Stockwatch: Proctor & Gamble - September 19, 2009

Recently, Proctor & Gamble stock has been on the move, reaching $57.32 this last Friday (up $1.79 that day). For most of the last year, P&G has been a disappointment. Since late April, P&G had been stuck in the $50-56 range. While the market has rallied nearly 60% off the March lows, P&G has only risen 27%. In early August, P&G reported 4^th quarter earnings of 80 cents a share, beating expectations of 79 cents a share by a penny but down from last year’s 92 cents a share. In addition, P&G forecast first organic sales growth of 0 to -3%. The stock immediately dropped from about $55.46 to $51.46 a couple days later.

Traditionally, P&G has been considered a solid defensive stock, one to buy in times such as the last year. However this time, P&G has been hit by two distinct problems. First, high commodity prices significantly increased costs, leading P&G to raise prices and to shrink its packaging. This led to the second problem: customers started to trade down – and have stayed there. As a result, P&G has been losing market share.

Now P&G is starting to sing a new tune. Here’s the new news:

- The new CEO, Robert McDonald, took over from A.G. Lafley, the man who drove P&G’s acquisition of Gillette as well as the push toward faster growing, higher margin businesses. For Mr. McDonald, who took over on July 1^st, the fourth quarter (P&G reported 4^th quarter results the first week in office) was just at the beginning of his term.

- For 1^st quarter 2010, P&G still estimates $0.95 - $1.00 in earnings and the Street is at $0.97. Organic growth is still expected to be 0% to -3%. However, for the second quarter, Mr. McDonald anticipates 1-4% organic sales growth. Second quarter will begin in October, 1^st quarter reports should be in the beginning of November.

- P&G sold its drug business to Warner Chilcott fror $3.1 billion on August 24. This is a good sign, meaning P&G is focusing on it’s core businesses.

- P&G has long feared cutting prices on its premium products, but in recent weeks, the company has announced its willingness to cut prices and to reposition its brands. This reflects – finally – a recognition that the landscape has changed, and that price cuts will be necessary to bring back volume and growth.

- The company reaffirmed 2010 earnings of $3.99-$4.12 for 2010. This includes a one time $0.44 benefit and a $0.10 – 0.12 dilution from the sale of its pharmaceutical business. Before, analysts were expecting $3.65 - $3.80.

With the stock trading at $57.12, this places P&G’s current valuation at about 14x 2010 earnings (excluding the benefit from the Warner Chilcott sale and using $3.80, P&G would trade at 15x 2010 earnings). Compare this to the current S&P index, which stands at 1068 and has projected earnings of $72.96 for a 14.6x PE. Debates about S&P projections aside, P&G still trades at a slight discount to the S&P today.

How far can P&G stock go? In the short term, assuming P&G keeps pace with the general market, a 15x multiple on $4.05 2010 earnings would place the stock at $60.75. If we use Colgate Palmolive’s 16x PE ($76.10 / $4.77 = 16x), then P&G would trade at $64.80.

In the longer term, if P&G can return to the days of 6-9% growth and a premium PE of 22x (22x from 2004-2007; as high as 40x from 1999-2001), then we’re talking a stock that would be $80-90 (a conservative $3.80 x 22 PE = $83.60).

Still, that would be some time away. Right now, we’re looking at the likelihood that P&G has seen the trough in sales and the expectation that it can regain growth and stabilize share. Proof, via performance in Q1, would go a long way toward rebuilding confidence and creating upward momentum.

Ming is long PG.

A TBT Trade

I’ve long advocated a trade in the TBT. The thesis has been straightforward: over the long-term, money will have to come out of Treasuries. In times of fear, investors buy Treasuries because it’s the safest security, even though interest payments are very, very low. At some point, risk appetite will come back, and those investors will sell their Treasuries. The TBT is short Treasuries.

This is a long-term trade. The issue is, of course, that in the short term, this trade has a lot of variability. So let me be upfront, this trade is not for the beginner or the part-time player. This is really for someone that takes the time to understand what’s going on in Treasuries.

In the short term, the TBT should see a lot of variability. Given the market’s tremendous run since March, there has been growing fear of a correction. If that occurs, then the appetite for risk will recede and investors will go back into Treasuries. This has already occurred a somewhat, and the TBT, which was as high as the high $50s, is now trading at $46. A run up into the end of the year will cause the TBT to rise, a fall in markets will cause the TBT to decline.

Given that, the TBT can also become a trading vehicle. Again, this is not for novice players, be advised.

