Porterian

This is my personal blog. Travel, financial and political observations. Notes to myself and my friends. Content development for my monthly newsletter, Porter Stansberry's Investment Advisory (www.stansberryresearch.com).

Thursday, March 23, 2006

INTER-NOTS

The myth, if you’ll recall, began in 1995 with the Netscape IPO.

The first Internet software stock to go public priced at $28 per share in August 1995, closed at $59 on its first day of trading and reached $171 per share by December, sporting a market capitalization over $1 billion.

By the top of the mania in 2000, Yahoo! had achieved a market cap of $150 billion.

The myth was that the Internet would change everything because the Internet would produce new levels of productivity and efficiency. Buying things from Amazon.com would cost less, allowing Amazon to sell at lower prices. Investors buying Internet stocks were told to throw out the old ways of valuing a business because, in the new economy, capital efficiency would make a mockery of low P/E ratios.

The Internet has changed some industries. Newspapers, in particular, have seen their revenues cannibalized by net advertising, which offers specific customer targeting and tracking and which, generally, costs much less. Internet advertising revenues reached $10 billion in 2004. According to Price Waterhouse Coopers (PWC), in the first six months of 2005, total ad revenue for websites reached $5.8 billion, 25% higher than for the same period in 2004. I personally know of financial websites that were able to raise their ad rates by 60% in 2005.

Meanwhile, newspapers have seen large single digit revenue declines.

So…the Internet did change everything in the print ad business. And, I bet, in time it destroys TV advertising too, with an assist from Tivo.

But what about the other stuff – the promise of far great capital efficiency? What about the promise that the Internet would make our lives easier, cheaper and vastly more profitable…?

It’s not happening.

While companies like Amazon and Google have offered users discounts and lots of free services (free shipping, free email, free data storage), the costs haven’t truly been removed – or even lowered – for any of these services. Who’s paying for them? Shareholders.

In early March Google announced it would have to spend 19% of net sales on capital investments – mostly the services and data warehouses required to give essentially free unlimited storage to email users who pay nothing (directly) for the privilege. These costs are the manifest result of the web’s low switching costs – something that’s always made it a troubling medium for business. When the Froogle search engine can tell you where on the web to buy that hot new widget at the lowest possible price, how can widget venders earn a profit? Only by spending huge amounts of money on user perks like free shipping and free email storage.

The result is that investors continue to subsidize Internet businesses in the same way they subsidized Netscape. The only difference is that the damage is hidden from the income statement because the required spending is put in the capital budget, where they hope you won’t see it.

Alas, I looked.

To make the study more interesting, I didn’t just look at the major internet stocks (Yahoo, Ebay, Amazon, Google), I also threw in smaller Internet businesses I know well (Digital Insight, Akamai) and I looked at another handful of stocks that are either very well-know (MSFT, GM, Dell) or have been recommended in my newsletters (BL, NOK, BUD).


[All $ figures below are in millions. Capex% refers to the percentage of capital spending, as measured against cashflow. "FCF Mult." refers to the companies market cap as a multiple of free cash flow.]

Cashflow Capex Capex% FCF Mult. '05 Rev. Growth
MSFT $16,605 $812 5% 18 9%
RTN $2,515 $338 13% 10 9%
NOK $4,900 $718 15% 22 13%
DELL $4,839 $728 15% 17 13%
BL $48 $8 17% 4 -7%
EBAY $2,000 $338 17% 31 42%
YHOO $1,700 $408 24% 35 40%
AMZN $733 $204 28% 28 17%
DGIN $57 $18 32% 31 16%
AKAM $83 $27 33% 77 44%
LXK $576 $201 35% 11 -12%
GOOG $658 $245 37% 245 86%
BUD $2,800 $1,100 39% 19 -1%
GM $13,000 $7,700 59% 2 -1%
VZ $22,000 $15,000 68% 14 6%



Some interesting things pop out right away.

First, the Internet companies aren't very efficient with their capital spending. Second, there are manufacturing companies that are surprisingly efficient -- Raytheon (RTN) and Nokia (NOK). Third, lots of capital spending doesn't ensure revenue growth (BUD). And fourth, telecommunications (Verizon, VZ) is incredibly capital intense. You have to wonder what that will mean in the future, as more and more businesses compete for the same home connection. Telecoms could end up in the same situation as the airlines. It's probably better to own the equipment makers.

