. Dunno why.)
To prepare for this pivot, I've been selling off part of my large position in the 7% Global Marine bonds of 2028. Since I bought a large slice of them at prices as low as 41 (yes, 41!), these trades have been cash-neutral. At 66, I can pair the sales against bonds bought at at higher prices to establish tax losses, but mentally match them against my rock-bottom purchases. As long as prices hold up for the Global Marine bonds, I can continue the pivot with only nominal losses, while substantially enhancing the safety of my overall Transocean exposure.
As to the 6.375% notes of 2021 and the 3.8% notes of 2022, well they'll require more fortitude. Their potential returns are large, though, and the risk is significantly lower today than it was before Transocean issued the new bonds. Absent an early default, they will be long-gone before the post-2023 holders are possibly savaged by their drop in priority in bankruptcy court. Even so, I think these longer bonds are a better bet than they were a week ago.
Moody's, perversely, has in general started being super cautious after its criminally negligent treatment of mortgage securities leading up to 2008. Over-reacting now, Moody's, won't make up for those catastrophic errors eight years ago. I'm just itching to revisit this issue in a couple of years. I'll bet Moody's present stance will look just as stupid then as it clearly was in 2008.
Sunday, January 11, 2015
Back to Bonds, Finally?
I've strayed from my bailiwick recently. With little to say about bonds, and little to recommend them, I've focused on other themes, particularly stock buybacks and the silly optimism that accompanies them. Well, I'm not backing away from this line of discussion at all, and have full confidence that time will validate my profound skepticism about the entire concept. So, I'll be commenting further as time passes, as my keen analysis bears fruit (!).
Twice before, I've kind of thrown in the towel, metaphorically, when it comes to bonds. Two once-in-a-lifetime opportunities (2008-9 mortgage crisis, 2010-11 Euro crisis) receded, and low-yield high ennui situations prevailed. And yet ... once again ... the relentless flow of current events brings me sharply back to new, inviting, and perilous opportunities in the wonderful world of bonds.
Not surprisingly, it all relates to oil, and the shocking collapse in prices that is revolutionizing world markets. Where to begin, where to end? Well, first and foremost, ignore the folks who argue that it's all a massive head fake. No, it's not that Obama (or Saudi Arabia) has a secret plan to crush Putin and Iran. It's actually simple: oil and gas prices are down, way way down, because the iron law of supply and demand is finally kicking in. Huge sources of new production have been coming online for several years (due to fracking in the US and Canada, and the slow recovery of production in other critical regions), while persistent political unrest has kept prices artificially high. The turning point is opaque (why now, why not a year ago?), but that very delay has magnified the downward price shock.
Huge movements like this (oil below $50/barrel!) cause turmoil, and turmoil, in turn, breeds confusion and fear. FEAR (think of it as negative GREED) is one of the most reliable and powerful forces in the market. And yes, dear ones, GREED is in fact the other. When it comes to bonds, fear is particularly powerful. Bond investors scare easily, and perceived threats to the stability of bonds make them bleat toward the exits.
So, what is getting stampeded right now? Of course, oil companies, and the companies that service them. Not surprisingly, many pundits are predicting catastrophe.
But, this whole tempest needs perspective. Is this a near-death event like the 2009 mortgage meltdown and the 2011 Euro crisis? Highly unlikely, I think. Russia will be on the ropes (oh, TOO BAD!), as will Venezuela and various other petro states. Yes, there's also a nasty round of currency devaluation going on, which could trigger recessions. On the other hand, consumers world-wide have just been gifted a huge cash infusion, via lower gas prices. That should cushion the shocks to what is, after all, a limited portion of the world economy. Common sense suggests that the solution to low gas prices will be ... low gas prices! New exploration and development will be postponed, consumption will pick up, and oil will start rising again. Political instability in any one of a dozen places could send prices soaring. How far, and when? Heck if I know. But we've been down this road many times, and I doubt it ends at Mt. Doom.
Let's get specific about this latest tempest. Transocean (RIG) is the biggest oil drilling company in the world. But, over the past two years it has dropped from $58 to $16 a share, a 72% pummeling. The dividend is now a stratospheric 18%.
Here's a helpful hint: that dividend is toast (not right away, but zwieback nevertheless). To buy the stock hoping to feast on that dividend would be stupid (really stupid). However, does this mean that the stock is dead? Or better asked, is Transocean dead? I think the answer is very clear: no. While both Moody's and S&P are threatening to downgrade Transocean's debt to junk level, I think there's a reasonable chance that one or both will hold back. Transocean has a well-diversified array of drilling units, many stable long-term contracts, and a pretty good stash of cash (over $3 billion, with current liabilities of $.9 billion). If it eliminates that dividend (it will, it will), another $1 billion is added to the company's cash. It has assets to sell, if needed, and can mothball other units to minimize the cash drain they represent. I suspect the company will find a way to fend off the downgraders.
However, the mere possibility of a downgrade has the faint of heart fainting heartily. Take a look at Transocean debt: One example, the 6.8% bonds of 2038, now trading around 80, for a yield to maturity of 8.8%. Those are yields associated with B- rated junk, perhaps six rating levels below the present (shaky BBB-). So, ask yourself, is Transocean really that close to the abyss?
Absent a default, what would a purchase of this issue offer? Well, a present yield of 8.8%, for 23 years! At maturity, a guaranteed 25% return on the initial investment, as the issue returns to par. This is the plain vanilla scenario. Add in a soupcon of leverage (say borrowing one dollar for each dollar invested), and the present yield sky-rockets to 15.75% (assuming that beautiful Interactive Broker margin rate of 1.25%). Imagine a return to par in five years, and the $5150 net profit (on $4000 invested and $4000 borrowed on a ten bond position) would be a gorgeous 128% of the initial investment, or 18% compounded. This is the stuff I dream of, and, to toot my own horn, that dream has been realized over and over in the past six years.
What if the future is less rosy for Transocean? What if, gulp, it actually crashes and burns? Well, here again, the beauties of bond investing come to the fore. As legal obligations of the company, the bonds must be repaid, if liquidation yields enough to do so. As the company presently has roughly $32 billion of assets, and roughly $12 billion of long and short-term bond obligations, it certainly looks like repayment (of principal AND interest) would be a pretty safe bet.
I am sure it comes as no surprise to my loyal readers (of course, since there are none at present, they are not easily surprised, or loyal, for that matter) that I have started buying these bonds, small nibbles of $5 and $10k at a time. So far, I have modest paper losses, which is keeping me cautious. If the bonds start a sustained recovery, I intend to get greedy, shades of 2009!
How about investing in the stock itself? Ordinarily, I'd say no, citing the almost endless list of things that can go wrong with stocks as a class. But here? As I've mentioned many times before, opportunity knocks when blood is in the water, things are ridiculously cheap, and fear holds you in absolute paralysis. Does Transocean (and the entire energy sector) meet these criteria? Hell yes. A recent seekingalpha column concludes the stock has 100% upside, even if oil remains at present levels, and earnings slump $1 billion in 2015. So, I intend to nibble on a few deep-in-the-money Transocean calls maturing in 2017. These babies could go to zero, or soar tenfold in the next two years. I'm obviously betting on the latter, but in no case betting a lot. I'll save most of my greed and aggression for the bonds instead.
How long will this particular once-in-a-lifetime situation last? Three to six months is my guess. Then oil prices will stabilize (probably at relatively low historical levels), oil-related companies will stagger slowly back to reasonable valuations, and their bonds will resume life as boring and low-yield creatures of the field. So, the opportunity lies between now and then. Be brave now, or curse the wasted opportunity later.
Update: Tax day, 2105. It's been about three months, so half-way through the window of opportunity described above. It's been mostly downhill, until just this week. Suddenly, the stock has jumped sharply from below $16 to nearly 19, most of the move today. My long calls have risen from a fairly substantial loss to an equally substantial paper gain. My bonds are still down a bit, following the ratings downgrades, but now only a little bit. So, the window is still open; but three more months might, as hypothesized, spell the end of this particular opportunity. I've been nibbling today; and may start gulping soon.
Twice before, I've kind of thrown in the towel, metaphorically, when it comes to bonds. Two once-in-a-lifetime opportunities (2008-9 mortgage crisis, 2010-11 Euro crisis) receded, and low-yield high ennui situations prevailed. And yet ... once again ... the relentless flow of current events brings me sharply back to new, inviting, and perilous opportunities in the wonderful world of bonds.
Not surprisingly, it all relates to oil, and the shocking collapse in prices that is revolutionizing world markets. Where to begin, where to end? Well, first and foremost, ignore the folks who argue that it's all a massive head fake. No, it's not that Obama (or Saudi Arabia) has a secret plan to crush Putin and Iran. It's actually simple: oil and gas prices are down, way way down, because the iron law of supply and demand is finally kicking in. Huge sources of new production have been coming online for several years (due to fracking in the US and Canada, and the slow recovery of production in other critical regions), while persistent political unrest has kept prices artificially high. The turning point is opaque (why now, why not a year ago?), but that very delay has magnified the downward price shock.
Huge movements like this (oil below $50/barrel!) cause turmoil, and turmoil, in turn, breeds confusion and fear. FEAR (think of it as negative GREED) is one of the most reliable and powerful forces in the market. And yes, dear ones, GREED is in fact the other. When it comes to bonds, fear is particularly powerful. Bond investors scare easily, and perceived threats to the stability of bonds make them bleat toward the exits.
So, what is getting stampeded right now? Of course, oil companies, and the companies that service them. Not surprisingly, many pundits are predicting catastrophe.
