Wednesday, December 31, 2008

Happy New Year!

What can be said in New Year rhymes,
That's not been said a thousand times?
The new years come, the old years go,
We know we dream, we dream we know.
We rise up laughing with the light,
We lie down weeping with the night.
We hug the world until it stings,
We curse it then and sigh for wings.
We live, we love, we woo, we wed,
We wreathe our prides, we sheet our dead.
We laugh, we weep, we hope, we fear,
And that's the burden of a year. - Ella Wheeler Wilcox

What a tough and rugged year it has been for all of us in capital markets! Who could have imagined the volatility, the fear, the panic that we, our friends, clients and employees felt at times. To our friends at Lehman, the Bear, and many others in investment banking, losses are particularly deep as victims of the financial tsunami that washed through the financial system.

We think of all of you as the old year passes and the hopes for a new year are in our hearts. We thank you for your readership, your support, and your thoughts! We are looking forward to a regular dialog through this blog and through some new and exciting alternative channels that we are developing. We appreciate the ongoing support of friends like Henry To of and David Korn of The Retirement Advisor. Special thanks to Geoff Gannon who has one of the most insightful blogs in investing. I look forward to hearing more about Geoff's ongoing publishing projects. I would be remiss in not mentioning David (Dah Hui Lau) who is determined to dedicate his life to value investing as well as a fellow Ontarioan Nurse B who continues to Triage his Way to Financial Success.

Finally, the ongoing help of The Wall Street Transcript as well as Cash Flow Analytics have helped mold and shape many of our thoughts and theories. Our friends at Seeking Alpha have also provided great support in terms of distribution of ideas as well as access to conferences.

Best of the New Year!


Finally, an Irish toast:

In the New Year, may your right hand always be stretched out in friendship, never in want.

Monday, December 29, 2008

Fair Value, Mark-To-Market and Financial Reporting-Another Revision?

Less than a week to go for 2008, and the Financial Accounting Standards Board (FASB) has a proposal which it has thrown into the arena to address the problem of fair value.

Mark to market accounting has stirred up a very ugly debate between its adversaries and its proponents. Mark Sunshine, in a Seeking Alpha post some months ago noted that: " Mark to market rules distort financial results and business decisions under the false cloak of conservatism. The rules make little sense, produce inconsistent results, lack a basis in reality and provide lots of room for abuse." Other prominent naysayers as far as the current accounting rules for mark-to-market include Steve Forbes and noted fund manager, Ron Muhlenkamp.Here is a recent interview where they discuss mark-to-market accounting.Forbes does not mince his words:

"Henry Paulson is the worst treasury secretary in living memory. But even though he's miserably mishandled this financial crisis there's still time for him to turn things around. He can--somewhat--repair his reputation. He simply needs to back away from the disastrous policies and practices that have defined his tenure."

"His first mistake was to support the weak-dollar policy that sparked and fed the crisis. Then he continued to enforce mark-to-market accounting rules. Mark to market destroyed bank balance sheets. Now insurance firms are faltering under its weight. But there's still time for common sense...And while mark to market is fine for publicly traded stocks, it makes no sense when you don't have a market, as with packages of subprime loans. And it also makes no sense for long-term insurance reserves. Paulson and the SEC can suspend this inane rule in a heartbeat, yet they refuse. Adhering to one position without regard to consequences and expecting a different result is the definition of insanity. It's time for Paulson to follow the path of reason."
Proponents of mark-to-market generally perceive greater transparency with its usage. For example, here is a part of a letter to FASB by Rebecca McEnally of the Investors Technical Advisory Committee (IATC):

"The ITAC believes that it is especially critical that fair value information be available to capital providers and other users of financial statements in periods of market turmoil accompanied by liquidity crunches such as we're now experiencing. In the absence of timely fair value information, uncertainty increases, further exacerbating market instability and causing investors to withhold investable funds or demand a hefty uncertainty premium. A cornerstone of the restoration of investor confidence must be to provide the information investors need to make risk-based decisions."

