Tag Archives: education

A Portfolio For The Next Market Crash – Revisited

Summary In February 2013, I published my thoughts on portfolio allocation and construction, assuming a negative market event in the next five years. That event has not yet occurred. In the interim, how has my portfolio held up? My relative conservatism has had its costs, but the portfolio still has performed pretty well, except for bad a call to include some exposure to oil. Going forward, what to do? I conclude this article with some thoughts on that. Two-and-half years ago, I published an article called “A Portfolio For The Next Market Crash”. The premise was that sometime in the next five years, there will be a significant negative market event, that a prudent investor should be prepared for such an event, but that in the meantime, equity returns were going to beat other investments. Halfway through the five years, the market event has not occurred and the equity market has provided good returns. The market, as represented by the S&P 500 plus dividends (Pending: GSPC ), is up about 30% in the two-and-a-half years, a return that would (or at least should) delight long-term investors for the long term. (click to enlarge) Therefore, we have to conclude that I left money on the table by suggesting that about a 50% allocation to equities was prudent. Had I said 70%, that would have been better with hindsight. But if and when the negative market event occurs, the 50% allocation will look better. I made two serious mistakes, however. One, I said an investment in non-leveraged oil companies should be part of the portfolio, basically as a hedge against inflation. I got the non-leveraged part right, but the oil part was dead wrong. And my portfolio has suffered from that. (On the bright side, my portfolio would have suffered far more had I invested in leveraged oil companies – or a leveraged shale play). Two, I shied away from longer-term debt on the ground that the downside was greater than the upside. In practice, the upside has come to pass. Again, I was too cautious, but for the right reasons, I think. Perhaps these errors of caution come from being over 70 years of age, when it is harder to recover from losses because one has less time. I did get the general theme right however: Invest in companies with low leverage and strong market positions. In general, those companies have performed well, with less risk. Companies I mentioned were Apple (NASDAQ: AAPL ), Cisco (NASDAQ: CSCO ), Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ), Bio-Reference Laboratories (NASDAQ: BRLI ), and Healthcare Services Group (NASDAQ: HCSG ). All have performed pretty well, with most performing better than the market. Berkshire is the laggard, with approximately market performance. BRLI’s performance depends on what you did with your shares after the merger with OPKO Health (NYSE: OPK ) was announced on June 4 of this year. That merger changed the nature of the investment, as I wrote at the time. If you sold about half of your BRLI holding soon after the announcement, as I suggested I would do (and did at $41.90), then for that part of your holding, you did just fine. Unfortunately, for the other half that you held, you have not done well so far, with the losses on OPKO Health destroying a lot of value. OPKO Health may pan out over the long term, but I wish I had sold all my BRLI instead of just half. As a consequence, I am sitting with a long-term investment that I did not really choose. I still hope it will pan out. That’s the basic two-and-a-half-year scorecard. Not bad. But where do we go from here? Is the negative market event still to come? Or did this past summer’s fake-out substitute for it? I think this summer’s mini-correction was indeed a fake-out. A few weeks ago, I wrote that: Interest rates and spreads have been kept low in recent years not only by central banks, but also by high global savings. Global savings rates appear to be declining, with the result that there is less money chasing yield. Just as pro-cyclical forces reinforced the narrowing of spreads in the recent past, such forces now will go into reverse and will make life hard for weak credits. Corporate bonds and emerging market debt will suffer. And I think I see a knock-on effect on the U.S. stock markets. I am sticking by that medium-term assessment despite the market having reacted otherwise in the last few weeks. The market is driven by sentiment, the lack of good alternatives, and the shilly-shallying Fed. Eventually, fundamentals come to the fore. And too much credit for companies and states that cannot afford to service it, much less repay it, is a fundamental that is hard to run away from for very long. It already is catching up with leveraged oil companies and leveraged companies that have depended on oil exploration and development or Chinese consumption of natural resources. That has an influence on their lenders as their own futures. Other non-U.S. borrowers in dollars also are likely to become victims, as will their lenders. Market Drivers I think we are seeing a market that is increasingly divided between the newer-style companies that have relatively few employees and comparatively little invested in hard assets, which are doing very well, and the older-style companies that have many employees and higher levels of hard asset investments that are not doing as well. I think this bifurcation is going to continue. Here are a couple of graphs that I think indicate the change