If you watch the TBT, it has, in recent months, fallen immediately after the sale of the 4-week Treasury. Then it has risen until the 30 year is sold, and has immediately retreated as soon as the results of the 30-year Treasury auction has been announced. That’s because people expect demand for short term Treasuries to remain high. So the short has performed well, and the TBT retreats after the 4-week Treasury sells well. Then the possibility that longer term Treasuries will not sell well infects the markets, and the TBT rises. In recent weeks, this fear has been unfounded. Fear of a correction has actually caused the longer term Treasuries to sell well. As a result, the TBT retreats after positive 30-year results have been announced.

So here’s the short-term trade hypothesis: buy the TBT after the 4-week auction, and sell just before the 30-year auction. Again, this is for active traders who understand the risk, not for novices. As always, put a stop loss in somewhere around your acquisition price to prevent pain from sudden downward moves.

I am currently long the TBT.

Natural Gas Gets A Bump

Last week, natural gas got a bit of a bump. Much has been said lately about the massive oversupply of natural gas and how natural gas has tracked the cost of oil rather than reflecting fundamentals. In short, recent natural gas discoveries have led to an overabundance of the fuel in the last few years. Surprisingly, the price of natural gas has fallen, but not as much as expected given the oversupply. Instead, natural gas has followed the cost of oil. Analysts believe that if the price of gas falls far enough, producers will eventually be forced to stop production. The market estimates that natural gas will be in the $6-7 range next year, compared to the $2-3 range of recent weeks. If the market is right, then natural gas stocks should be a buy. A small decline in inventories last week created the bump in natural gas last week.

It makes sense that natural gas should bottom as storage reaches maximum capacity. Exactly when that will happen is unclear, and I won’t claim to know. As for investing in natural gas, I am, for the moment, just watching to see if how supply and demand actually works the way we think it does.

I am long XTO (a trade, as opposed to an investment).

Morgan Stanley’s New CEO

I’ve written about and recommended Morgan Stanley through much of this year. Over the last several months, Goldman Sachs has led, taking risk in trading and reaping profits. On the other hand, Morgan Stanley was more conservative, and ironically, suffered as a result. I was encouraged to hear a month or so ago that the firm was beefing up its trading operations and hiring more traders.

This week, the firm announced that John Mack would be stepping down as CEO, and that James Gorman, the head of Morgan Stanley’s brokerage unit, would take over. The problem here: Gorman was a former McKinsey & Co. consultant and currently manages the retail sales side of the house. He has no investment banking experience. This seems to indicate that the board wants to stay conservative and stay away from the risk that is yielding profits for Goldman Sachs. While selling stocks and bonds to retail investors can be profitable, it’s not as profitable as trading.

Of course, we can’t really know until Mr. Gorman has a little time in his job. Still, this wait and see situation changes my position on Morgan Stanley. I’m long, and it’s not a sell, but with any new money, I think it makes much more sense to toss it toward Goldman Sachs. They’ve proven that they can manage risk and profit in this environment. Mr. Gorman may yet try to follow Goldman’s lead, but if the firm remains conservative, it’s likely to lag the market. So why invest in a maybe when you can invest in the proven performer?

I’m long both Goldman Sachs and Morgan Stanley.

September 14, 2009: The Coming Week

After a bit of a run up, it would be reasonable to expect a bit of selling pressure this week. There’s not much expected in terms of market-moving news, just small indicators of trends. We have some tech news with Oracle reporting, and some consumer indicators with Best Buy and Kroger reporting. On the macro side, market watchers will be looking toward retail sales numbers and housing starts. Unless these numbers are significantly out of line, there seems to be little reason to anticipate significant market moves.

September Investing Article

My latest investing article is up at www.asiancemagazine.com. I'd post it here, but it's several pages. Here's a quick overview:

The Next Few Weeks. Over the next few weeks, I don’t expect significant movements in the market. We’re capped by skepticism above and a floor created by recent buyers unwilling to sell. Still, many in the market are positioned for a correction.

A Vulnerable Q3. A quick scan of sectors shows that we’re likely to have mixed earnings, but there’s no convincing case for a bad quarter. Still, we have to account for the possibility of a negative earnings surprises and given the nervousness of markets, we need to be ready for this possibility.

Managing A Position. A look at managing a position in the TBT (short Treasuries) and Apple. Trading with stops is can be a good thing.

Looking Ahead: Financials

I like looking at financials for two reasons. First, they are very indicative of the economy. Their exposure to residential and commercial real estate, credit and capital markets are all mirrors of our economy. Second, the financials will move with the markets, and the long-term thesis remains: over the next 3-5 years, I believe that the financials will offer substantial returns for investors.

The real question is how to handle the short-term. Over the next couple weeks, a correction, probably in the 10-20% range, is likely. Of course, such a correction needs to be confirmed by follow-through (several consecutive down days) and can depend greatly on data, such as unemployment reports (the next is Friday, September 3, 2009). Still, if it occurs, such a correction would actually be a good thing: it allows financial stocks to regroup and continue moving forward.