But, this whole tempest needs perspective. Is this a near-death event like the 2009 mortgage meltdown and the 2011 Euro crisis? Highly unlikely, I think. Russia will be on the ropes (oh, TOO BAD!), as will Venezuela and various other petro states. Yes, there's also a nasty round of currency devaluation going on, which could trigger recessions. On the other hand, consumers world-wide have just been gifted a huge cash infusion, via lower gas prices. That should cushion the shocks to what is, after all, a limited portion of the world economy. Common sense suggests that the solution to low gas prices will be ... low gas prices! New exploration and development will be postponed, consumption will pick up, and oil will start rising again. Political instability in any one of a dozen places could send prices soaring. How far, and when? Heck if I know. But we've been down this road many times, and I doubt it ends at Mt. Doom.
Let's get specific about this latest tempest. Transocean (RIG) is the biggest oil drilling company in the world. But, over the past two years it has dropped from $58 to $16 a share, a 72% pummeling. The dividend is now a stratospheric 18%.
Here's a helpful hint: that dividend is toast (not right away, but zwieback nevertheless). To buy the stock hoping to feast on that dividend would be stupid (really stupid). However, does this mean that the stock is dead? Or better asked, is Transocean dead? I think the answer is very clear: no. While both Moody's and S&P are threatening to downgrade Transocean's debt to junk level, I think there's a reasonable chance that one or both will hold back. Transocean has a well-diversified array of drilling units, many stable long-term contracts, and a pretty good stash of cash (over $3 billion, with current liabilities of $.9 billion). If it eliminates that dividend (it will, it will), another $1 billion is added to the company's cash. It has assets to sell, if needed, and can mothball other units to minimize the cash drain they represent. I suspect the company will find a way to fend off the downgraders.
However, the mere possibility of a downgrade has the faint of heart fainting heartily. Take a look at Transocean debt: One example, the 6.8% bonds of 2038, now trading around 80, for a yield to maturity of 8.8%. Those are yields associated with B- rated junk, perhaps six rating levels below the present (shaky BBB-). So, ask yourself, is Transocean really that close to the abyss?
Absent a default, what would a purchase of this issue offer? Well, a present yield of 8.8%, for 23 years! At maturity, a guaranteed 25% return on the initial investment, as the issue returns to par. This is the plain vanilla scenario. Add in a soupcon of leverage (say borrowing one dollar for each dollar invested), and the present yield sky-rockets to 15.75% (assuming that beautiful Interactive Broker margin rate of 1.25%). Imagine a return to par in five years, and the $5150 net profit (on $4000 invested and $4000 borrowed on a ten bond position) would be a gorgeous 128% of the initial investment, or 18% compounded. This is the stuff I dream of, and, to toot my own horn, that dream has been realized over and over in the past six years.
What if the future is less rosy for Transocean? What if, gulp, it actually crashes and burns? Well, here again, the beauties of bond investing come to the fore. As legal obligations of the company, the bonds must be repaid, if liquidation yields enough to do so. As the company presently has roughly $32 billion of assets, and roughly $12 billion of long and short-term bond obligations, it certainly looks like repayment (of principal AND interest) would be a pretty safe bet.
I am sure it comes as no surprise to my loyal readers (of course, since there are none at present, they are not easily surprised, or loyal, for that matter) that I have started buying these bonds, small nibbles of $5 and $10k at a time. So far, I have modest paper losses, which is keeping me cautious. If the bonds start a sustained recovery, I intend to get greedy, shades of 2009!
How about investing in the stock itself? Ordinarily, I'd say no, citing the almost endless list of things that can go wrong with stocks as a class. But here? As I've mentioned many times before, opportunity knocks when blood is in the water, things are ridiculously cheap, and fear holds you in absolute paralysis. Does Transocean (and the entire energy sector) meet these criteria? Hell yes. A recent seekingalpha column concludes the stock has 100% upside, even if oil remains at present levels, and earnings slump $1 billion in 2015. So, I intend to nibble on a few deep-in-the-money Transocean calls maturing in 2017. These babies could go to zero, or soar tenfold in the next two years. I'm obviously betting on the latter, but in no case betting a lot. I'll save most of my greed and aggression for the bonds instead.
How long will this particular once-in-a-lifetime situation last? Three to six months is my guess. Then oil prices will stabilize (probably at relatively low historical levels), oil-related companies will stagger slowly back to reasonable valuations, and their bonds will resume life as boring and low-yield creatures of the field. So, the opportunity lies between now and then. Be brave now, or curse the wasted opportunity later.
Update: Tax day, 2105. It's been about three months, so half-way through the window of opportunity described above. It's been mostly downhill, until just this week. Suddenly, the stock has jumped sharply from below $16 to nearly 19, most of the move today. My long calls have risen from a fairly substantial loss to an equally substantial paper gain. My bonds are still down a bit, following the ratings downgrades, but now only a little bit. So, the window is still open; but three more months might, as hypothesized, spell the end of this particular opportunity. I've been nibbling today; and may start gulping soon.
Thursday, November 7, 2013
IBM and Buybacks
Awhile ago, I mentioned IBM as a company that has done well for its investors, even though it has pursued a very active stock buyback program. I'd like to take a second look at this poster boy for the strategy.
An item in a recent Barron's magazine points out that IBM's earnings per share have risen sharply since 2007, but largely due to its very aggressive program of stock buybacks. Outstanding shares have been reduced by 25% in this period, meaning that its earnings are spread over fewer shares, thus raising earnings per share. This is the flavor of the month in the world of stocks.
The company recently announced ANOTHER stock buyback, this time $15 billion, bringing the total since 2007 to $75 billion. That's a huge figure. People talk all the time about Apple's cash hoard, but IBM has offloaded over half as much of Apple's total hoard in the last six years!
On the face of it, IBM's ten year story is compelling. In 2003, the stock was roughly $91 per share, in 2007 $105, and now $176, a rise of nearly 100%. The stock has outperformed the S&P 500 index by about 50%. Much of the outperformance coincides with the huge stock buybacks initiated in 2007. Interestingly, though, gravity seems to be kicking in. A fast rise following the latest buyback announcement has fizzled, and the S&P gap is shrinking rapidly. By the way, if you look back over longer periods (25 years or more), IBM looks anemic, underperforming the S&P 500 vastly since 1988. Does that matter? Well, if you're over fifty and have owned IBM for awhile, it probably does.
In 2006, the company earned $9.7 billion, which rose to $16.6 billion in 2012, a rise of 70%. (For a ten-year comparison, the company earned $7.58 billion in 2003, with a rise in earnings of more than 100%). That's impressive, especially since sales have risen far less rapidly (from $91 to $104.5 billion since 2006. These guys know how to make money, and they've been able to increase net earnings sharply even as revenue growth has slowed greatly. Still, that slow growth is sobering. Can the upcoming decade offer a similar bottom line of high profit on meager sales? Color me skeptical.
Let's do two run-throughs. First, let's assume an investor who has sold shares to take advantage of the buybacks. Assuming an initial position of $105,000 in 1997 (1000 shares at $105 per share), this individual would have sold off 250 shares (25% of the entire position) at an average price of $140, netting $35,000. The remaing 750 shares would be worth $132,000, or a total of $167,000. This would be a 59% gain over seven years, with taxes due on the shares sold.
The buy and hold investor would still own 1000 shares, presently worth $176,000, a bit better than the seller, even before taxes! That's interesting, isn't it, Carl Icahn fans? Grabbing the cash isn't necessarily the better option, at least short term. Long term, well, we'll see.
Now, has this wash of cash into buybacks really been shareholder friendly? Let's imagine a scenario where IBM had not bought back shares. There would still be 1.5 billion shares outstanding. The PE ratio would now be 10.9 instead of 15. Unless you believe getting rid of cash actually improves a company's ability to earn money, you would assume earnings would, at the very least, have held steady. Therefore, I would expect the market to value these earnings at the same 10.9 PE as now.
But, IBM would still have the $60 billion in hand, at a minimum, to add to its present $12 billion! That constitutes nearly 1/3 of its present market capitalization of $197 billion. The additional $60 billion would amount to an additional $40 per share. At a minimum, therefore, I calculate that the stock price would be $229 a share, or 30% higher than it is now.
And as to net income, would it really still be flat? Could IBM have done nothing with that extra $60 billion, other than toss it overboard like chum? Surely they could have used it to earn a modest amount more, perhaps 10% over these last six years? After all, I've already agreed that these guys know how to make money. The extra $1.6 billion in earnings would (at a P/E ratio of 10.9) add another $11.6 to the stock price, so $237.6. So I think it's entirely reasonable to assume that IBM, as a company, would now be worth nearly 35% more if it had eschewed the buybacks.
Now we get to the crux of the issue. Earnings that would "normally" generate a PE of 10.9 are sitting out there today with a PE of 16. Since today's IBM is clearly weaker financially (by over $60 billion) than the hypothetical one, why would this be? Obviously shareholders are expecting future buybacks, as IBM has obediently just promised. What would happen if the company reneged on the promise, or simply failed to repeat a future renewal? Bad things! Buybacks inject steroids into stock prices; withdrawal symptoms would (will) be severe.
Now is this potential stumble any different than that following the suspension or reduction of a regular dividend? Stock prices plummet in both cases. So what's the difference? Well, look where the money goes. Dividends go to all shareholders. If they are regular and predictable and rising, shareholders benefit greatly. They build retirement portfolios on these "safe" earnings. Buyback money goes to the sellers of stock, who must generally pay taxes on the gains. Non-sellers might see a temporary rise in stock prices, but are vulnerable to the end game. Substantial buybacks (like IBM's) clearly weaken a company, often just prior to market turbulence and a frantic need for cash. And by the way, the most publicly acknowledged flaw of stock buybacks is terrible timing. CEOs initiate them when they have money in hand, which usually coincides with high stock prices, and terminate them in downturns, when their stock is actually cheap. This is classic buy-high/sell-low behavior.