that has been occurring over the last 40-plus years and that is continuing. Comparison between income per employee of the Top 50 U.S. public companies by market capitalization with the Top 20 U.S. public companies by number of employees 1970-2013, in dollars deflated to 1970 using the GDP deflator (data from S&P Capital IQ, computations and graph by Martin Lowy) (click to enlarge) Net Income as a percentage of revenue for the Top 50 public U.S. companies by market cap versus the Top 20 ranked by number of employees, 1970-2013, in dollars deflated to 1970 using the GDP deflator (data from S&P Capital IQ, computations and graph by Martin Lowy) (click to enlarge) As you can see, the top 20 companies by number of employees have had a relatively static income per employee compared with the top 50 companies by market cap. (It has increased, but little by comparison). That is because the types of companies in the top 20 by number of employees have remained fairly constant while the types of companies in the top 50 by market cap have changed dramatically, as the likes of Apple, Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ), Microsoft (NASDAQ: MSFT ), Amazon (NASDAQ: AMZN ) and Facebook (NASDAQ: FB ) have replaced more employee-heavy and resource-rich (mostly oil) companies. It is the employee-light companies that have provided the big returns over the last 20 years. At the current point in the business cycle, this disparity in investment returns is likely to grow even further, as less slack in the labor market (weekly initial unemployment claims are the lowest since 1973, according to Calculated Risk , for example) leads to higher wages and governmental policies are evolving toward requiring employers to pay more for employees in a variety of ways (healthcare, overtime, minimum wage, to name a few). The employee-heavy companies have nowhere to turn to increase their profits because most of them are under pricing pressure from the employee-light companies. We saw that recently as Wal-Mart (NYSE: WMT ) announced depressed results due to increased employee costs and its response to that result as being to invest in competing with Amazon. Some think Wal-Mart will not succeed at this. See New York Times on the subject here . The gig economy is moving in the same direction. Competition from the likes of Uber (Pending: UBER ) and Airbnb (Pending: AIRB ) affects high-employee and high-fixed investment companies more than it does the opposite. Therefore, even though I may not be able to anticipate where the gig economy will strike next, I do anticipate that it will be in sectors that require high fixed investments or high levels of employees relative to revenue. Based on these considerations, I am configuring my portfolio to reduce exposure to employee-heavy companies as well as highly leveraged companies. There are still plenty of investments to choose from without those. Of course, I am not the only person in the world who has noticed these trends, and they are reflected in stock prices. Therefore, in many cases, one has to go up the p.e. scale in order to buy in. What to do going forward? Where does this leave us regarding a going-forward investment posture? (1) I am sticking to my basic asset allocation – 50% stocks. People I respect (e.g., Cam Hui) are saying the remainder of 2015 will be good for stocks. But I still fear a reversal of some consequence in 2016. There are just too many things that can go wrong for a market that still seems priced for perfection. And if something could go wrong in 2016, it could go wrong earlier. (2) I am reviewing my portfolio to make sure that on balance it reflects my investment thesis. Though there will be exceptions, I do not see the high-employee-count style of a company as the engine of future growth. (An exception in my portfolio is Berkshire, which now ranks among the nation’s largest employers. Its net income per employee remains respectable, and its large number of employees is accounted for by the sheer size of its portfolio of companies). One of the questions that a few readers asked two-and-a-half years ago was why I am not recommending international exposure. I replied at the time that (1) where a company manufactures and sells matters more than where it is headquartered or its stock is listed, and (2) most large U.S. companies offer significant international exposure. For example, look at Apple’s recent financial results, which were driven by sales and profit increases in China, according to the WSJ . Despite many U.S.-based frauds etc., I place more trust in the financial information from companies subject to U.S. accounting conventions and securities laws than I do in companies subject to other rules. The kind of company that I wish I could find more of is MarketAxess Holdings (NASDAQ: MKTX ), which operates a leading bond trading platform. It has a high return on capital, few employees, and operates in a space that is ripe for automated takeover because the costs of traditional bond trading have been astronomical. The stock is up five-fold over five years, but there still should be plenty of room for growth unless some other similar platform steals market share or undercuts the pricing. Perhaps some readers will give me good ideas. Please remember, I am not a securities analyst. I am just a guy who reads a lot and tries to reflect the panoply of things going on in the world in his investment decisions. I also enjoy my interaction with the Seeking Alpha community.