"Regulators recognize that fair value measurement is an essential tool in their oversight and monitoring of the risk management practices and risk profiles of financial institutions, and ensuring that the institutions' capital provisions are adequate to support the risks embedded in the financial instruments and other assets the institutions hold and the financing used to support those assets. Given this widely-recognized critical importance of providing relevant, high-quality financial information to the markets, the ITAC has been dismayed to learn that a few managers of major financial institutions, along with representatives of industry organizations representing some financial institutions, are now calling for a suspension of fair value reporting for financial instruments. They argue, in effect, for a return to the old financial reporting model for financial instruments in effect decades ago with its out- of-date historical cost reporting and lack of transparency, particularly for embedded financial risks."

The proponents credit the transparency they believe that mark-to-market has brought to capital markets with the market's improved understanding of the risks and consequent selling off of many financial services stocks.

"Recently, some have attempted to shift the blame for the current crisis from the poor business and investment decision-making, including the flawed underwriting, securitization, risk management, and disclosure practices in which they engaged, to fair value financial reporting, a "shoot the messenger" argument. This reasoning is both perplexing and misleading. In fact, the current requirement to report financial instruments at fair values was instrumental in the uncovering of the deep and widespread problems in the markets. The long-term solution to the problems relies heavily on the retention of the requirement to provide fair value information to investors and regulators: the higher the quality of fair value information that is provided, the faster will be the necessary market adjustments to the problems."
"What those making the argument fail to recognize is that these are not abnormal features of the measurements, per se, but rather characteristics of the normal functioning of markets as investors reassess risks and rewards and liquidity disappears for poor quality securities and investments with little transparency. Some downward price revisions will inevitably result in the triggering of covenants that the original purchasers of securities or lenders demanded as a condition of investing in the securities and agreeing to the terms upon which the capital was provided to issuers. Again, these triggers are a normal part of the contracting process and designed to protect the investors, including lenders. The fact that the triggers were activated is not an indictment of the measurement system but rather is a direct function of the poor or deteriorating quality of the investments. Arguing that by not recognizing the poor or deteriorating quality of the investments we will somehow solve the problem is not only inappropriate but is a variant of the "shoot the messenger" argument: Pull the covers over the problems and maybe they will just go away."
I certainly recognize that under most normal circumstances, there is great transparency in fair value as opposed to other methodologies. However, it is also very clear to me that a myopic and complete focus on fair value can in effect be liquidation or bankruptcy value in times of severe systemic stress. I would agree with Forbes that the triggering of covenants that has resulted from large and probably unnecessary write-downs has caused more panic than elucidation as far as asset values. As he said very colorfully:

"Also of immediate urgency is for regulators to suspend any mark-to-market rules for long-term assets. Short-term assets should not be given arbitrary values unless there are actual losses. The mark-to-market mania of regulators and accountants is utterly destructive. It is like fighting a fire with gasoline."

A compromise of sorts appears to be coming. The FASB would like firms to include in their financial statements a table which provides a comparison of three different reporting measurements:
  1. The reported carrying value
  2. Fair Value
  3. Incurred Loss Amount

These changes would allow managements to highlight future cash flows of securities that will be held to maturity and are available for sale. Though the near term "fair value" or "market value" in a very constrained and illiquid market may look dreadful, the majority of many of these assets will likely pay off over their long term maturity. Hence, the "incurred loss" category when it demonstrates that few losses have actually been incurred may create some substantiation of long term value that is more realistic in my opinion than what we have now.

This proposal labelled proposal FAS 107-a, if approved, would go into immediate effect for reporting periods after December 15th, 2008! That puts more than a little uncertainty into forecasts of fourth quarter financial services profit forecasts. But at least the uncertainty may be somewhat positively skewed in favor of less write-down in the recognition of "fair value."