But, you say, IBM's game has been going on for seven years, with nice results. Even Warren Buffett jumped in in 2011. Why worry? Well, what should be worrisome for IBM shareholders is that recent flattening of income. The growth rate of earnings has been declining for five years, even as earnings per share have jumped. Retiring shares has masked this troubling trend. Hmm, could that actually be the point of the exercise? Specifically, think about who gains by manipulating the stock price. Who gets immediate rewards in stock options exercised as soon as humanly possible, and floats serenely into the sunset on golden parachutes when the storm ultimately strikes?
Update: Nearly a year later. The same trends I discussed above continue. IBM's revenue for 2013 declined 4.55% to $99.75 billion from 2012. This year, the earnings drop continues, at a 4% pace. In the first two quarters of 2014, the company bought back nearly $12 billion worth of shares. The stock price? Absolutely flat, year to date! While the market is reaching all-time highs, IBM is limping along below levels reached in 2011. All that money poured into buybacks, and the stock has gone nowhere! Since the company's plan is to "only" buy back another $3 billion this year, what is likely to happen when the binge stops? Of course, these wizards could simply declare another giant buyback program (how about $20 billion this time?). The point is: no amount of trickery can evade the inevitable reckoning. IBM is shrinking, and eventually the market will punish it for the lack of real growth. Throwing away its lifeblood (cash) will only make the painful adjustment to reality worse. Folks, if a company has nothing better to do with its precious cash than stock buybacks, you should RUN away! Where? Well, that's a difficult question, but I'll try to explore some ideas in my next post.
Update (October 21, 2014): A couple of weeks hence, and 2014 third quarter results are in. It's not pretty. Operating earnings for the quarter fell 10%, resulting in a nasty drop in the stock price to $169. So, in a year when the stock market rose steadily, IBM has dropped seven points, despite pouring $15 billion into buybacks! The New York Times has an article that is music to my ears: The Truth Hidden by IBM's Stock Buybacks. It points out that the company's revenue has been flat for TEN years, it has spent $108 BILLION on buybacks, $30 billion on dividends, $59 billion on capital expenditures and $32 billion on acquisitions. That $1.50 out the door for every $1 invested in the business. The article suggests that IBM has "been spending its money on the wrong things; shareholders, rather than building its own business". I would correct that a bit: ex-shareholders have been the real winners. The only sure way to take advantage of a buyback is to sell, after all. The article also mentions a "dirty secret": buybacks "can have an impact on executive compensation by goosing certain metrics that boards use to measure a company's performance." Good for the executives, bad for the shareholders, bad for the company. The bottom line here is that the value of an investment is ultimately determined by the company's earnings stream. No amount of financial voodoo will change that fact. IBM's extravagant cash spew has clearly weakened the company's ability to grow earnings (through investment and acquisitions), and there will probably be hell to pay. Warren, you might end up owning a larger share of the company due to buybacks (his rationale for climbing on board, while blithely rooting for a long-term flat stock price!), but it's a far weaker company. Do you seriously think IBM would have NO use for that wasted $108 billion in today's dog-eat-dog world?
Update: February 1, 2015. The saga continues. IBM is now down to $152, a point last seen in early 2011. This is because the company's revenue is below what it was in 2004! Guess what, they STILL intend to buy back $6 billion of stock right away, with more to come in April. The company has, however, abandoned its earnings goal of $20/share. Even with gigantic repurchases (lowering the number of shares participating in the earnings figure), the core business is so weak that the fantasy figure looks out of reach. Don't worry though, Ginni Rommetty just got a $3.6 million bonus, with more to come if she meets the company's next set of goals. So, she'll throw $6 to $15 billion more at the stock, to make sure she nabs that bonus. It's good for her, at least, especially once she gathers in her golden parachute when the natives finally come howling for her scalp. I'm not alone in my dyspepsia, the company is now the fourth most-shorted issue in the NYSE.
Update: October 23, 2015. Two years after I said it, here's a paragraph from a scathing SeekingAlpha article entitled "Too Many Stock Buybacks have Hurt IBM":
"IBM has been generating huge amounts of cash over the past ten years, ranging from $8 to $16 billion, and all that cash is almost nowhere to be found. Where is all that cash? Most of it has been given to those who have sold their shares to the company. Practically, the company, as things stand right now, has been rewarding the sellers of the shares at the expense of loyal shareholders who have been holding their ownership stakes. Of course, people do not usually see it like this, but when the stock price goes down, things turn out this way. When the share price goes up, it turns out better for loyal shareholders."
I couldn't have put it better myself ... WAIT, I did, back in November of 2012: "
"So why does Carl (Icahn) want the company (a theoretical company in this example) to initiate a buyback? Simply put, it's a great way to make a fast buck. Announcing the buyback, and then initiating it, puts upward pressure on the stock. Suddenly, extra cash is chasing the shares available for sale. Demand outruns supply (temporarily), and the price jumps. So, Carl sells into a rising market, pockets the quick gain, and departs. He could care less about "stockholder value!" He's a scorpion, stinging companies is what he does. Lesson for non-scorpions? Stock buybacks only benefit the folks who sell! Those who stay are left with a company whose cash has been frittered away to others. I think it's a form of financial rape."
Yeah, a bit overwrought (buybacks COULD make sense if the stock is frantically cheap), but anyone listening in 2012 might have taken a pass on IBM with its high of $210 and low of $193 in 2012. A good choice, as the company has just announced further miserable results, with the stock now having fainted to $141. Sadly, though, no one is listening ... yet.
Update January 29, 2016. After YET another bum quarter, IBM's stock price is down to $124. People are finally listening (not to me, of course, but to the Johnnie-come-latelies who have finally recognized that something is not right in Rometty-land. This time they're blaming currency conversion ailments. Otherwise, earnings would have declined by only 2%. Yeah, it's always sumpin' with Ginni. By the way, they just gave her a special EXTRA bonus of $5 million (for a job well done?).
The argument for IBM (articulated fatuously by Warren Buffett himself) is that the stock price doesn't matter. He even rejoices (he says) when the stock price drops. He, and others, say they're in the game for the dividends. On the face of it, the argument is compelling. IBM's dividend has risen from $.18 quarterly in 2004 to $1.30 today, a compounded growth rate of nearly 20% over eleven years. Why that's Buffett-worthy. No wonder Warren jumped on board. He's found a magic formula for getting even richer, right? Well ... let's go to the blackboard.
Say you had bought 1000 shares of IBM at the 2004 year-end price of $94. Over eleven years, you would have received $34.70 per share in steadily rising dividends. Add that to today's share price of $124 and you would have netted $64,700 on an investment of $94,000, which happens to be 4.8% compounded, with taxes due on dividends along the way. WAIT, WAIT! What happened to that lovely 20% yearly growth rate? Shouldn't you now have $698,000? Isn't that what the dividend growth rate promises?
Buddy, you've been jobbed. IBM's relentless stock buy-backs have dropped the share count from 1.6 billion to just under 1 billion over this span. The company's revenue is being spread out over fewer shares. And something alarming has happened along the way. The amount IBM steers to dividends has risen precipitously (making for those delicious yields), but dividends represent an ever-larger percentage of company earnings. In 2004, dividends were just under 16% of company net income. Now, it's 38%.
The scenario above assumes you'd bought at at the beginning of the shell game. What if you'd bought mid-way, when the stock was over $200 a share? Would you still be rooting for a decline, Buffett-style?
Ginni (and her former boss) have been robbing Peter to pay Paul. The proof of the pie is in shareholder equity. That, folks, is what the owners of the company actually own, total assets minus total liabilities, or approximate breakup value, if you like. At the end of 2004, the figure was $31.69 billion (already down from a peak of $43 billion in 1990). Shareholder equity has deflated with a loud hiss ever since, to a nadir of $11.87 billion in 2014, and a still feeble $14.26 billion at the end of 2015. That's a fat 55% loss of value, far exceeding the 38% decrease in shares outstanding over these eleven years! What happened to that equity? Look no further than stock buy-backs (over $100 BILLION - money handed over to the stock's sellers) and lavish dividend increases. It's a miracle this whale still floats!
Still, shareholders have in fact received steadily rising dividends. So, why should these widows and orphans worry? Even the near-sighted should be able to spot what's wrong with Rometty's reverse ponzi scheme. It's unsustainable. Raising dividends by 425% over eleven years, while net income wobbles downward is no way to run a railroad. What do you think will happen to the stock once the buybacks end or, horror of horrors, the company actually is forced to cut the dividend? Hint: gravity!
Of course, Rometty's promising gigantic new revenue streams ... eventually. "Forget the disastrous decay in the core business; the cloud will launch IBM to the stars! And by the way, would you like to buy a nice bridge to Brooklyn?"
March 2017. After a huge run-up in the stock market following Donald Trump's electoral victory, IBM appears to be sitting pretty. The price is $173. Compared to the dismal $120 seen last year, that's a good run. But ... $173 is actually just about where IBM was FIVE years ago! It topped $200 several times since then, and has fallen back from those peaks.