Westar Energy: Why I’m Buying This Midwest Utility

Summary Westar Energy is a solid utility company with an 11-year history of increasing its dividend. Kansas economy grows despite tax problems initiated by its state governor. Westar stock sports a 3.89% yield. I’ve been watching Westar Energy (NYSE: WR ) since 1999. As a journalist, I covered the rise and fall of David Wittig, former Westar Energy CEO, who ran the utility like a hedge fund, making a big bets on various businesses unrelated to electricity generation. Westar Energy was for many years a natural gas and utility business. Because of Wittig’s mismanagement, the company was forced to sell natural gas assets to pay down debt. The debt reduction and subsequent CEOs’ focus on improving Westar’s utility business helped the company’s bonds become investment grade by the rating agencies. The company is way more attractive today as an investment than 16 years ago when I started covering it. I have met every CEO of this company since 1999. Toward the end of his reign Wittig was trying to dismantle the company by selling off assets, it was sad to watch. Investors who bought the stock at $9 per share during the crisis in the early 2000s have done quite well, but at the time, there was a very dark cloud over the company. I believe Wittig should have been running a hedge fund, not a regulated utility. Wittig resigned in November 2002 amid a scandal that involved a local banker in a real estate deal. Wittig’s cloud hung over the company until the two parties settled for $36 million payout to Wittig in 2011. Under CEO Jim Haines, Westar streamlined into a pure-play utility company. Bill Moore continued this mission while embracing wind power and cheap natural gas generation. Current President and CEO Mark Ruelle has picked up momentum by investing in wind generation and transmission projects while upgrading coal fired power plants to meet stringent emission standards. Westar spent over $1 billion in air quality investments in the past five years. The company is winding down expenses in air quality, from upwards of $200 million annually to less than $100 million this year and less than $30 million 2016. A June 2, 2015, presentation says Westar has seen “dramatic improvements in air quality.” Wind Renaissance Meanwhile, Westar Energy has really increased its use of renewable energy, especially wind. Renewable energy is currently 9% of generation mix — more than uranium at 8%. Renewable energy will grow to 16% in 2015. This is huge. And coal is declining. Westar uses cheap natural gas to generate electricity. Natural gas is easier to use than coal. Coal plants take some time to start up and shut down. Natural gas generators are quick to turn on and off. So natural gas assets are timely when the wind isn’t blowing, although the wind blows mightily in western Kansas most of the time. (click to enlarge) A year ago, Prairie Wind Transmission, LLC, a joint venture between Westar Energy and Electric Transmission America, celebrated completion of its 108-mile, 345-kilovolt high-capacity electrical transmission line in south-central Kansas. The double-circuit line will serve as an electric energy super highway between eastern and western Kansas, promoting growth of renewable energy in Kansas, providing greater access to lower-cost electricity and improved reliability in the region. Electric Transmission America is a joint venture between subsidiaries of American Electric Power (NYSE: AEP ) and Berkshire Hathaway Energy (NYSE: BRK.B ) to build and own electric transmission assets. “With our current wind resources and those we’ve already committed to next year, we’ll have enough renewable energy to power half our residential customers,” Ruelle said in a recent call with investors. Ruelle said Gov. Sam Brownback has favored renewables. “It’s just pragmatic Kansas politics,” Ruelle said . “He has been a big sponsor of renewables and supported renewables for what it means for rural Kansas. But as you also know there are folks that don’t like the concept of subsidize the energy period and Kansas has made a lot of progress in renewables and everybody has sort of been doing it…We have been doing it because that makes sense economically. And basically Kansas got to a place where we didn’t think a mandate was probably needed to step it up. We’re doing it not because of the mandate, we’re doing it because it’s relatively inexpensive and it’s a good way to navigate the environmental rates.” Westar Energy is the largest electric energy provider in Kansas, providing generation, transmission and distribution to approximately 687,000 customers in east and east-central Kansas. The company is headquartered in Topeka, and employs about 2,400 people in Kansas. Its energy centers in 11 Kansas communities generate more than 7,000 megawatts of electricity, Westar operates and coordinates 34,000 miles of transmission and distribution lines. The Economy The Kansas economy has grown slowly and steadily since the Great Recession of 2008-09, but lags the robust growth of Nebraska or Colorado. Kansas Gov. Sam Brownback is business friendly, but his tax policy has drained state reserves and forced cuts to education and welfare. The political situation here is backward to say the least. Growth occurs in places like Wichita because it is more entrepreneurial than Topeka, it’s not surprising that Pizza Hut started in Wichita. You will find more entrepreneurs in western Kansas than in the statehouse of Topeka. Kansas’ Gross State Product has grown from $121 billion in 2009 to $144 billion in 2013. In a recent conference call, Ruelle said, industrial sales