Part of the backbone of accounting is what's known as the conceptual framework which describes the function and purpose of accounting. As the FASB and the global body, the IASC consider a new conceptual framework, they propose (italics are mine):

The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders, and other creditors in making decisions in their capacity as capital providers. Capital providers are the primary users of financial reporting. To accomplish the objective, financial reports should communicate information about an entity’s economic resources, claims to those resources, and the transactions and other events and circumstances that change them. The degree to which that financial information is useful will depend on its qualitative characteristics.

Financial reporting information is a faithful representation if it depicts the substance of an economic phenomenon completely, neutrally, and without material error. It must also be relevant.

In my view, the substance of financial reporting should focus on the long term substance of the transaction rather than the strains of the current capital market. Perhaps the new proposal begins to address the situation. Perhaps what is sacrificed in terms of timeliness and verifiability is offset by improvements in comparability and relevance.

Unfortunately, forecasting results will become even more difficult as accounting rules may be modified at the worst possible time, the year-end for most companies. But, if implemented, these rules may provide a bit of sunshine and upside at long last to a sector that has been wrapped in uncertainty and fear if not deprived of common sense for some time.

Wednesday, December 24, 2008

Happy Holidays!

A simple and sincere message to all. Here's wishing you the best of holidays in this blessed season.

Wishing all of you a Happy Hanukkah, a Merry Christmas, and peace!

Looking forward to 2009, a Happy, Healthy and Prosperous Year for all!


Sunday, December 21, 2008

Stocking Stuffers

It has been a remarkable year. It has been year that many of us would just as soon forget. The cascading effects of deleveraging have been rampant across all markets.

The financial turmoil of 2007-08-09? has deeply affected households as well as businesses in most parts of the world. The reduction in the target Fed Funds rate since September of 2007 has been dramatic going from 5.25% (it really was this high!) at the beginning of this period to its current range of 0 to 0.25%. As any borrower knows, reductions in Fed Funds do not result in immediate parallel movements in interest rates that you and I pay, nevertheless, interest rates are likely lower than they otherwise would have been.

After peaking at a multi-decade high of +9.8% in July, the US producer price index (PPI), inflation rate has completely collapsed to +0.4% in November.

Little wonder that investors are huddling for warmth, are seeking "guarantees," and are about as risk-averse as I have ever witnessed. I warn my analysts about turning into "life insurance company treasurers" seeking relative shelter rather than seeking capital appreciation. Strangely, for long term real returns what appears to be safest in the capital markets at the moment may well be the most dangerous investment you can make,treasury bonds.

In this weekend's Barron's (subscription required) Rob Arnott, the former editor of the Financial Analyst's Journal provides some very thoughtful discussion in this interview by Lawrence Strauss.

As he describes,

"What we saw in September and October was a take-no-prisoners market in which everything outside of Treasuries was savaged. Finally, in November, we saw the beginnings of a rationalization where some markets did begin to recover-but some markets had been hit beyond any rational valuation of the risks associated with those assets."

Arnott goes on to describe very aptly, the behavioral tendency of most investors to continue to bank on "winners" rather than looking for bargains.

So the notion of looking at markets and asking what has been hit really hard and, as a consequence, may be priced at really attractive levels is alien to most investors.

He describes the current environment as "the richest environment of low-hanging fruit I've seen in my career."

A further key point...

"This is not a time to be hunkering down in the safety and comfort of the Treasury curve." "There are tremendous opportunities right now."
This being the holiday season, I suspect that Mr. Market has provided us some gifts for the taking if we choose to partake. I will be putting together a number of screens of bargain or quality ideas that I think may contribute to a happy new year. As well, I will be providing a review of many of these names in the coming days and weeks.