Now I'd call a flat five years no victory at all. But there's still a drum-beat of positive hype regarding the company's aggressive buybacks. A recent SeekingAlpha column just ran through the Buffett line: that flat or dropping stock prices along with steady stock buybacks are just great for the long-term dividend investor. He points out that Buffett now owns 6.8% of the company, as opposed to 5.5% when this particular period began. This is due to the drop in shares outstanding. So, that's a 23% increase in Berkshire's share of IBM's equity. That equity is actuall2016y down a bit over the same span ($18.98 billion then, $18.4 billion now), resulting in a compounded rate of return just under 5%. Even adding dividends received into the calculation does little to improve this very modest result. This is the best the Sage of Omaha can do?
Furthermore, this point in time looks particularly favorable to Warren. It skips past that ugly year-ago low, and presumes a fairly low starting point (2012). Pick a few other starting points, and the picture dims fast. The article mentions that net buybacks over the years have been over $100 billion (perhaps somewhat less once adjusted for sneaky new issuances). That's over FIVE TIMES the company's net present worth! Please, do you seriously think IBM is worth more now that it would have been if it had simply kept the money? If so, Warren would own 5.5% of a company worth far more than today's shrunken total.
You want to know the strongest argument against IBM's stock buyback program? The company itself! Between 2010 and 2014, it poured $70 billion into buybacks!. In 2015 that fell to $4.7 billion. The latest figure? $3 billion. So, if buybacks are so magical, then why stop them? Why throw tons of money at the market when the stock is hovering at or over $200 / share, and then nearly stop once it has plummeted? Ginni can slather on all the lipstick she wants; the object of beautification is still a pig (to be precise: I mean the company, not Ginni). She has a proven track record of buying high; is she her successor about to sell low?
July 2017. Stock has swooned again, down to 145, a price last seen in 2015 and again in 2009. So ... depending on entry point, a flat 8 years! And Warren has finally pulled the plug. Why didn't he listen to me sooner? And still the company buys back shares.
December 2018. Another year past, and the stock is now down to $115. Admittedly, it's been a brutal couple of months, with a full year's upside wiped out, and more. Still, IBM stand out as a truly punk investment. It's still getting touted as a magnificent dividend play, but really?
An item in a recent Barron's magazine points out that IBM's earnings per share have risen sharply since 2007, but largely due to its very aggressive program of stock buybacks. Outstanding shares have been reduced by 25% in this period, meaning that its earnings are spread over fewer shares, thus raising earnings per share. This is the flavor of the month in the world of stocks.
The company recently announced ANOTHER stock buyback, this time $15 billion, bringing the total since 2007 to $75 billion. That's a huge figure. People talk all the time about Apple's cash hoard, but IBM has offloaded over half as much of Apple's total hoard in the last six years!
On the face of it, IBM's ten year story is compelling. In 2003, the stock was roughly $91 per share, in 2007 $105, and now $176, a rise of nearly 100%. The stock has outperformed the S&P 500 index by about 50%. Much of the outperformance coincides with the huge stock buybacks initiated in 2007. Interestingly, though, gravity seems to be kicking in. A fast rise following the latest buyback announcement has fizzled, and the S&P gap is shrinking rapidly. By the way, if you look back over longer periods (25 years or more), IBM looks anemic, underperforming the S&P 500 vastly since 1988. Does that matter? Well, if you're over fifty and have owned IBM for awhile, it probably does.
In 2006, the company earned $9.7 billion, which rose to $16.6 billion in 2012, a rise of 70%. (For a ten-year comparison, the company earned $7.58 billion in 2003, with a rise in earnings of more than 100%). That's impressive, especially since sales have risen far less rapidly (from $91 to $104.5 billion since 2006. These guys know how to make money, and they've been able to increase net earnings sharply even as revenue growth has slowed greatly. Still, that slow growth is sobering. Can the upcoming decade offer a similar bottom line of high profit on meager sales? Color me skeptical.
Let's do two run-throughs. First, let's assume an investor who has sold shares to take advantage of the buybacks. Assuming an initial position of $105,000 in 1997 (1000 shares at $105 per share), this individual would have sold off 250 shares (25% of the entire position) at an average price of $140, netting $35,000. The remaing 750 shares would be worth $132,000, or a total of $167,000. This would be a 59% gain over seven years, with taxes due on the shares sold.
The buy and hold investor would still own 1000 shares, presently worth $176,000, a bit better than the seller, even before taxes! That's interesting, isn't it, Carl Icahn fans? Grabbing the cash isn't necessarily the better option, at least short term. Long term, well, we'll see.
Now, has this wash of cash into buybacks really been shareholder friendly? Let's imagine a scenario where IBM had not bought back shares. There would still be 1.5 billion shares outstanding. The PE ratio would now be 10.9 instead of 15. Unless you believe getting rid of cash actually improves a company's ability to earn money, you would assume earnings would, at the very least, have held steady. Therefore, I would expect the market to value these earnings at the same 10.9 PE as now.
But, IBM would still have the $60 billion in hand, at a minimum, to add to its present $12 billion! That constitutes nearly 1/3 of its present market capitalization of $197 billion. The additional $60 billion would amount to an additional $40 per share. At a minimum, therefore, I calculate that the stock price would be $229 a share, or 30% higher than it is now.
And as to net income, would it really still be flat? Could IBM have done nothing with that extra $60 billion, other than toss it overboard like chum? Surely they could have used it to earn a modest amount more, perhaps 10% over these last six years? After all, I've already agreed that these guys know how to make money. The extra $1.6 billion in earnings would (at a P/E ratio of 10.9) add another $11.6 to the stock price, so $237.6. So I think it's entirely reasonable to assume that IBM, as a company, would now be worth nearly 35% more if it had eschewed the buybacks.
Now we get to the crux of the issue. Earnings that would "normally" generate a PE of 10.9 are sitting out there today with a PE of 16. Since today's IBM is clearly weaker financially (by over $60 billion) than the hypothetical one, why would this be? Obviously shareholders are expecting future buybacks, as IBM has obediently just promised. What would happen if the company reneged on the promise, or simply failed to repeat a future renewal? Bad things! Buybacks inject steroids into stock prices; withdrawal symptoms would (will) be severe.
Now is this potential stumble any different than that following the suspension or reduction of a regular dividend? Stock prices plummet in both cases. So what's the difference? Well, look where the money goes. Dividends go to all shareholders. If they are regular and predictable and rising, shareholders benefit greatly. They build retirement portfolios on these "safe" earnings. Buyback money goes to the sellers of stock, who must generally pay taxes on the gains. Non-sellers might see a temporary rise in stock prices, but are vulnerable to the end game. Substantial buybacks (like IBM's) clearly weaken a company, often just prior to market turbulence and a frantic need for cash. And by the way, the most publicly acknowledged flaw of stock buybacks is terrible timing. CEOs initiate them when they have money in hand, which usually coincides with high stock prices, and terminate them in downturns, when their stock is actually cheap. This is classic buy-high/sell-low behavior.
But, you say, IBM's game has been going on for seven years, with nice results. Even Warren Buffett jumped in in 2011. Why worry? Well, what should be worrisome for IBM shareholders is that recent flattening of income. The growth rate of earnings has been declining for five years, even as earnings per share have jumped. Retiring shares has masked this troubling trend. Hmm, could that actually be the point of the exercise? Specifically, think about who gains by manipulating the stock price. Who gets immediate rewards in stock options exercised as soon as humanly possible, and floats serenely into the sunset on golden parachutes when the storm ultimately strikes?
Update: Nearly a year later. The same trends I discussed above continue. IBM's revenue for 2013 declined 4.55% to $99.75 billion from 2012. This year, the earnings drop continues, at a 4% pace. In the first two quarters of 2014, the company bought back nearly $12 billion worth of shares. The stock price? Absolutely flat, year to date! While the market is reaching all-time highs, IBM is limping along below levels reached in 2011. All that money poured into buybacks, and the stock has gone nowhere! Since the company's plan is to "only" buy back another $3 billion this year, what is likely to happen when the binge stops? Of course, these wizards could simply declare another giant buyback program (how about $20 billion this time?). The point is: no amount of trickery can evade the inevitable reckoning. IBM is shrinking, and eventually the market will punish it for the lack of real growth. Throwing away its lifeblood (cash) will only make the painful adjustment to reality worse. Folks, if a company has nothing better to do with its precious cash than stock buybacks, you should RUN away! Where? Well, that's a difficult question, but I'll try to explore some ideas in my next post.
Update (October 21, 2014): A couple of weeks hence, and 2014 third quarter results are in. It's not pretty. Operating earnings for the quarter fell 10%, resulting in a nasty drop in the stock price to $169. So, in a year when the stock market rose steadily, IBM has dropped seven points, despite pouring $15 billion into buybacks! The New York Times has an article that is music to my ears: The Truth Hidden by IBM's Stock Buybacks. It points out that the company's revenue has been flat for TEN years, it has spent $108 BILLION on buybacks, $30 billion on dividends, $59 billion on capital expenditures and $32 billion on acquisitions. That $1.50 out the door for every $1 invested in the business. The article suggests that IBM has "been spending its money on the wrong things; shareholders, rather than building its own business". I would correct that a bit: ex-shareholders have been the real winners. The only sure way to take advantage of a buyback is to sell, after all. The article also mentions a "dirty secret": buybacks "can have an impact on executive compensation by goosing certain metrics that boards use to measure a company's performance." Good for the executives, bad for the shareholders, bad for the company. The bottom line here is that the value of an investment is ultimately determined by the company's earnings stream. No amount of financial voodoo will change that fact. IBM's extravagant cash spew has clearly weakened the company's ability to grow earnings (through investment and acquisitions), and there will probably be hell to pay. Warren, you might end up owning a larger share of the company due to buybacks (his rationale for climbing on board, while blithely rooting for a long-term flat stock price!), but it's a far weaker company. Do you seriously think IBM would have NO use for that wasted $108 billion in today's dog-eat-dog world?
