Stock Gurus: Meredith Whitney

Meredith Whitney appeared on CNBC on Monday, 11/16, on CNBC's Closing Bell after Bernanke’s speech. I don’t always agree with Meredith, but she’s always insightful and her opinions are backed up by solid analysis. The only caveat is that timing may be an issue for her. For me, her comments make sense, question of when things will happen, and perhaps if they will be as severe (which is related to timing. Timing more spread out, less severe). Here’s the highlights of her comments:

- Mortgage Backed Securities. Bernanke didn’t say much. She wanted him to talk about the agency mortgage-backed purchase program, and he didn’t. The Fed has been buying Fannie, Freddie agency mortgage paper, and it’s 1/3 of their balance sheet, was zero at the beginning of the year. Fed is probably buying more than 100% of what’s available. Through these programs, rates are low, 20% of the banks’ capital has been created (estimated), allowed bank asset values to rise. Program almost done. When Fed exit, interest rates go up dramatically (probably more than 10%), affordability goes down, credit losses spike again, another leg down in the housing market. “I haven’t been this bearish in a year.”

Other programs have wound down, except for agency MBS. Extend program, Fed becomes one of the largest buyers of junky debt. Deed for lease program. If you can’t afford modification, then gov will rent house. So does gov become direct owner of US real estate?

- Consumer. Doesn’t Understand Why Stocks Are Up. Particularly in the consumer space. No fundamental reason. Plus contraction in consumer credit. Never been so much consumer credit contraction, even in Great Depression. In 1990-91, contraction, but securitization provided liquidity to consumers, consumer actually had more liquidity during that time. $1.5 trillion of credit lines pulled from the system. Is now re-accelerating. Not a good Christmas coming. “There’s nowhere to hide at this point”.

Retailers have reduced inventories, so that may be better. But so many credit lines cut, the middle class is getting squeezed the hardest. Worry about that most. Also getting kicked out of banks.

- Banks. To pay back TARP, banks will have to raise capital again. Adequate capitalized today? No way. Trade has been short regionals, long capital markets banks. Works because government behind capital markets. “If the lifeguard is on duty, people will jump into the pool”. Lifeguard will go off duty, just don’t know when. Capital markets volumes will be down. Equity volumes down, fixed income volumes are down, so big banks are converging closer to the regional banks. Reducing weightings on big banks.

But still, their stocks are rallying, doesn’t make sense. No root in fundamentals. Money on sidelines – never underestimate, usually goes to smarkt places. But now money not going to agency MBS. No substitute buyer. Money going to hard assets, businesses, gold. No one is buying mortgage backs.

Dip like last year? Don’t think so because before had mark-to-market accounting, makes big difference. Don’t think BAC will go back to $3. But thinks banks will go back to tangible book value. Have said this for 2.5 years now. Only trade above when there are core earnings. But increasingly clear, core earnings will not be what they claim. Likely will be ½ to ¾ of that, some fraction. Implying estimates will go down. Therefore, sell the banks.

- States. States need money. 44-48 states underfunded, and will be progressively more underfunded.

- Real Estate. Surprised Bernanke talked about real estate. Still residential real estate, many people have glossed over the fact that there will be another leg down in commercial real estate. Home ownership stands at 67.8%, will normalize at 65%. “Still the great sucking sound of liquidity coming out from the market.” Mortgage modifications – only 1% of trial modifications have gone to permanent modification status. Just waiting, 1^st quarter, when numbers show up, mortgage rates spike and fewer people qualify for mortgages, another leg down. Residential still much bigger threat than commercial. Banks assume real estate doesn’t go down further, 10% unemployment – already there. And states are still firing people.

- Where Put Money? Sit on cash for a little bit because you have to wait for leg down, S&P expensive across the board. Estimates have to come down, look opportunistically. Banks that are asset-sensitive to consumer credits are not where you want to be. Some core business that benefit from transaction services will benefit. Everything’s expensive now.

- Double Dip? Not as severe on second part of dip.

- What does it take to become more positive? Valuation, all about price.

Stockwatch: Goldman, Sachs & Co.

So early today, Goldman announced Q3 earnings, and again, it blew away the numbers. Still, the market has gotten used to Goldman outperforming and had high expectations, especially after JP Morgan’s great numbers the day before.