I will start with a list of Stocking Stuffers, as you will see, not necessarily very high quality businesses with strong competitive advantages. This list was constructed using Reuters and the following assumptions:

  1. Price under $10 per share...i.e. Stocking Stuffers
  2. Operating margins on a Trailing Twelve Month (TTM) basis better than that of the respective industry and showing improvement versus last year or two years ago.
  3. Company must be generating free cash flow in the most recent TTM period
  4. PE multiple must be within 20% of the lowest PE in the last five years
  5. Enterprise Value/EBITDA must be less than six times.
Here's a look at several reporting formats for this screen:

Stocking Stuffers-Operating Margins, PE's, FCF

Stocking Stuffers-ROI, ROE

Stocking Stuffers- Debt Leverage

Here is another screen but rather than considering operating margin improvement, this screen looks for the following attributes:

  1. Price under $10 per share but above $1.
  2. Stock price below book value per share
  3. Cash exceeds debt
  4. Interest coverage more than two times
  5. Net earnings must be positive for the most recent twelve months.

Remember that frequently, book value can be a misleading metric for value investors. Companies which chronically earn below average returns on capital or equity may well have assets whose valuation needs to be written-down. Impairment of these overvalued assets can lead to too low a price to book ratio. It is also important to note that companies that have a history of buying back stock at prices above book value will drive down Book Value and hence increase P/BV. Consequently, excellent companies that have generated excess cash and treated shareholders well by returning capital through buybacks will be missed by P/BV screens.

Book Value Bargains?

The Barrons interview makes it clear that Arnott favors investment grade corporate bonds at this stage. Spreads against treasuries have widened to immense gaps, for investment grade about 6% over treasuries, for below investment grade, perhaps 15-20%. As Arnott suggests, even if defaults reach historic proportions, it would take several years of defaults to lose a 20% spread in the competition against treasuries.

As Arnott concludes, and I agree, the less you hold in Treasuries, the better you are likely to perform in 2009. Riskier assets are priced to provide some significant returns for the coming years.

We'll have a deeper look at a few of the names within these screens over the coming days and weeks.

Sunday, December 07, 2008

The Commodity Investment World Conference-Some Observations on Commodities as a Diversifier

For two days last week, it was my privilege to attend the Commodity Investment World conference through the courtesy of Seeking Alpha. A broad spectrum of commodities markets, their economics and approaches to these markets were discussed.

Commodities conferences historically have been the denizens of inflation hawks. Theories of Malthusian catastrophes as population and consumption growth outpace agricultural production have always suggested dwindling supplies with the development of shortages and hence,higher prices for commodities.

Beyond the Club of Rome disaster scenarios, come monetary arguments for inflation. If currencies have value because of scarcity, central banks around the world have spent the last several months creating fiat money by decree-simply put, when money becomes too plentiful, it loses its value. Even Ben Franklin observed some 230 years ago:
"The currency, as we manage it, is a wonderful machine. It performs its office when we issue it: it pays and clothes troops and provides victuals and ammunition, and when we are obliged to issue a quantity excessive, it pays itself off by depreciation."
Many commodities historically have functioned to offset the depreciation in the currency that Franklin described and have been storehouses of value and hence, inflation hedges.

This conference was much more realistic in its tone. Commodities, which generally serve portfolios as tremendous diversifiers because of their low or negative correlations to equities have unfortunately demonstrated near perfect positive correlation with equities recently. The English translation of this statistical notion is straightforward...stocks have been declining- and so have all commodities.

So why bother even thinking about commodities in what appears to be a deflationary environment? Two reasons:

  1. As Marc Faber of GloomBoomDoom fame has cited, when the investment community is fascinated by a major theme (deflation), outstanding opportunities arise elsewhere. "The greater the mania in one sector of a market or in one stock market, the more likely that neglected asset classes elsewhere offer huge appreciation potential." I believe that commodities, as several panelists at the conference indicated, may bottom within a few quarters.
  2. The sources of return for commodities relate not only to issues of supply and demand and economic fundamentals but also to the possible returns from long/short active management as well as what are termed, "roll yield" and "collateral yield."
Roll yields occur when the price of a commodity is higher for shorter delivery dates. The investor earns a positive roll yield by buying, waiting for the price to appreciate as the delivery date approaches, then selling and using the proceeds to reinvest at a cheaper price at a longer term future delivery date. Collateral yield is the return earned by margin held against a futures position (generally T-bills.) The significance of roll returns should not be ignored...for the 15 years between 1989-2004, crude oil returns averaged about 20% per annum of which 6% per annum consisted of pure spot price returns and 9% consisted of roll returns.