Personally, I plan to buy into the correction. To be clear, I’m not saying that it’s all clear in the financials, not by any means. As investors, we have to watch out for events or news that could turn stocks in one direction or another.

So here are the things I’m looking at. First, let’s take a look at the capital markets operations – the investment banking side of the equation. This applies to the pure plays – Goldman Sachs and Morgan Stanley, as well as the banks with substantial investment banking operations: Bank of America, Wells Fargo, JP Morgan and even Citigroup.

Over the next couple quarters, investment banking operations should continue to bring profits. In part, the investment banks should do well just because there are now fewer of them. With the fall of Lehman and Bear Stearns and to a certain extent, Wachovia, investment banking business falls to the few remaining players. Meanwhile, trading in government securities, corporate bonds and high yield debt remains very strong. Equity underwriting remains slow, and those that have retail brokerage operations and asset management divisions will see some weakness there. Still, propects remain good here. And, the government continues to support profits in this sector. This all bodes well for Goldman Sachs, Morgan Stanley (to a lesser extent, because it is less aggressive than Goldman), and the investment banking divisions of the banks.

Greater questions emerge in the last quarter of 2009 and going into 2010. Eventually, government support will have to be withdrawn, and if substantial profits are reported through year-end (already, there’s talk that 2009 might be a very strong year for bonuses at Goldman Sachs), withdrawal of support becomes more likely. A tightening of interest rate spreads may also make it harder for these companies to finance their operations. And if the second half of the double dip occurs, trading, debt and government securities operations may very well slow. Remember that in 2009, the investment banks will benefit from companies re-capitalizing their balance sheets and credit markets returning. Much of that may fall away in 2010.

For the more traditional banks, the picture is more serious and I believe that the possibility of a double dip is fairly strong. 2009 has been an usual year because of the need to stabilize the banks. As we go into 2010, the Fed will feel the need to start withdrawing support from the system. Truth be told, the Fed probably wants to support the banks for a long as possible, but I suspect that there will not be the political will to do so because everyone believes the crisis has past. And Washington does not work well without a crisis.

On the economic side, all indications are that foreclosures are now affecting the prime and jumbo market, and these are mortgages that can’t be worked out because these homeowners are having trouble paying their mortgages (due to job losses, etc.). Reports this week say that the number of homes in foreclosure are increasing, not decreasing. Commercial real estate is also beginning to hit the point where they have to be dealt with, and so that will be another hit to the banks. In 2009, banks have delayed recognizing losses by trying to work them out, providing extensions and so forth. We will soon reach the point where delaying tactics won’t work anymore; it will be time to face the music.

Other macro factors will test banks. Eventually, the Fed will have to start exiting the quantitative easing strategy. That means interest rates may start to rise and banks will not benefit from the fat spreads that they’ve seen in the last year. Foreign banks may very well slow their purchases of US debt, and inflation may also start to rear it’s head.

All in all, there are several reasons to be concerned about the banking sector going forward. So what would be the game plan? I still like Goldman Sachs and Morgan Stanley to a lesser extent, especially if their prices dip because of a correction. For the banks, I plan to buy the next pullback, but with two qualifications: much depends on the individual bank, and these banks have to be owned with a careful eye to the obstacles mentioned above. JP Morgan remains the strongest; Wells Fargo has great earnings power but needs to figure out how to pay back TARP; US Bancorp is solid, well managed bank, but has lending exposure; Bank of America and Citi are interesting but risky because their balance sheets are weaker. All can are subject to the headwinds mentioned above, so if things start to turn the wrong way and we get the second half of a double dip, it may mean stepping out and then stepping back in later.

For those that don’t want to trade in and out, I still think that dollar cost averaging, or buying on pullbacks, remains the best strategy. For example, if you are conservative and don’t want to spend too much time watching the markets, you could buy JP Morgan on dips, and dollar cost average if we enter the second half of the “W” recovery. This will give you a lower cost, and JP Morgan will probably emerge as a very strong bank in 3-5 years with most of its troubled assets off its books. This is a conservative, long-term strategy that has a strong probability of working.

For the regional and smaller banks, these are more-lending based, and so they are exposed to all the headwinds mentioned above without the benefit of diversification into the capital markets. Most analysts expect as much as 500 more banks to fail by the time this is all over. For me, this is a steer clear area, or a lot of work to make sure a smaller bank is a good investment.

All in all, the entire banking sector still faces challenges ahead. But for the patient investor, that could very well mean opportunity.

I am long Goldman Sachs, Morgan Stanley, JP Morgan, US Bancorp, Bank of America and Citigroup. I have no position in Wells Fargo at the current time.