Update: February 1, 2015. The saga continues. IBM is now down to $152, a point last seen in early 2011. This is because the company's revenue is below what it was in 2004! Guess what, they STILL intend to buy back $6 billion of stock right away, with more to come in April. The company has, however, abandoned its earnings goal of $20/share. Even with gigantic repurchases (lowering the number of shares participating in the earnings figure), the core business is so weak that the fantasy figure looks out of reach. Don't worry though, Ginni Rommetty just got a $3.6 million bonus, with more to come if she meets the company's next set of goals. So, she'll throw $6 to $15 billion more at the stock, to make sure she nabs that bonus. It's good for her, at least, especially once she gathers in her golden parachute when the natives finally come howling for her scalp. I'm not alone in my dyspepsia, the company is now the fourth most-shorted issue in the NYSE.
Update: October 23, 2015. Two years after I said it, here's a paragraph from a scathing SeekingAlpha article entitled "Too Many Stock Buybacks have Hurt IBM":
"IBM has been generating huge amounts of cash over the past ten years, ranging from $8 to $16 billion, and all that cash is almost nowhere to be found. Where is all that cash? Most of it has been given to those who have sold their shares to the company. Practically, the company, as things stand right now, has been rewarding the sellers of the shares at the expense of loyal shareholders who have been holding their ownership stakes. Of course, people do not usually see it like this, but when the stock price goes down, things turn out this way. When the share price goes up, it turns out better for loyal shareholders."
I couldn't have put it better myself ... WAIT, I did, back in November of 2012: "
"So why does Carl (Icahn) want the company (a theoretical company in this example) to initiate a buyback? Simply put, it's a great way to make a fast buck. Announcing the buyback, and then initiating it, puts upward pressure on the stock. Suddenly, extra cash is chasing the shares available for sale. Demand outruns supply (temporarily), and the price jumps. So, Carl sells into a rising market, pockets the quick gain, and departs. He could care less about "stockholder value!" He's a scorpion, stinging companies is what he does. Lesson for non-scorpions? Stock buybacks only benefit the folks who sell! Those who stay are left with a company whose cash has been frittered away to others. I think it's a form of financial rape."
Yeah, a bit overwrought (buybacks COULD make sense if the stock is frantically cheap), but anyone listening in 2012 might have taken a pass on IBM with its high of $210 and low of $193 in 2012. A good choice, as the company has just announced further miserable results, with the stock now having fainted to $141. Sadly, though, no one is listening ... yet.
Update January 29, 2016. After YET another bum quarter, IBM's stock price is down to $124. People are finally listening (not to me, of course, but to the Johnnie-come-latelies who have finally recognized that something is not right in Rometty-land. This time they're blaming currency conversion ailments. Otherwise, earnings would have declined by only 2%. Yeah, it's always sumpin' with Ginni. By the way, they just gave her a special EXTRA bonus of $5 million (for a job well done?).
The argument for IBM (articulated fatuously by Warren Buffett himself) is that the stock price doesn't matter. He even rejoices (he says) when the stock price drops. He, and others, say they're in the game for the dividends. On the face of it, the argument is compelling. IBM's dividend has risen from $.18 quarterly in 2004 to $1.30 today, a compounded growth rate of nearly 20% over eleven years. Why that's Buffett-worthy. No wonder Warren jumped on board. He's found a magic formula for getting even richer, right? Well ... let's go to the blackboard.
Say you had bought 1000 shares of IBM at the 2004 year-end price of $94. Over eleven years, you would have received $34.70 per share in steadily rising dividends. Add that to today's share price of $124 and you would have netted $64,700 on an investment of $94,000, which happens to be 4.8% compounded, with taxes due on dividends along the way. WAIT, WAIT! What happened to that lovely 20% yearly growth rate? Shouldn't you now have $698,000? Isn't that what the dividend growth rate promises?
Buddy, you've been jobbed. IBM's relentless stock buy-backs have dropped the share count from 1.6 billion to just under 1 billion over this span. The company's revenue is being spread out over fewer shares. And something alarming has happened along the way. The amount IBM steers to dividends has risen precipitously (making for those delicious yields), but dividends represent an ever-larger percentage of company earnings. In 2004, dividends were just under 16% of company net income. Now, it's 38%.
The scenario above assumes you'd bought at at the beginning of the shell game. What if you'd bought mid-way, when the stock was over $200 a share? Would you still be rooting for a decline, Buffett-style?
Still, shareholders have in fact received steadily rising dividends. So, why should these widows and orphans worry? Even the near-sighted should be able to spot what's wrong with Rometty's reverse ponzi scheme. It's unsustainable. Raising dividends by 425% over eleven years, while net income wobbles downward is no way to run a railroad. What do you think will happen to the stock once the buybacks end or, horror of horrors, the company actually is forced to cut the dividend? Hint: gravity!
Of course, Rometty's promising gigantic new revenue streams ... eventually. "Forget the disastrous decay in the core business; the cloud will launch IBM to the stars! And by the way, would you like to buy a nice bridge to Brooklyn?"
March 2017. After a huge run-up in the stock market following Donald Trump's electoral victory, IBM appears to be sitting pretty. The price is $173. Compared to the dismal $120 seen last year, that's a good run. But ... $173 is actually just about where IBM was FIVE years ago! It topped $200 several times since then, and has fallen back from those peaks.
Now I'd call a flat five years no victory at all. But there's still a drum-beat of positive hype regarding the company's aggressive buybacks. A recent SeekingAlpha column just ran through the Buffett line: that flat or dropping stock prices along with steady stock buybacks are just great for the long-term dividend investor. He points out that Buffett now owns 6.8% of the company, as opposed to 5.5% when this particular period began. This is due to the drop in shares outstanding. So, that's a 23% increase in Berkshire's share of IBM's equity. That equity is actuall2016y down a bit over the same span ($18.98 billion then, $18.4 billion now), resulting in a compounded rate of return just under 5%. Even adding dividends received into the calculation does little to improve this very modest result. This is the best the Sage of Omaha can do?
Furthermore, this point in time looks particularly favorable to Warren. It skips past that ugly year-ago low, and presumes a fairly low starting point (2012). Pick a few other starting points, and the picture dims fast. The article mentions that net buybacks over the years have been over $100 billion (perhaps somewhat less once adjusted for sneaky new issuances). That's over FIVE TIMES the company's net present worth! Please, do you seriously think IBM is worth more now that it would have been if it had simply kept the money? If so, Warren would own 5.5% of a company worth far more than today's shrunken total.
You want to know the strongest argument against IBM's stock buyback program? The company itself! Between 2010 and 2014, it poured $70 billion into buybacks!. In 2015 that fell to $4.7 billion. The latest figure? $3 billion. So, if buybacks are so magical, then why stop them? Why throw tons of money at the market when the stock is hovering at or over $200 / share, and then nearly stop once it has plummeted? Ginni can slather on all the lipstick she wants; the object of beautification is still a pig (to be precise: I mean the company, not Ginni). She has a proven track record of buying high; is she her successor about to sell low?
July 2017. Stock has swooned again, down to 145, a price last seen in 2015 and again in 2009. So ... depending on entry point, a flat 8 years! And Warren has finally pulled the plug. Why didn't he listen to me sooner? And still the company buys back shares.
December 2018. Another year past, and the stock is now down to $115. Admittedly, it's been a brutal couple of months, with a full year's upside wiped out, and more. Still, IBM stand out as a truly punk investment. It's still getting touted as a magnificent dividend play, but really?
Monday, October 7, 2013
A Social Security Screed
Yeah, I know this blog is supposed to be about bonds. But I only have one blog (to date), and I need to vent somewhere.
I just got a huffily aggressive letter from AARP. On the envelope is the following reproach: "You have not responded to our previous letters." Right there, I'm peeved. Am I somehow obligated to respond to every damn thing AARP sends me (endless offers for overpriced car and life insurance among other things)? That's a bad start.
Then a cover letter indicating that it's urgent for me to protest to President Obama and Congress about unfair cuts to my social security benefits. Hmm, and what are these unfair cuts? Well, actually not cuts at all. Actually, a proposal to reduce the amount by which future benefits will be raised (via the so-called Chained CPI). In what world is a smaller raise a "cut"? Why the deceptive language?
The letter then skips merrily into the realm of untruth. The "average senior", I am informed, subsists on a mere $20,000 a year. Gee, that's a bit of a surprise to me, and the figure is, in fact, just not true. The average retiree drew in $29,000 a year in 2008! So by now, this average person is clearly receiving substantially more, so at least 50% more than the AARP terror figure. And, of course, consider that a majority of seniors are married, and therefore often pulling in two sources of retirement income. In fact, the median (not average) income of a retired household is more like $36,000.
What's the difference? Well, it's a lot easier to live on $36,000 than $20,000. It's the difference between dignity and desperation, decent food and cat food. I am not foolish enough to insist that the higher figure is great. It's not. Life on $36,000, depending on where you live, can be tight indeed. And the poor oldster trying to live on $20,000 or less, is in desperate straits.
But why is the AARP trying to pretend that desperation is "average"? It's cynical and dishonest, preying on the uneasiness we all have about an uncertain future. I think this effort represents one of the worst things about our system: entrenched interests protecting their slice of the government pie, regardless of need, fairness or common sense. Middle class entitlements of all sorts defy logic. Why collect money (mostly from middle and upper earners) only to dole it right back to those very folks? Subsidizing the needy is morally compelling; subsidizing the majority is dumb.