were mixed to down. “The biggest negatives are from our largest chemical manufacturer and pipelines reflecting the impact of lower oil prices,” Ruelle said. “On the positive side, the refineries were operating at capacity and commercial aerospace remains strong. Other good news is that the large candy maker (Mars) who just came to our service territory a couple of years ago has already announced a big expansion and that will add a few more megawatt to our sales.” Rate case Westar Energy asked regulators for a $152 million rate increase but the Kansas Corporation Commission staff recommended $55 million based on a 9.25% Return on Equity (ROE). “If adopted that would be among the lowest authorized ROEs in the nation,” Ruelle said on the investor conference call. I believe the KCC’s proposed 9.25% ROE is lower than the historically 10% to 11% ROE built into previous rate cases. The KCC’s decision on the rate case is expected by Oct. 28 with implementation of new rates in November. I predict a negotiated settlement somewhere around $75 million. That would add $0.53 cents per share in revenue or about $0.06 cents per share in profit. EPS for the trailing 12 months was $2.25 per share, while the company is predicting 2015 earnings guidance at $2.18 to $2.33 per share. An additional $0.06 cents from the rate case would increase EPS by 2.6%. With large air quality projects finishing in 2015, the company’s need to raise capital has diminished. The company has a decent balance sheet, plenty of liquidity and no need for new equity. As a result, I expect the company to continue its trend of increasing its dividend. Growth and income investors will like this: The company has increased its dividend every year for 11 years. Payout ratio is reasonable at Westar Energy. Company pays out 60% to 75% of earnings in dividends. The current $0.36 cent per share quarterly dividend is a yield of 3.89%. I like the stock at $36.00. I believe the stock is fully valued at $40 per share. WR was trading at $39 per share in mid August before the recent stock market correction. Risks It is likely the Federal Reserve will start raising interest rates. This may or may not happen in 2015, but I do expect rates to go up by fall 2016. The cost of debt will go up for all utilities, including Westar Energy. However, I believe we will see relatively low interest rates for many years, perhaps the next decade. Economic growth is sluggish in Kansas. Gov. Sam Brownback eliminated income taxes for most small businesses, with the hope the owners would re-invest the tax savings into job creation. But business owners, farmers and ranchers did not need additional employees, so they never went on a hiring spree as Brownback had hoped. With a reduction in state revenue, local school boards will likely raise property taxes to fund the education gap. Weather has been mild all year, reducing the need for a boost in generation that is typical in summer months. Conclusion Westar Energy is a solid company with good management. A year ago I had purchased Westar stock at $36 per share and sold it at $40 per share. I recently bought shares at $37.07, and may add shares at lower prices. The stock market is going through substantial volatility. I can sleep at night owning this stock. People need electricity. Westar rates are among the most affordable in the country. I believe a rate increase will happen this fall and the company will be able to raise its dividend in 2016. Disclosure: I am/we are long BRK.B, WR. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Time To Short The VIX?

Summary Historically, we haven’t reached breakout status for the VIX. Many global factors are at play. This is possibly an economic event leading to longer periods of backwardation. The last week in volatility has been very exciting to say the least. The VIX Index logged the highest ever one week gain in percentage terms. Again, we immediately had the pundits out yelling short the VIX. I saw posts on Thursday around the web urging readers to short the VIX. Someday, this will end poorly for them and the people that heed their advice (Friday should have been a good sign). Below we will examine whether this really is a good opportunity to short in terms of risk verses reward. I am always analyzing my risk and reward in a trade. Once the reward begins to outweigh the risk, then I will begin planning my entrance. I believe risk and reward are currently the same. Essentially giving you a 50/50 chance of profiting right now. More to come on that later. Let’s start by reviewing the past month for the Proshares Ultra VIX Short-Term Futures ETF (NYSEARCA: UVXY ) and the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ: XIV ). You can clearly see the effect of last week in the chart. Similarly here is a chart showing the front-month VIX futures contract. As you know (or should know), UVXY does not track the VIX Index, which is currently at 28. This is a large divergence from the front month futures contract. Remember futures trade independent of the market and the VIX Index. This, in my opinion, means that investors aren’t that concerned yet over a crash in the markets. U.S. economics continue to be neutral to positive. However, global economic fears are beginning to spillover. Just six months ago analysts were touting emerging markets, now look at them. For more on how UVXY profited during the 2008 and 2011 VIX events, check my library here on Seeking Alpha. UVXY will benefit from the current levels of backwardation if they can hold for a longer period of time. See below: (click to enlarge) Backwardation at 6.5% roughly means that UVXY will