Under more normal circumstances, if any of us can remember what normal is anymore, commodities can be a terrific portfolio diversifier. Why?

  1. Commodities tend to correlate positively with inflation whereas stocks and bonds tend to negatively correlate with inflation. In an article that Warren Buffett authored in Fortune in 1977, he explained the deterioration of securities under inflationary conditions.
  2. Commodity prices and stock and bond prices react differently under different phases of the business cycle. As business cools, treasury bonds tend to rally, whereas stocks and commodities tend to skid. As business expands, stocks and commodities tend to be pro-cyclical whereas bonds will decline.
  3. Commodity prices tend to be more affected by short-term expectations whereas stocks and bond prices tend to be more affected by long-term expectations...not necessarily true at the moment, but at least a "normal" expectation.
Hence, commodities can be very potent portfolio risk diversifiers.

Here are a few links which you may find useful:
The Benefits of Commodity Investment

Alpha, Beta, and Commodities: Can A commodities Investment be Both a High Risk-Adjusted Return Source and a Portfolio Hedge?

Perhaps, one of the most interesting presentations at the conference was Dan Sternoff of Medley Global Advisors whose primary research focus is China. Though much of the commodity boom prior to July related to a silly notion that Chinese and Asian economies had decoupled from North America, the slowing of the Chinese economy has become quite evident.

Disturbingly, the deceleration is more rapid than even the Chinese government had anticipated no doubt precipitating China's biggest interest-rate cut in 11 years with the 108 basis point cut in one-year lending rates. However, according to Sternoff, the slowdown so far has been domestically led and not yet linked to the global cycle, more a consequence of China's slowing property sector affecting industries such as cement, steel, cars, appliances, and furniture.

Residential construction represents a significant 12% of Chinese GDP. Though not a real estate bust per se, (there are no Mortgage backed securities or other forms of securitization and housing is purchased with 25-30% down payments) property prices are down probably 5-10% nationwide with higher end apartments in larger cities down markedly more. Real estate transaction volume has fallen off a cliff.

Though Sternof expects Chinese GDP growth of about 7-8% next year, the composition of Chinese GDP growth is shifting away from resource intensive activities. He expects that state owned enterprises may well become acquisitive overseas as global valuations provide opportunities.

Other presenters had rather bleak views of Europe suggesting that most European authorities did not have a pro-active view of stimulus programs and that no governments had the skills of a Larry Summers or Paul Volcker in handling crises. Their conclusion in short, it is wrong to think that despite the steepness of the price waterfall, it is wrong to think that commodities have bottomed.

Roger Kubarych of UniCredit and a former associate of Henry Kaufman suggested that a reasonable fiscal stimulus plan of perhaps $400 Billion for the new Obama regime could include 4 segments:

  1. Low to middle income tax benefits
  2. A business investment tax credit or R&D tax credit
  3. A program to stop foreclosures or a plan to help states and municipal governments buy foreclosed properties
  4. An infrastructure building plan
It seems that many commodity traders are perplexed by the rather tight correlation of commodities to one another, not just their price movement relative to securities. It is unusual for industrial commodities such as base metals or energy which are clearly sensitive to economic activity to correlate this well with agricultural products that generally have little sensitivity to the economy.

As well, most commodities tend to bottom at their marginal cost of production, yet many instances were cited where producers, starved for working capital in the credit crunch, are willing to produce under their full cost of production merely to access cash flow.