Here a breakdown of the Social Security problem. Most people, particularly retirees, believe Social Security is a grand savings plan: you pay in while working, and collect in retirement. So, you are getting back what you put in when your check arrives every month. This is a comforting fiction, but it's simply untrue.
To quote the National Academy of Social Insurance:
By law, the funds are invested in special-issue Treasury securities that earn interest. In effect, the funds are loaned to the Treasury, which borrows the money just as it borrows money when it sells Treasury securities to the public. In other words, the surplus money collected by Social Security helps pay for the rest of the government. In return for the funds it loans to the government, the trust funds receive Treasury securities bearing a market rate of interest. The average interest rate on the portfolio held by the Social Security trust fund was about 4.1 percent in 2012.
Note: there is no saving plan, no separate account into which your monthly social security contributions flow. Instead, these payments, both from you and your employer, are go directly into the government general fund (via the purchase of treasury securities), from which pretty much all bills are paid, The result is an IOU to the Social Security Trust. If you think that's terrible, well it's been terrible from ... the very beginning. Social Security has ALWAYS been a pay as you go scheme. Present retirees are paid, in effect, from the present stream of money going into the government, whether from income taxes or Social Security taxes. My major objection to the scheme is not that it is deceptive (which it is), but that it's an open-ended commitment. Today's promise must be honored in the future. There is no provision for matching income and expenditures. Old folks today are relying on their children and grandchildren to cough up the dough, regardless of whether that is affordable or not.
And, folks, the affordability of Social Security is very much in question. It's a combination of demographics and dubious populism. Demograpics matter because the cohort of retirees is mushrooming, while the working folks who must pay the bill is static, perhaps even shrinking. Thus, while many workers supported each retiree in the thirties, we might face a situation where as few as two working folks will be supporting each retiree. How much can these guys handle before something gives?
Populism matters because politicians of all stripes (yes, even Republicans, even conservatives) have succumbed spinelessly to the "plight" of the elderly, raising benefits relentlessly, even as the baby boomer wave rolls relentlessly forward. So, Social Security is indexed to inflation, but at a rate that almost certainly exceeds real inflation. And benefits have been expanded to the disabled, a category that has mushroomed far faster than the population. Why do you suppose that is? Well, for one things, it's a whole lot easier to achieve that designation that ever before. Just take a look to see how many lawyers are eager to help you get on board. And benefits are regularly given to children, not just those of dead retirees, but minor children of living pensioners! I kid you not. When I retired in 2008, my benefits were exactly doubled because both of my children were below the age of 18. This ride will not end until my son heads off to college in another five years.
Above all, this tidal wave of largesse is distributed irrespectively of need. In fact, it's worse than that. The system is specifically designed to reward those with the least need. Take a look at Social Security charts, and you'll see that payments rise steadily with income, particularly peak income. So, if you have a few fat years just prior to retirement (I did), then you pull in maximum benefits. Be unfortunate enough to have punk earnings, then you'll come in at the very bottom. But folks, the whole point of Social Security is .... SECURITY. It only makes real sense as part of the safety net.
Here's a radical idea: suppose Social Security were need-based. It would be payment designed to ensure a safe and dignified retirement, declining for those with higher incomes, disappearing with those whose need is spurious. Since the number of people with such pressing needs is small relative to the entire population of retirees, the funding pressure from Social Security would ease greatly.
Now, what about the rest of us? Well, how about a REAL savings plan? Many of us already have (or had) one, an IRA or a 401K. Since Social Security is a tax, and therefore presently mandatory, why not steer the excess into a form of forced (but real) savings, a government IRA perhaps? Individuals could be afforded the same level of investment control they now have over their IRAs and 401Ks. They would just have to wait for the money, as they probably should anyway. The flow of funds into these saving accounts would be enormous. One important side benefit would be the stimulative effect such investment might have on the economy. It could be huge.
Would this fly? The major problem is that government would no longer be allowed to spend retirement income flows on non-retirement matters. That would be painful, particularly the transition. The new approach would surely need to be phased in over a period of years. It would, however, be logical, prudent and fair.
The political issues would be thorny: worst would be the outrage seniors (egged on by the AARP) would feel at "losing" their benefits. It would probably be necessary (although silly) to separate out "savings" Social Security from the payments directed to needy elders. If payments came from different buckets, regular retirees might feel less hostile to seeing part of their monthly working contributions diverted elsewhere. So, ultimately, needs-based Social Security might come from the general ledger (as now), and savings Social Security (based on a lower tax rate than at present) going into a separate, shielded trust, a real one, not a sham.
I just got a huffily aggressive letter from AARP. On the envelope is the following reproach: "You have not responded to our previous letters." Right there, I'm peeved. Am I somehow obligated to respond to every damn thing AARP sends me (endless offers for overpriced car and life insurance among other things)? That's a bad start.
Then a cover letter indicating that it's urgent for me to protest to President Obama and Congress about unfair cuts to my social security benefits. Hmm, and what are these unfair cuts? Well, actually not cuts at all. Actually, a proposal to reduce the amount by which future benefits will be raised (via the so-called Chained CPI). In what world is a smaller raise a "cut"? Why the deceptive language?
The letter then skips merrily into the realm of untruth. The "average senior", I am informed, subsists on a mere $20,000 a year. Gee, that's a bit of a surprise to me, and the figure is, in fact, just not true. The average retiree drew in $29,000 a year in 2008! So by now, this average person is clearly receiving substantially more, so at least 50% more than the AARP terror figure. And, of course, consider that a majority of seniors are married, and therefore often pulling in two sources of retirement income. In fact, the median (not average) income of a retired household is more like $36,000.
What's the difference? Well, it's a lot easier to live on $36,000 than $20,000. It's the difference between dignity and desperation, decent food and cat food. I am not foolish enough to insist that the higher figure is great. It's not. Life on $36,000, depending on where you live, can be tight indeed. And the poor oldster trying to live on $20,000 or less, is in desperate straits.
But why is the AARP trying to pretend that desperation is "average"? It's cynical and dishonest, preying on the uneasiness we all have about an uncertain future. I think this effort represents one of the worst things about our system: entrenched interests protecting their slice of the government pie, regardless of need, fairness or common sense. Middle class entitlements of all sorts defy logic. Why collect money (mostly from middle and upper earners) only to dole it right back to those very folks? Subsidizing the needy is morally compelling; subsidizing the majority is dumb.
Here a breakdown of the Social Security problem. Most people, particularly retirees, believe Social Security is a grand savings plan: you pay in while working, and collect in retirement. So, you are getting back what you put in when your check arrives every month. This is a comforting fiction, but it's simply untrue.
To quote the National Academy of Social Insurance:
By law, the funds are invested in special-issue Treasury securities that earn interest. In effect, the funds are loaned to the Treasury, which borrows the money just as it borrows money when it sells Treasury securities to the public. In other words, the surplus money collected by Social Security helps pay for the rest of the government. In return for the funds it loans to the government, the trust funds receive Treasury securities bearing a market rate of interest. The average interest rate on the portfolio held by the Social Security trust fund was about 4.1 percent in 2012.
Note: there is no saving plan, no separate account into which your monthly social security contributions flow. Instead, these payments, both from you and your employer, are go directly into the government general fund (via the purchase of treasury securities), from which pretty much all bills are paid, The result is an IOU to the Social Security Trust. If you think that's terrible, well it's been terrible from ... the very beginning. Social Security has ALWAYS been a pay as you go scheme. Present retirees are paid, in effect, from the present stream of money going into the government, whether from income taxes or Social Security taxes. My major objection to the scheme is not that it is deceptive (which it is), but that it's an open-ended commitment. Today's promise must be honored in the future. There is no provision for matching income and expenditures. Old folks today are relying on their children and grandchildren to cough up the dough, regardless of whether that is affordable or not.
And, folks, the affordability of Social Security is very much in question. It's a combination of demographics and dubious populism. Demograpics matter because the cohort of retirees is mushrooming, while the working folks who must pay the bill is static, perhaps even shrinking. Thus, while many workers supported each retiree in the thirties, we might face a situation where as few as two working folks will be supporting each retiree. How much can these guys handle before something gives?
Populism matters because politicians of all stripes (yes, even Republicans, even conservatives) have succumbed spinelessly to the "plight" of the elderly, raising benefits relentlessly, even as the baby boomer wave rolls relentlessly forward. So, Social Security is indexed to inflation, but at a rate that almost certainly exceeds real inflation. And benefits have been expanded to the disabled, a category that has mushroomed far faster than the population. Why do you suppose that is? Well, for one things, it's a whole lot easier to achieve that designation that ever before. Just take a look to see how many lawyers are eager to help you get on board. And benefits are regularly given to children, not just those of dead retirees, but minor children of living pensioners! I kid you not. When I retired in 2008, my benefits were exactly doubled because both of my children were below the age of 18. This ride will not end until my son heads off to college in another five years.
Above all, this tidal wave of largesse is distributed irrespectively of need. In fact, it's worse than that. The system is specifically designed to reward those with the least need. Take a look at Social Security charts, and you'll see that payments rise steadily with income, particularly peak income. So, if you have a few fat years just prior to retirement (I did), then you pull in maximum benefits. Be unfortunate enough to have punk earnings, then you'll come in at the very bottom. But folks, the whole point of Social Security is .... SECURITY. It only makes real sense as part of the safety net.