First, the numbers. Goldman earned $3.19 billion, or $5.25 per share, compared to the average analyst estimate of $4.24 per share. Revenue was $12.37 billion, again, far in excess of analyst estimates of $11.02 billion. The firm’s return on equity was 21.4%, despite high capital levels that would drag down the return on equity.

Next, the more interesting part: the business model and its sustainability. This is the part of the analysis that they never talk about post earnings. A quick look at the income statement tells you the following:

- Increased Fixed Income Share. The key was trading and principal investments, and in particular, fixed income. But in addition to skill, Goldman’s revenues in this area were driven by the disappearance of its competitors Lehman (a bond house), Bear Stearns and to a certain extent, Merrill Lynch. As Goldman’s CFO Dave Viniar said on the conference call, “we’re getting a bigger piece of a smaller pie.” Consider the Trading and Principal Investments line for the last three quarters: $5.7 billion in Q1; $9.3 billion in Q2; and $8.8 billion in Q3.

- Cost Cutting. The media coverage never talks about this, but cost cutting made a significant contribution to the bottom line. Again, look at the operating expense line: $6.8 billion in Q1; $8.7 billion in Q2; and $7.6 billion in Q3.

- Investment Banking Declined. Investment banking fell from $1.4 billion in Q2 to $899 million in Q3 , mostly due to a decline in leveraged loans. While a negative, investment banking is traditionally lowest in the 3^rd quarter because of slow IPO and merger activity during the summer, and because of vacations.

All this speaks to the trend in earnings: $3.49 per share in Q1; $4.93 per share in Q2; and $5.25 per share in Q3. Today, the stock closed at $188.63. And look at the profit margin by quarter: 17.6% in Q1; 19.8% in Q2; and 24.5% in Q3.

Today, the stock closed at $188.63. Based on 2009 estimated earnings of $17.74, that’s 10.6x PE. Based on 2010 estimated earnings of $18.05, that would be 10.5x forward earnings (these are today’s numbers, so these are pre-Q3 earnings estimates).

Now we get to the big question – what does Goldman look like in the long term? Are these numbers sustainable? It’s very possible.

- Investment Banking. Next year, in 2010, IPOs and mergers and acquisitions activity should pick up as the big fish with cash buy out the small fish that are still struggling upstream.

- FICC (Fixed Income, Currency and Commodities). You would think that a compression in the yield curve would hurt revenues here, but Meredith Whitney asked this exact question on the earnings call: “When the government stops buying assets (Such as mortgage securities. The government’s buying keeps prices high, yields low, expanding the yield curve), who will be the substitute buyers and how will that reduced buying affect Goldman’s business?” Dave Viniar’s answer: “There’s plenty of other buyers with lots of cash to spend. It won’t affect us because our profits are not based on positioning, but on velocity.” Meaning volume, and the commission earned on the turnover, is what is generating profits. If we are to take him at his word, this means that the fall of Lehman and Bear brought them business which can be expected to continue into the future. Time will tell, but for the moment I think we can take him at his word.

- Principal Investments. This is always a tricky line, because the company can manage this number, and what drives this number changes. This quarter, $344 million came from the sale of Goldman’s stake in ICBC (share in the Chinese bank) plus $911 from “Other corporate and real estates gains and losses.” Chances are, these are sales and mark-ups on assets. Whether this level will be maintained is hard to say. One fact that bodes well for this area is Goldman’s high level of capital. When the credit crisis recedes further, Goldman is likely to deploy the capital that it is holding in reserve. So no certainty here, but Goldman can probably find ways to sustain this number if necessary.

All in all, there’s no reason to think that Goldman couldn’t maintain $5 per share in earnings per quarter through 2010 (given $5.25 this quarter and $4.93 in the previous quarter). That would mean $20 per year in earnings, and with a 10x – 11x PE, that’s $200-210 on the conservative side.

Here’s one other way to calculate future share price. Book value per common share increased 4% to $110.75 this quarter. Based on today’s $188 close, the stock trades at 1.7x book. If we were to assume that book value could be increased at 4% per quarter, that gives us a $220 stock. And if Goldman increases its ROE, then of course, we get a bigger number.

If Goldman hits $220 within the next year, based on today’s $188 price, that would be a 17% gain. I’m currently long Goldman and would buy at this level. It may still trade down a bit as the stock rests, but that’s just another buying opportunity.

Monthly Investing Article

My October investing article is up at www.asiancemagazine.com:

http://asiancemagazine.com/2009/10/12/investing--the-forces-at-work

Thanks for reading,

Ming

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.