Now...about those Internots...

In almost all respects except for its medium, Amazon.com is a catalog retailer, the Sears Roebuck of our day. There are many other companies in the direct sales retail space. Two I know well are Dell and Blair (BL). Both Blair and Dell (despite their enormous respect size differences) have a website business and a catalog presence. And both spend around 15% of their free cash flow on capital investment each year. Amazon on the other hand spends 28% of the cash its produces each year on investments. That’s a lot of spending to produce only marginally more growth. (Dell grew sales at 13% last year; Amazon 17%).

But the Google example is much more startling. Google, like Microsoft, is a software company. It sells access to its software through its Internet site (Google.com), which generates advertising revenue through tracked sales links and paid-for search results. You would think that a totally centralized software operation, based completely on Internet connectivity would prove to be a far more capital efficient business than Microsoft, with its multiple products, multiple versions and its mix of hardware devices (the Xbox.) But you’d be wrong…

Microsoft only spends 5% of its free cash flow on capital investments, while Google is spending 37% -- putting Google on par with one of the huge industrial stocks in our survey, Budweiser. Is Google’s outstanding growth rate (86%) worth this rate of investment? I can’t imagine how. Not when switching to another search engine provider is as simple as forwarding a few of your favorite email files to someone else’s server.

Tuesday, March 14, 2006

WHO PROFITS FROM OBSCENE EXECUTIVE COMPENSATION?

The top three executives at North Fork Bancorp…stand to receive $288 million from the large New York Regional Bank’s $14.6 billion acquisition by Capital One Financial.”
-- WSJ, March 14, 2006


These payments to the executives of North Fork Bancorp are obscene.

There are 475 million shares outstanding of North Fork Bancorp stock. So, each shareholder will give about $0.60 to the top three executives, just for selling the company. That’s more than half a year’s dividend!

A small shareholder, say a 1,000 share round lot buyer, will give $60 directly to the top three executives – just for selling the company!

These payments come mostly in the form of accelerated stock option vesting and cash payments to cover the tax burdens of such equity grants. The IRS requires people to pay taxes on all compensation. So, when ten years worth of stock options get vested all at once, there is a big tax bill. Covering these tax payments has become a regular executive benefit, although such payments are expected to occur over the life of the executives’ employment, not all at once. In any case, North Fork Bancorp’s CEO, John Kanas, will receive $111 million in cash, just to cover his tax bill, when the deal closes.

Why should some employees have their taxes paid by the corporation? They justify it by explaining that if the CEO had to pay his own taxes, he’d have to sell half the shares he earns and that selling might negatively impact share price. But that, of course, is a retarded argument. It assumes that a temporarily depressed share price is a bad thing – it’s not. A weak share price for a week or ten days is a blessing for other shareholders, who could buy more at a better price.

The real explanation for the obscene payments being made each year to executives is a corporate governance system that’s still completely broken – because it’s dominated by third party, institutional shareholders who have deeply conflicted interests.

Board members have to approve executive compensation deals. Board members also have to approve mergers. Shareholders vote on who gets on the board. Therefore, board members check in with big shareholders, to make sure their interests are being represented.

So, who are the large shareholders of North Fork Bancorp…? Whose interests are being rewarded by this merger…? And whose interests are served by paying the top three executives more than a quarter billion dollars…?

In this case, it’s JP Morgan, which owns 4.42% of North Fork Bancorp (a little more than 21 million shares). JP Morgan is also the world’s largest derivatives trader and has a large, proprietary trading group. Is it possible that JP Morgan encouraged this deal in order to prop up its own trading account? JP Morgan’s share of the executive compensation bill for the top three North Fork Bancorp executives comes to nearly $13 million.

Would JP Morgan agree to spend $13 million for nothing…?

Thursday, March 09, 2006

OIL HEADING LOWER

I was in a meeting with Matt Baldiali, our oil analyst on Monday and I had to confess to him that I think the current high price of oil is both unsustainable and something of a bubble.