Here's a radical idea: suppose Social Security were need-based. It would be payment designed to ensure a safe and dignified retirement, declining for those with higher incomes, disappearing with those whose need is spurious. Since the number of people with such pressing needs is small relative to the entire population of retirees, the funding pressure from Social Security would ease greatly.
Now, what about the rest of us? Well, how about a REAL savings plan? Many of us already have (or had) one, an IRA or a 401K. Since Social Security is a tax, and therefore presently mandatory, why not steer the excess into a form of forced (but real) savings, a government IRA perhaps? Individuals could be afforded the same level of investment control they now have over their IRAs and 401Ks. They would just have to wait for the money, as they probably should anyway. The flow of funds into these saving accounts would be enormous. One important side benefit would be the stimulative effect such investment might have on the economy. It could be huge.
Would this fly? The major problem is that government would no longer be allowed to spend retirement income flows on non-retirement matters. That would be painful, particularly the transition. The new approach would surely need to be phased in over a period of years. It would, however, be logical, prudent and fair.
The political issues would be thorny: worst would be the outrage seniors (egged on by the AARP) would feel at "losing" their benefits. It would probably be necessary (although silly) to separate out "savings" Social Security from the payments directed to needy elders. If payments came from different buckets, regular retirees might feel less hostile to seeing part of their monthly working contributions diverted elsewhere. So, ultimately, needs-based Social Security might come from the general ledger (as now), and savings Social Security (based on a lower tax rate than at present) going into a separate, shielded trust, a real one, not a sham.
Sunday, September 15, 2013
Out on a Limb!
A couple of entries ago, I went on a rant about my favorite stock bugaboo: the share buyback. Today I came across a particularly fatuous discussion of this very topic in Barron's Weekday Trader column of September 16, 2013. Entitled "Seagate: The Shareholder's Friend", the article describes a very aggressive share buyback program that is designed to reduce the company's outstanding shares by 30%, to 250 million shares. An earlier program has already reduced the share count by 26% to 371 million from 500 million over the last three years. Seagate's president is quoted as saying "We don't believe in holding excess cash on our books."
Notably, the article proceeds to draw a comparison with Seagate's main rival in the disk drive business, Western Digital. It says that Seagate's share price is up 30% this year, while Western Digital's is up 50%. The difference is that Western Digital has been investing its "excess cash" in flash memory acquisitions, a strategy Seagate dismisses as premature. The company president is confident that he'll be able to buy mature technology later on.
Now, I am no expert in this business, but I do know that flash drives are vastly quicker than disk drives. For example, the very sexy Ultrabook I'm using to compose this blog boots up in seventeen seconds, due to its advanced flash memory. I also know that flash is upending memory technology across the board. The very biggest players (EMC and IBM) are investing huge sums in this area. So, what I see here is a classic face off between a company committed to financial engineering and one committed to reinvesting in the business.
While both companies have risen sharply over the last three years, that rise is from very low levels following a long period of distress: too much capacity and falling volumes. Seagate bottomed at $3.80, Western Digital at $11.45. Neither, therefore, has been a particularly great investment over a 15 year span. Still, economic recovery coupled with careful capacity management has caused both stocks to soar in the last couple of years.
With its "shareholder friendliness" and 26% buyback, why has Seagate's recovery lagged its rival's? Well, folks, follow the money! As opposed to dividends, which clearly end up in the shareholders' pockets, and are therefore, clearly shareholder friendly, the funds allocated to buybacks have ended up in the pockets of ... the sellers! People who no longer own Seagate (or who own fewer shares) have received the dough. For the rest, it's gone! If that makes you feel like a sucker for loyally staying the course, well ...
Cash comparisons between the companies are eye-opening. Seagate's 2012 ending cash position was nearly identical with the start of the year; Western Digital was up by $1.1 billion. Seagate spent $1.4 billion on stock buybacks, while WD spent $.66 billion. Seagate also spent $518 million on dividends, compared to WD's $181 million. Making the comparison extreme is the fact that Western Digital is 1.55 times the size of Seagate. So, which do you think is the grasshopper, and which the ant?
Why is Seagate up at all? Don't forget about the law of supply and demand. A constant flow of buyback dollars has an effect on the share price. It rises temporarily when there are more buyers than sellers. What I find compelling is that Western Digital is up quite a bit more, with far less tinkering. Clearly, I think, its more sophisticated investors find the pursuit of technology a superior path to shareholder rewards.
So, which company is right? Well, again, I'm no expert. What I do know is that Seagate now has much less cash on hand to buy flash drive technology, or do anything else, for that matter. And once it's retired another 30% of the shares, it will have even less money when the time comes to buy a "mature" flash drive company at sharply higher prices. Hmm, what sounds like the better way to reward shareholders: invest in technology that is clearly the future of the business, or get rid of excess cash while waiting for a better entry point?
What is the likely outcome? Well, if history repeats (or rhymes), Seagate will eventually face a huge financing nut relating to its tardy effort to acquire flash technology. One way to free up cash will be to cut the dividend. Then it will then borrow a ton of money, at much higher rates than today's, or perhaps raise funds in a massive issuance of "new" stock. None of these things will be good for the stock price.
At present, Seagate's per share price is about $40, Western Digital's 65. I see this as a perfect test case for my abhorrence of buybacks. I hereby go on the record with a prediction: five years from now, Western Digital will have significantly outperformed Seagate (not by a few percentage points, but by factors: two, three, four times). Will I actually make the bet (perhaps by shorting Seagate, or establishing option spreads in Western Digital's favor? Probably not. I'm a Bondsman, after all.
Update: Over a year later. The trends I discussed above continue. Seagate's revenue has fallen 4.7% in 2014, while net income has declined even faster, 14.58%. Yet the stock is up 40% for the year (to $56). Why would that be? Well, while the market is rising as a whole, such a sharp rise against a backdrop of dreary financial results can only be understood in the context of stock buybacks. As for Western Digital, its revenue fell much less (1.44%), while its net income has exploded 65%. And Western Digital's price is up even more than Seagate, even though its buyback program is dwarfed by Seagate's. What do you think will happen to Seagate's price when the company stops blowing its cash on buybacks? Western Digital, using far less cash for buybacks and dividends, is investing in the core business. Down the line, I continue to predict that it will outperform Seagate by large margins.
Update: January 2015. Well, I did take a flyer in Western Digital, purchasing out of the money calls and selling at the money calls. The stock flew up, and I ultimately cashed out for a $5,000 profit. No big deal, but a nice confirmation of my read on WDC. As to Seagate, it just announced that it's halting stock buy-backs, now indicating that they only make sense below a stock price of $60. Guess what? The stock immediately dropped 7%. Why? Because folks were counting on further buybacks! Guess what's going to happen going forward? Gravity, folks!
Update: May 2016. Well ... Both stocks have hit hard times. Today Seagate is trading at $18.64, Western Digital at $35.74. Both have been rocked by a slump in sales of personal computers, and both are down roughly 70% from year ago highs. Now, however, Western trades nearly double Seagate. So, even in tough times, its price relative to Seagate has improved sharply. And, despite sharp controversy relating to Western's purchase of flash drive maker Sandisk, the company has solidified its technology going forward. So, it has spent its money on the company's future. And Seagate? It announced ANOTHER $2.5 billion buyback a year ago. The result? The stock has PLUNGED, and now has a preposterous dividend of 13% (200% of net income, while Western's dividend yield is a far more sustainable 5%). All that money, tossed overboard in the name of enhancing shareholder value! Once Seagate cuts its dividend, the stock will face more downward pressure. The company will still have its core technology issue and the prospect of further income erosion. So, I'm fairly sure the gap between the two companies will widen further ... much further. Does that make Western a good buy? Hell if I know. This article is, after all, about the follies of stock buybacks. I think that point is strongly substantiated by this ongoing thread. An arbitrage strategy, shorting Seagate and going long Western might be attractive, but that's no longer my game.
Notably, the article proceeds to draw a comparison with Seagate's main rival in the disk drive business, Western Digital. It says that Seagate's share price is up 30% this year, while Western Digital's is up 50%. The difference is that Western Digital has been investing its "excess cash" in flash memory acquisitions, a strategy Seagate dismisses as premature. The company president is confident that he'll be able to buy mature technology later on.
Now, I am no expert in this business, but I do know that flash drives are vastly quicker than disk drives. For example, the very sexy Ultrabook I'm using to compose this blog boots up in seventeen seconds, due to its advanced flash memory. I also know that flash is upending memory technology across the board. The very biggest players (EMC and IBM) are investing huge sums in this area. So, what I see here is a classic face off between a company committed to financial engineering and one committed to reinvesting in the business.
While both companies have risen sharply over the last three years, that rise is from very low levels following a long period of distress: too much capacity and falling volumes. Seagate bottomed at $3.80, Western Digital at $11.45. Neither, therefore, has been a particularly great investment over a 15 year span. Still, economic recovery coupled with careful capacity management has caused both stocks to soar in the last couple of years.
With its "shareholder friendliness" and 26% buyback, why has Seagate's recovery lagged its rival's? Well, folks, follow the money! As opposed to dividends, which clearly end up in the shareholders' pockets, and are therefore, clearly shareholder friendly, the funds allocated to buybacks have ended up in the pockets of ... the sellers! People who no longer own Seagate (or who own fewer shares) have received the dough. For the rest, it's gone! If that makes you feel like a sucker for loyally staying the course, well ...
Cash comparisons between the companies are eye-opening. Seagate's 2012 ending cash position was nearly identical with the start of the year; Western Digital was up by $1.1 billion. Seagate spent $1.4 billion on stock buybacks, while WD spent $.66 billion. Seagate also spent $518 million on dividends, compared to WD's $181 million. Making the comparison extreme is the fact that Western Digital is 1.55 times the size of Seagate. So, which do you think is the grasshopper, and which the ant?