increase 13% in one month’s time if futures stay the exact same price, minus any fund fees. Now we know futures never stay the same, but this is just an easier way to think about contango and backwardation. Backwardation hit over 20% in 2011 and over 40% in 2008 (backtested). Backwardation is the only way UVXY will hold profits over longer periods of time. Again, check my library for articles on backwardation if you are unfamiliar with the term. Historical Numbers I know many of you are very excited about this spike. However, let’s compare this event to past events. Backwardation: (click to enlarge) At 6.5%, this puts backwardation higher than a normal political event. If you remember in my last article we discussed the differences between an economic and political event. This event, so far, is leaning towards an economic event. Economic events are usually much more drawn out. I told you earlier in the year I was looking for a backwardation event higher than 10%. I believe this could become that event. More about this in the conclusion. Futures Levels Futures levels directly impact UVXY. Here is a longer-term chart of those futures levels: Yes, futures are towards the higher end of what they have been over the past three years. However, this is nowhere near breakout status. Futures generally trade lower than the VIX Index during a spike. For reference however, here is the VIX Index dating back to 1990: Conclusion The best entry points in the VIX futures, for shorting UVXY or going long XIV, occur during periods of prolonged economic turmoil. Yes, we logged the highest ever one week rise (by percentage) in the VIX Index. However, I feel we still have room to rise. Those pundits that are shouting short the VIX may be right or may be wrong, that is not the point of this article. I like a lot of reward for the risk I am taking. I don’t see the VIX returning to 12 anytime soon. We are in a prolonged period of slower economic growth. Eventually that was going to catch up to valuations and the U.S. stock market. We have recessions in Brazil and Chile. We have slowing growth in China, which should be your biggest concern. The Greek drama is off the table for now but you still have a case of many countries within the Euro that have very high debt levels and growth that isn’t high enough to sustain it. Here in the U.S. we also have unsustainable debt levels but can print however much money we desire. Ultra low rates have helped lower the burden of interest payments but the lack of decent inflation has backed The Fed into a corner in regards to raising rates. A September rate hike would spook the markets. The fact we don’t see higher inflation even given the ultra low interest rates is a realization and confirmation of the slow growth era. For now, I will remain on the sidelines and hope conditions continue to worsen. If I miss the opportunity, I am certainly okay with that. My total VIX portfolio is up a healthy amount YTD and I am fine with locking in those gains instead of gambling it away. This is not to say that I am not salivating at the mouth for a chance to short the VIX. Here is what I am currently watching, in order of importance: The Fed (what’s going to happen with rates, I view any delay as a negative confirmation on the U.S. economy) Economic data out of China (can the government stop the decline this time?) U.S. employment data (weekly) Devaluation of the Yuan (will it continue?) Economics in South America Political/debt situation in Europe (Greece drama is on the back burner for now) I am not backing up the truck to short this spike. We may get a bounce in the U.S. next week but economic problems always take a while to resolve themselves. I would short the VIX with caution if you feel that is the right thing to do. Call spreads (more info on my blog), stop losses, and not jumping all in help to limit your risk/reward. Risk management is needed here, otherwise you are just gambling. I wish you the best this week and know that I will be following the situation and posting updates when needed. It will be an interesting week! Should conditions deteriorate even more, I might begin shopping for a small position. With school starting, I would only be looking for a more long-term position since I am busy during the day. I just need more reward for the current level of risk. Donate to my classroom! I am trying to create a 360 degree mathematics classroom. Much of the money I make here on Seeking Alpha is donated back into public education, something I really believe in. My students come from the highest area of poverty where I live. They are truly great students with a desire to better themselves. My job is to level the playing field and give them a chance to succeed. One tool I used last year at a different school was a 360 degree mathematics classroom. It is a great tool for math teachers. A lot of what I teach lays the foundation for financial literacy and success in post-secondary education. Here is the link if you would like to help fund my 360 degree boards. Use the code SPARK at checkout (until 8/27) and your donation will be matched 100% up to $100. Currently they are running another promotion from The Gates Foundation that will also match 100% up to $1,000 (which would be more than what is needed). That code is JUMPSTART but will only be available for a limited time. You can’t use both codes. All donations are tax deductible and will make an actual difference in the education of some great kids. We are getting close to funding. Thank you! Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in UVXY over the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.