Here are my reasons –

1. The oil to gold price ratio is still completely out of whack. Normally it takes about 20 barrels of oil to buy an ounce of gold. The ratio is surprisingly stable, as both oil and gold respond to world political events and inflationary pressures. But, last August the ratio fell to a record low level – 7. This can’t last: either oil has to fall, gold as to rise or both have to happen to some degree. (I should have a chart of this up by tomorrow.)

2. Wall Street believes in “peak oil” – the idea that oil prices must forever go higher because there is no more oil. The oil sector analysts are the most wildly bullish group on Wall Street: 73% of all oil service stocks are rated “buys” and 61% of oil stocks are rated “buys” – the two highest buy-rated groups. Gold is the lowest. I can tell you from experience that pro investors still think gold is a joke. I met with a dozen top private equity firms last fall, in a failed attempt to buy a large publicly traded publishing company. At each meeting I would make a point of telling the assembled “stars” that we published reports about rare gold coins. The groups laughed every single time. At some point the speculators that have bought oil as an inflation hedge will buy gold instead.

3. Individual investors have full committed to oil: assets in the Rydex Energy Services Sector Fund (RYVAX - 41.94), when adjusted for net-asset value changes, swelled by 94% during the past two months. Total assets in the fund reached a new historical high last week.

4. Norwegian billionaire John Fredriksen is at it again. He is part of a group of financiers that are building 40 new floating deep-water rigs. They cost about $600 million each, or between $15 and $20 billion altogether. I say Fredriksen is “at it again” because at the previous top in the market (1997) he raised money (Northern Offshore) to build rigs too. That company went bankrupt about a year later when oil plunged below $10 a barrel. Fredriksen’s new company, SeaDrill, raised over $800 million on claims to become the world’s fifth largest offshore drilling company. It has already committed to spend over $1 billion on new rigs.

5. A big, wildly overpriced merger. Think TimeWarner/AOL. In the oil boom, the biggest, most overpriced deal happened in December when ConocoPhillips bought Burlington Resources for $35 billion. Judged in terms of proven reserves, ConocoPhillips paid $17.50 per barrel. That’s about twice as much on a per barrel basis as Chevron paid for Unocal five months earlier.

6. Nature abhors a bubble and it won’t cooperate: too much oil is coming out of the ground. U.S. crude-oil inventories jumped 4.5 percent to 335.1 million in the four weeks ended March 3, leaving supplies at the highest since May 1999. Last week's gain was the biggest since Oct. 29, 2004, the report showed. The increase left supplies 14 percent above the five-year average.

SMART GUYS BUY ARGENTINA

Lots of “smarter” money seems to be heading into Argentina.

Some of the smartest guys I know – Doug Casey (caseyresearch.com) and Bill Bonner (dailyreckoning.com) have been buying up thousands and thousands of acres of ranch land in northwest Argentina.

It’s difficult for most investors to invest in Argentina this way. Are you going to spend $20 million dollars buying up dozens of individual ranches, some of which are more than 100,000 acres in size? I doubt it.

But, there’s a publicly traded company, Cresud (CRESY) that owns million of acres in the same area, plus a big stake in IRSA (NYSE: IRS), which owns top office properties in Buenos Aires. My friend Steve Sjuggerud, editor of our True Wealth newsletter recommended Cresud a few years ago, based on the value of its land holdings and on the savvy of its CEO, Eduardo Elzstain. Elzstain has good relations with many of New York cities top financiers – Soros was once his partner. I’ve met Elzstain. Steve and I had lunch with him in BA two years ago and we took a group of subscribers with us. Eduardo would meet with us – but not with any of Wall Street’s analysts – because we wanted to talk to him right after the crash when Wall Street wouldn’t return his calls.

It pays to build relationships

I’ve been researching Leucadia (LUK) – billionaire investor Joseph Steinberg’s investment vehicle -- for an upcoming sales letter about the world’s best investment holding companies.

Turns out great minds think alike about Argentina…

Leucadia recently became a top holder of Cresud. A Leucadia subsidiary, Nead, bought a bunch of Cresud warrants, some of which were sold back to Elzstain, but some of which were held and will convert into stock – more than 17% of all Cresud shares outstanding.