Another interesting presentation addressed timber as an uncorrelated commodity asset whose value creation is largely attributable to biological growth rather than inflation. Basically, value increases as tree diameter grows and if current prices for small diameter trees don't work for you, a tree will grow about 7% every year, so greater value should accrue over time.

A very broad spectrum of commodity topics was considered. My only complaint about the conference relates to no-shows-there were numerous no-shows among presenters who were scheduled to appear for some topic panels. Despite this annoyance, in my view, the conference was worth attending.

Historically, portfolio construction meant a split between stocks, bonds and cash. I believe that going forward, commodities will also be an important component for portfolio construction.

Opportunities exist for not only portfolio hedging because of their usual uncorrelated returns, but also for active management strategies that take advantage of unusual backwardation. Like capital markets, commodity markets are in disarray and bathed in horrible sentiment. Though highly volatile in physical or futures formats, structured products and commodity ETFs may offer individual investors better opportunities to participate. It is too important a market with too many unique characteristics to ignore.

Tuesday, December 02, 2008

Analysts in the Confessional

So why the lag in taking earnings estimates down? NBER yesterday declared the existence of recession, yet analysts continue to be reluctant to fess up and mark down their numbers.

In an interesting article in Australia's Business Spectator this morning, two analysts confess why it is so hard to reduce their forecasts.

The confession was written by two Goldman Sachs JB Were analysts, Sam Ferraro and Matthew Rose, who, after meeting their buy side counterparts, detected some frustration. So even though their strategist was forecasting a decline in earnings of 15%, their own forecasts still pointed to higher earnings.

Here are the reasons they cite:

  • The analysts haven't seen anything like this before--hence, they tend to underestimate the effects of systematic or top-down developments.
  • Their researched companies and managements haven't seen anything like this before- A survey of analysts reveals that 25 per cent of companies that used to provide profit guidance no longer do (and guidance is all-important – see the next point, below). CEOs, they say, are chosen for their “left brain skills: optimism, ambition, hard work, focus and decisiveness. Patience and an appreciation of history are not considered virtues for these individuals"
  • Analysts seek to curry favor with management in order to preserve their information networks- Remember, that for most brokerage firms, the investment banking client is the "real" client...the individual client represents far less revenue, and hence, upsetting him/her is less onerous and career-threatening than upsetting the major client.
  • Analysts need to manage their "reputational risks" so they engage in herding behavior. There is comfort in numbers. The costs of being out in left field with a big call gone wrong far outweigh the benefits of getting the big call right.
As I said in my previous post, earnings estimates at this stage of the game may well be ignored by most participants,"I also believe that in a well-established and hopefully, late stage bear market, analysts are completely ignored and stocks will rally in the face of declining earnings estimates."

As portfolio managers, we do our own forecasts and tend to use Wall Street for idea generation rather than forecasts or recommendations. We have long recognized that many estimates are candy-coated to stroke the egos of the "real" clients rather than serve our needs. Similarly, there is a reluctance of research analysts to say "sell" or to couch it by calling a company a "hold" so as not to offend the investment banking client.

As in every part of investing, self-reliance and judgment are an important part of success.

Monday, December 01, 2008

Staying in the Game

My sincere apologies to readers I have disappointed in my absence over the last several months. As our business has grown, time has certainly been at a premium and unfortunately, we have neglected our responsibilities to this blog. We hope to mend our ways with more regular postings of commentary regarding markets, economies, analyst upgrades and downgrades, as well as independent analysis of interesting companies.

Some of you may be aware of our regular monthly commentary to Marketthoughts, Henry To's excellent subscription service. Henry, who is currently working on his MBA at the UCLA Anderson School is a CFA charterholder as well as an actuary. Henry's thought provoking analysis and commentary is insightful and ruminative. His productivity in his subscription service despite his full time efforts as an MBA student is a real inspration to me. I hope to aspire to his level of publishing productivity! In Ocotober, I first published this commentary in Marketthoughts. I think most of this remains quite applicable:

Baffled? Frustrated? Worn out? Most of us have to answer yes to these questions. After over thirty years of investment management, I still try to stand up to my own sinking feelings and act professionally and as unemotionally as possible. A value discipline forces you to take notice, to battle your emotions, and to recognize value with at least a small order. Courage is in exceptionally short supply especially among newer clients who have never seen this before. But even when I visit some of the brokers who sell our products, many of whom have years in this business equal to or greater than mine, there is terror in their eyes and no activity in their books. It is never easy to battle feelings of inadequacy and powerlessness which overcome you in bear markets.