Why is Seagate up at all? Don't forget about the law of supply and demand. A constant flow of buyback dollars has an effect on the share price. It rises temporarily when there are more buyers than sellers. What I find compelling is that Western Digital is up quite a bit more, with far less tinkering. Clearly, I think, its more sophisticated investors find the pursuit of technology a superior path to shareholder rewards.
So, which company is right? Well, again, I'm no expert. What I do know is that Seagate now has much less cash on hand to buy flash drive technology, or do anything else, for that matter. And once it's retired another 30% of the shares, it will have even less money when the time comes to buy a "mature" flash drive company at sharply higher prices. Hmm, what sounds like the better way to reward shareholders: invest in technology that is clearly the future of the business, or get rid of excess cash while waiting for a better entry point?
What is the likely outcome? Well, if history repeats (or rhymes), Seagate will eventually face a huge financing nut relating to its tardy effort to acquire flash technology. One way to free up cash will be to cut the dividend. Then it will then borrow a ton of money, at much higher rates than today's, or perhaps raise funds in a massive issuance of "new" stock. None of these things will be good for the stock price.
At present, Seagate's per share price is about $40, Western Digital's 65. I see this as a perfect test case for my abhorrence of buybacks. I hereby go on the record with a prediction: five years from now, Western Digital will have significantly outperformed Seagate (not by a few percentage points, but by factors: two, three, four times). Will I actually make the bet (perhaps by shorting Seagate, or establishing option spreads in Western Digital's favor? Probably not. I'm a Bondsman, after all.
Update: Over a year later. The trends I discussed above continue. Seagate's revenue has fallen 4.7% in 2014, while net income has declined even faster, 14.58%. Yet the stock is up 40% for the year (to $56). Why would that be? Well, while the market is rising as a whole, such a sharp rise against a backdrop of dreary financial results can only be understood in the context of stock buybacks. As for Western Digital, its revenue fell much less (1.44%), while its net income has exploded 65%. And Western Digital's price is up even more than Seagate, even though its buyback program is dwarfed by Seagate's. What do you think will happen to Seagate's price when the company stops blowing its cash on buybacks? Western Digital, using far less cash for buybacks and dividends, is investing in the core business. Down the line, I continue to predict that it will outperform Seagate by large margins.
Update: January 2015. Well, I did take a flyer in Western Digital, purchasing out of the money calls and selling at the money calls. The stock flew up, and I ultimately cashed out for a $5,000 profit. No big deal, but a nice confirmation of my read on WDC. As to Seagate, it just announced that it's halting stock buy-backs, now indicating that they only make sense below a stock price of $60. Guess what? The stock immediately dropped 7%. Why? Because folks were counting on further buybacks! Guess what's going to happen going forward? Gravity, folks!
Update: May 2016. Well ... Both stocks have hit hard times. Today Seagate is trading at $18.64, Western Digital at $35.74. Both have been rocked by a slump in sales of personal computers, and both are down roughly 70% from year ago highs. Now, however, Western trades nearly double Seagate. So, even in tough times, its price relative to Seagate has improved sharply. And, despite sharp controversy relating to Western's purchase of flash drive maker Sandisk, the company has solidified its technology going forward. So, it has spent its money on the company's future. And Seagate? It announced ANOTHER $2.5 billion buyback a year ago. The result? The stock has PLUNGED, and now has a preposterous dividend of 13% (200% of net income, while Western's dividend yield is a far more sustainable 5%). All that money, tossed overboard in the name of enhancing shareholder value! Once Seagate cuts its dividend, the stock will face more downward pressure. The company will still have its core technology issue and the prospect of further income erosion. So, I'm fairly sure the gap between the two companies will widen further ... much further. Does that make Western a good buy? Hell if I know. This article is, after all, about the follies of stock buybacks. I think that point is strongly substantiated by this ongoing thread. An arbitrage strategy, shorting Seagate and going long Western might be attractive, but that's no longer my game.
Thursday, September 12, 2013
Reality vs Hype
In the world of investing, you are subject to an endless flow of hype. At every level, from the most granular (a specific stock, annuity, fund, ETF, REIT, option straddle, etc.) to the broadest (are we on the brink of collapse, or historic opportunity?), experts will bombard you with recommendations to DO SOMETHING NEW! Overwhelmingly, they want you to stop whatever you're doing now, and follow them down a yellow brick road of endless opportunity. They will always make their advice seem irresistable, with pie charts, tables, Powerpoint slides and inspirational videos sweeping you into ... well, usually questionable actions.
The most useful advice I can give you is to remember that the interests of people who come to you unasked are vastly different from yours. Every time you follow such an expert's advice, he or she makes money. Do you? Distressingly, most people have no answer to this question. They swing one way for awhile, then head off in another direction, but ultimately don't know what's working and what isn't.
To do better, long term, you MUST keep track of your own personal results. It is utterly amazing to me that many people have no real idea of how they are doing with their investments. They might look a year-end statements from a brokerage or mutual fund, but usually don't track things more closely.
If you haven't set set up a means of monitoring your investments, both short and long term, then you should start now. If the technology is intimidating, then hire someone to do it. Mind you, hire them to track your investments, not direct them. You should still do the latter, particularly if you're interested in being a Bodacious Bond investor. If you're at all tech savvy, or willing to become so, then there are many tools to help you. Things like Quicken will hold your hand throughout the (frankly painful) setup process. I personally make do, and very well, with a spreadsheet, I use Open Office, which is free, but most folks have a version of Microsoft Excel lying around too.
What you need to do is get a comprehensive listing of what you own, when you got it, what it cost when you got it, and what it's worth now. Money in and money out is exceptionally important. If you're saving regularly (a very very good thing), then you might be building substantial net worth, but still be failing as an investor. Your tracking system should enable you to distinguish between the performance of money already invested, and new money coming in.
Where am I headed with this? Simply put, once you have a detailed tracking system in place, then you are positioned to take charge of future choices. When you bite on a new ETF promising to goose returns by buying commodities, you can see how it actually does, as compared to the glowing, back-tested projections in the brochure. Whenever you do something new, I would strongly recommend including a note as to why you did it. Look at that note regularly, and see how your reasoning has worked out over time. I guarantee this will be a sobering experience, particularly so in the world of stock investing. Even if you own a portfolio richly studded with Microsoft, Google, Facebook, IBM, EMC, etc., you will probably be bewildered by how much less well you have done than all the charts would suggest.
If you are like me, or the huge majority of individual investors, your tracking tool will help you see the vast gap between hype and reality. One key thing you might learn is that hype can come from within just as easily as without. In the grip of enthusiasm (or depression) we are all prone to doing goofy things. Your tracking tool will be relentlessly objective, even if you are not. Most likely, you will, reluctantly or not, come to the realization that a plan is necessary. If you're attracted to bonds (since you've come thing far in my blog, I'm sure you are), then the Bodacious Bond portfolio might be perfect for you. And note one thing: I won't make a dime off of you! This blog is a labor of love after all.
The most useful advice I can give you is to remember that the interests of people who come to you unasked are vastly different from yours. Every time you follow such an expert's advice, he or she makes money. Do you? Distressingly, most people have no answer to this question. They swing one way for awhile, then head off in another direction, but ultimately don't know what's working and what isn't.
To do better, long term, you MUST keep track of your own personal results. It is utterly amazing to me that many people have no real idea of how they are doing with their investments. They might look a year-end statements from a brokerage or mutual fund, but usually don't track things more closely.
If you haven't set set up a means of monitoring your investments, both short and long term, then you should start now. If the technology is intimidating, then hire someone to do it. Mind you, hire them to track your investments, not direct them. You should still do the latter, particularly if you're interested in being a Bodacious Bond investor. If you're at all tech savvy, or willing to become so, then there are many tools to help you. Things like Quicken will hold your hand throughout the (frankly painful) setup process. I personally make do, and very well, with a spreadsheet, I use Open Office, which is free, but most folks have a version of Microsoft Excel lying around too.
What you need to do is get a comprehensive listing of what you own, when you got it, what it cost when you got it, and what it's worth now. Money in and money out is exceptionally important. If you're saving regularly (a very very good thing), then you might be building substantial net worth, but still be failing as an investor. Your tracking system should enable you to distinguish between the performance of money already invested, and new money coming in.
Where am I headed with this? Simply put, once you have a detailed tracking system in place, then you are positioned to take charge of future choices. When you bite on a new ETF promising to goose returns by buying commodities, you can see how it actually does, as compared to the glowing, back-tested projections in the brochure. Whenever you do something new, I would strongly recommend including a note as to why you did it. Look at that note regularly, and see how your reasoning has worked out over time. I guarantee this will be a sobering experience, particularly so in the world of stock investing. Even if you own a portfolio richly studded with Microsoft, Google, Facebook, IBM, EMC, etc., you will probably be bewildered by how much less well you have done than all the charts would suggest.
If you are like me, or the huge majority of individual investors, your tracking tool will help you see the vast gap between hype and reality. One key thing you might learn is that hype can come from within just as easily as without. In the grip of enthusiasm (or depression) we are all prone to doing goofy things. Your tracking tool will be relentlessly objective, even if you are not. Most likely, you will, reluctantly or not, come to the realization that a plan is necessary. If you're attracted to bonds (since you've come thing far in my blog, I'm sure you are), then the Bodacious Bond portfolio might be perfect for you. And note one thing: I won't make a dime off of you! This blog is a labor of love after all.
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