Here’s a link to Leucadia’s SEC filing about the position:

http://yahoo.brand.edgar-online.com/fetchFilingFrameset.aspx?FilingID=4232790&Type=HTML

MORE ABOUT "DEADSUMERS"
AND THE HOUSING BUBBLE

Paul Kasriel, the top economist at Northern Trust, and one of the very best data hounds out there now, wrote about the housing bubble in John Mauldin's latest ezine (http://www.investorsinsight.com/otb_va_print.aspx?EditionID=289).

You'll recall that my thesis is that while housing prices may not collapse, real estate sales volumes are likely to contract and the ability of consumers to "refi" and draw equity out of their homes is likely to end -- which would have a seriously negative effect on consumer spending. That's bad news for our economy, because consumer spending and the housing market are the main contributors currently to economic activity.

Kasriel points out that the last time there was a correction in home prices, consumer spending wasn't directly hit because back then people still thought paying off the mortgage was a good idea. Back then, people didn't use the equity in their homes as an ATM machine. Here are the relevant figures (from Kasriel): "in the third quarter of last year, households extracted equity at an annual rate of $633 billion, representing 7.0% of their after-tax income, from their houses. In 1989, home-equity extraction totaled only $82 billion, or 2.0% of after-tax income."

And here's a chart that shows equity extraction since about 1980...as you can see, most of the time it's near $0. But since 2000, it has soared.

When the economy crashed after the tech bubble in 2001/2002, most of the experienced investment writers I follow noted that equity valuations should have fallen to much lower levels and dividend yields should have reached new highs. In the past, extreme bear markets have always fallend extreme bull market and no bull market was longer or more extreme than the bull of '81-2000.

But the expected correction in stocks never came. We didn't see the Dow trading at 8 times earnings and yielding 6.5%. High quality tech stocks, like Amgen, for example, never even traded below 30 times earnings! Why not? Why didn't the economy contract more...why didn't assets become cheaper...

Mmmnn.... I wonder.

Wednesday, March 08, 2006

ELAN SOARS... AGAIN!


The first time I "bought" Elan was in December of 2002.

The company was a mess, trading for around $2.00, and reeling from what amounted to an Enron-like scandal. Under Irish management, the firm had sold-off stakes in its best products to outside investment groups. It was also lending money to start-up biotech firms and then booking the same funds back as revenue for "joint venture" partnerships. Worst of all, it was borrowing the money it was lending out, operating as a kind of biotech hedge fund. The whole thing was a big house of cards. When biotech stocks crashed in 2002, it came toubling down.

It was Garo Armen's job to fix it, as the company's new chairman of the board.

In 2001, before Elan collapsed, I'd gotten to know Garo Armen by studying his cancer technology company closely -- he's the CEO of Antigenics. I greatly admire Garo's brains and ambition. Because I had gotten to know him, I knew he had the highest standards of personal integrity. I knew he was telling the truth when I spoke with him about Elan. And in a situation like Enron, or WorldCom or Elan, knowing the guy in the middle of it all, and knowing that he's totally honest is the most valuable information you can ever have in the stock market.

Garo told me Elan was worth saving because of its excellent science -- in particular the company's new drug for MS. This drug would be worth $10-$20 billion in the market, but Elan was trading for less than $1 billion at the time because most investors thought the company would go bankrupt and nobody trusted its managers. But I did.

I wrote that Elan would be the best stock on the NYSE in 2003 ("Investing in Garo" PSIA December 2002). Unfortunately, we got stopped out in March, at $3.00, up a bit from where we'd bought....but not the big gains I was expecting. A few months later, in September of 2003, after checking in with Garo and seeing additional clinical trial results on its MS drug (Tysrabri), I re-recommened it -- this time at $6.00. We made a killing this time, riding the stock to around $18.00.

Then everything fell apart. The company hit a huge landmine in early 2005, shortly after we sold. Its MS drug was pulled from the market, over safety concerns. I reviewed the data -- only 3 out of several thousand patients developed a rare brain disease. I believed the drug would be reinstated by the FDA after further study. I re-recommended the shares in July 2005, for around $7.00.