It's been over a year since housing issues triggered problems in mortgage markets which triggered problems in credit markets which triggered problems in the shadow banking system which triggered a bust in the commodity cycle, etc, etc, etc. The sequence of events reads much like the "begat" verses which describe generations in the Old Testament.

We have been through some twenty years of credit most "topping" experiences, as we neared the peak, more and more credit was needed to produce less and less real economic growth. The credit experience of the last twenty years parallels most other addictions where greater amounts of the abused substance are needed to achieve the desired result. Not unlike substance abuse, too much will indeed kill you.

The widespread deflation of asset values, whether stock prices, housing prices, or commodity prices has exposed the excesses of borrowing and destroyed the creditworthiness of the debt that was secured by the price inflation of the underlying assets.

All business cycles are driven by some excess "thing" that needs to be corrected. Many bear markets of the past have been triggered by credit tightening...not this time. Others, such as the internet bubble burst were triggered by excessive valuation of a sector...not this time. Others, such as the 1974 bear were triggered by fears of earnings collapse in the face of a seemingly uncontrollable macro variable, at that time oil some degree, this had been an aggravating factor again.

Abrupt changes in the availability of credit lead to abrupt changes in liquidity and hence, asset prices. This turns into a self-fulfilling prophecy...fears that asset prices may fall, lead to falling if not cratering asset prices.

The downward spiral of the current crisis parallels the emerging markets crisis of 1997 and 1998 where Thailand, the Philippines, Indonesia, and Malaysia faced currency attacks that undermined investor confidence in foreign denominated debt. Asia lost access to foreign credit, currencies plummeted and creditors lost confidence that they would get their dough back, all rushing for the exits at the same time. The decisions of the credit markets ensured that the crisis deepened.

The global economic response this time is much more heartening with bank recapitalization, broadened limits on deposit insurance, guarantees of bank debt, coordinated interest rate cuts, and major increases in liquidity. I suspect that much more can be done in terms of encouraging increased lending into the rea leconomy from the newly recapitalized coffers of the "favored few" banks. In addition, in this deflationary time, interest cuts have only begun.

The somewhat haphazard and piecemeal initial response to the crisis, especially in Europe has done little to boost confidence. However, following the UK's massive bank recap plan, the world began to coordinate it activity.

I am encouraged by some signs of life in the commercial paper market and by recent moves in LIBOR (finally.) As well, perhaps whimsically, there is now a TED spread gadget to be monitored on your iGoogle homepage. In my view, more of a sign of the late innings of a crisis than the beginning. We have also survived the Lehman CDS episode with nary a whimper.

The very high probability of a long and deep recession has prompted considerable fear recently. Though quite clearly, cyclical stocks
have reacted quite negatively to this prospect, most analysts have yet to revise their estimates downward for next year. Of course, this is causing some trepidation that more disappointment will follow. Here's a look at S&P consensus estimates according to Bloomberg and Bank of America stats.