Today all 12 members of a FDA advisory board voted to urge the FDA to allow the drug back on the market. (See the Reuters story here: http://biz.yahoo.com/rb/060308/tysabri.html?.v=11 ) The stock rose 24% on the news, to close near $16.00 per share, up more than 100% from my most recent recommendation.

Three recommendations. Profits each time. In total, several hundred percentage points of profit.
All the Elan profits my subscribers made stem from one relationship I cultivated in biotech -- Garo Armen. When young editors join our group, I always tell them the most important thing to do for your career as a newsletter writer is to build good relationships with the smart guys you meet.

Thanks Garo.

Gran Pacifica Looks GREAT

Plus, Wad O’ Cash



*** ROADS! ***

I’m fired up today... about roads!

I got a JPEG picture in an email from my friend Mike Cobb. Mike is the CEO of Gran Pacifica, a real estate development company with beachfront projects in Nicaragua and Costa Rica. The picture Mike sent me is of newly paved cobblestone streets! It was taken in Nicaragua, at the Gran Pacifica development. The roads even have curbs and a sidewalk! There’s nothing else like this in all of Nicaragua.

Steve Sjuggerud and I bought a beachfront lot in Gran Pacifica about six months ago – before there were roads of any kind. The roads look nice – as nice as any you’d find in America. Maybe nicer. And that’s a wonderful surprise. We bought for the beach, the surf, the people and the price. That the developers (our friends, Mike and Joel) are doing a first class job is icing on the cake.

Take a look for yourself. The folks standing in the photo are my future neighbors. They all came down for a party and shareholders meeting in January. The roads look great, don’t they? Holy cow. I’m sure it’s hard for you to understand why it’s such a big deal…but basically nothing else in the whole country looks this nice…

By the way, Gran Pacifica will soon be selling “turnkey” casitas (with two bedrooms) for less than $100,000. If you’re looking for a very low cost second home in a very low cost destination…you should check out Gran Pacifica (http://www.granpacifica.com/). If I wasn’t in the midst of a buying a new home for my family in Baltimore, I’d scoop up as many of those casitas as I could afford. In a few years (3-5) I bet they’ll sell for $200,000 or more. Full disclosure: My wife and I own a tiny stake in the development company.


*** WAD O CASH ***

I found about $10,000 in cash ($100 bills) in my camera bag two weeks ago.

I was sitting in the airport in Managua, digging around in my camera bag for a cable to upload pictures onto my laptop. What’s this envelop…? I cracked it open and $100 dollars bills started pouring out.

Holy cow – I’d just found a huge wad o’ cash in my bag!

Of course, I didn’t really think I’d found $10,000, I thought I'd re-discovered a stash of my own "travel money.” I'd taken out for one of my past trips and then forgotten about. I tend to do that from time to time, because I'm always afraid of running out of money. I have this never ending fear that my American Express card will simply stop working one day and I won’t be able to pay my hotel bill. So, before I travel, I take out $10,000 in 100s and hide them in my luggage, in case I ever need "get away money."

It's funny...finding $10,000 that you didn't know you had feels better than earning $100,000 investing.

Anyway...I was so freakin' excited. I thought about what I could do with the money -- go to New York, buy a new mountain bike...get a few really nice new suits, etc. Maybe a case a great wine...
Then I remembered: a colleague of mine, Lief, gave me this money to deliver to another colleague. I’d spent the night with Lief at an apartment in Buenos Aires six months ago. I was supposed to deliver the money months and months ago, when I flew to back to Miami. But I’d completely forgotten. I'd hidden the cash in my camera bag, in a pocket I never use, so that it would be safe. I knew my camera bag would be "on me" at all times during the trip, so the money couldn't get stolen...but by the time I got home I'd completely forgotten about it.

I was so depressed...

Monday, March 06, 2006

DEADSUMERS

Rising mortgage rates have finally taken the equity piggy bank away from the deadsumers.

Rising commodity prices have destroyed all of their wage gains since 1995. Manufacturing has been gutted by foreign competition and now India is beginning to take white collar jobs too. Sooner or later people with huge mortgages and declining real wages who face strengthening foreign competitors are going to have to tighten their belts.