Of all estimates that are higher in 09 versus 09:

Consensus estimates for 406 (82%) in the S&P are higher for 09 over 08. The overall average increase is +19% with a median of +11%.
  • 45 of 500 (9%) are up +30-200% averaging +64%
  • 34 of 500 (7%) are up +20-29% averaging 23%
  • 156 of 500 (31%) are +10-19% averaging +13%
  • 120 of 500 (24%) are up +5-9% averaging +7%
  • 48 0f 500 (10%) are up +0-4% averaging +2%

In my view, most investors/ speculators/ traders in this market are completely oblivious to Wall Street estimates in this environment. People are trading from the gut rather than from consensus estimates. I believe Roy Neuberger ( of Neuberger and Berman fame) once spoke of analysts quite disparagingly, " In a bull market, who needs 'em, in a bear market, they'll kill ya.) I also believe that in  a well-established and hopefully, late stage bear market, analysts are completely ignored and stocks will rally in the face of declining earnings estimates.

Recently one street strategist described a complacency that given stocks are down 30%+ that earnings misses are reflected in the valuations. According to him,"Magnitude of surprises on the downside can still surprise the market despite significant downward moves in the stock price prior to earnings release." As an example, Alcoa which had already been down 54% YTD dropped another 12% on its recent negative earnings surprise, and then fell another 27% after the earnings date. similar fates awaited shareholders of EAT, RT, IR, MWV, PEP, DPZ, JNY, SVU, NVLS, EBAY and others.

I have attempted my own analysis of negative earnings surprises. According to Zacks data between September 1st and October 23rd, there have been 190 companies that reported a negative earnings surprise of 10% or more.I chose the first 50 names of their screen for further analysis. Companies selected were not necessarily part of an index and had market caps ranging from $30 million to $72 Billion.

The average earnings surprise was -129%, obviously a horrific miss! The reaction on the earnings miss was as high as -37% though it averaged about -7.2%, even in these hardened times, a significant reaction.

However, after the earnings miss, the performance from that date to October 23rd was hardly supportive of the strategist's conclusion. In 25 cases, the stock outperformed the broad Russell 3000 index. In the other 25 cases, the stock underperformed the Russell. Here is a spreadsheet link outlining the findings.

Wall Street frequently puts far greater emphasis on its ability to forecast earnings as a stock picking methodology than is warranted. Though I have enormous respect for the work that analysts do, having served as a research director for a sell side firm, there are tremendous lags in information flow that can result in very limited usefulness. As well, GAAP  allows tremendous scope for a management to make choices or assumptions that are not captured in a single point E.P.S. number. My advice, look for confirmatory evidence of conservatism and focus on cash flow rather than earnings.

Some final thoughts for this month. The market abounds in very cheap stocks. Free cash flow yields exceeding 10% are relatively easy to find. This particular metric is always a standard that I find produces the first inkling of a decent business value. Naturally, all screening depends on observation of historical data, and it is dangerous to simply extrapolate the past into the hereafter. Look to return on invested capital for evidence of superior profitabiity relative to its peers. Explore the basis of this competitive advantage.

When credit is difficult to obtain, companies with free cash flow generation can obviously survive. Low capital expenditure needs, low working capital needs keep both commercial bankers and investment bankers from knocking at the door, or at least management need not answer their futile calls. The ability to self-fund is golden in these times. Great businesses have histories of free cash flow generation for some years, not merely flash in the pan occurrences.

The adage of investigating before you invest is more important than ever. pronouncements by strategists using selective data points may sound impressive but check the reliability of the may not always be complete. Though the Buffetts of this world may find a price to swing the bat with fierce determination when that fat pitch arrives, most of us do not have the intelllectual capital or emotional wherewithall to do so with confidence. Nibble and graze...diversify rather than feast. You will be able to concnetrate your positions later as evidence mounts that you have chosen well. Cash may seem like the greatest refuge but when a market abounds with bargains, it represents the sirens' lure.

In an environment where daily returns resemble traditinal monthly or even annual returns, volatility creates tremendous fear. Show some greed when the world seems to be falling apart. If your portfolio contains questionable stocks, use this opportunity to buy high quality names that you can grow wealth with through time.

Ignore Cramer and other prophets of myopic fortune or doom. These are times to think big and have long horizons.

It is exceedingly tough out there and easy to be discouraged. Be careful but stay in the game!

< ? Market Blogs £ >