I think the “tipping point” is happening right now.

Let’s take a look at the evidence. The story has three parts. First, wages and savings are NOT responsible for the huge growth in consumer spending since 2003. That’s because wages haven’t kept pace with inflation and the savings rate has been in decline for more than ten years. Second, the rise in housing prices (fueled by huge increases to outstanding mortgage debt) gave U.S. consumers the ability to spend far more than they earned through refinancing their homes and cashing out equity. Everyone knows this anecdotally and the statistical evidence of it is overwhelming too. The game ends when mortgage rates rise (killing the ability to refinance) and housing prices cool. That’s when the “deadsumer” will have to retrench. They’ll simply have no more money to spend.

Here’s a chart of non-manager wages in the service industry and manufacturing wages (80% of all wages paid in the U.S.) since November 2001. The big jump higher in November 2005 is an anomaly: the government’s statistical body, the BLS, says that inflation fell in November (yeah right). Bottomline: incomes aren’t growing for the vast majority of Americans, even if you accept the government’s inflation figures.


Next, the surge in consumer spending over the last several years couldn’t have been based on savings (i.e. wealth), because as wages have been falling, U.S. consumers have been spending more. The savings rate has been decimated. You’ve seen the chart (below, left) below many times before, I’m sure. It shows that savings have declined, in almost a straight line, since 1985 and that the savings rate has been negative for most of 2004 and all of 2005. A negative saving rate means that “deadsumers” are spending money that don’t have – a condition that can’t last very long.


So…where did the money come from?

Simple, mortgages. Total outstanding mortgage debt rose from $6.6 trillion in 2000 to $11.3 trillion by the 3Q of 2005.

Outstanding mortgage debt nearly doubled in five years!

Total household borrowing increased from $6.9 trillion to $11 trillion in the same period – a 59% increase. The increase in mortgage leverage led to a rapid increase in the prices of existing homes. In fact, the prices of homes that were sold and re-sold grew at a much faster pace the price of brand-new homes (see chart below), clear evidence that much of the boom in housing has been caused by additional debt.


With the incomes augmented by additional mortgage debt turned into cash via refinancings, Americans went on a huge spending spree. The share price of retail stocks (below, left) shows what happened: up, up and away. Standard & Poor’s maintains a good index of retail businesses – about 35 companies like Home Depot, Bed Bath & Beyond, Big Lots, Costco, Dollar General, etc. (You can see the whole list here: http://www.analyzeindices.com/ind/retailers.htm).

These are big, big businesses – not the kind of stocks that should jump around like Internet stocks. But the average stock in the index has doubled since 2003!

Keep in mind, that’s the average. Some companies, like Sears Holdings, have gone up much, much more. Since early 2003, shares of Sears Holding have gone from around $12 to as high as $150 – an increase of over 1000%.

Sears Holdings was originally the remnants of Kmart. It emerged from bankruptcy in early 2003. The hedge fund manager who owned a majority, Eddie Lampert, sold off some of Kmart’s real estate holdings and got investors excited, which drove up the share price enough to allow for the acquisition of Sears. Ironic huh...a hedge fund manager uses the real estate of a retail company that’s being pumped up by real estate-inspired spending to acquire more retail locations. I wonder what will happen to Sears’ share price when the mortgage-spending bubble bursts?


FOR WHOM THE BELL TOLLS…

My final point: the party is coming to an end.

Mortgage rates are rising. Housing prices have stalled and will soon decline. New home inventories are building. Consumers are beginning to pull back.

I see this most vividly in the results of two companies. First HouseValues Inc., which is an internet business dedicated to helping realtors sell houses, fell apart last week when it lowered its earnings guidance for 2006 from $0.14 per share to $0.04 per share. The stock fell more than 30% in a day.

Of course, you don’t have to go far down the quality spectrum to see that housing is starting to cool. Tollbrothers, the homebuilder famous for its McMansions, has reported falling sales trends since last year. Orders for new homes in the 1Q of 2006 are down 29% since last year!

Even more worrisomely, 8.8% of the homes it had sold but not yet delivered were canceled – considerably above the company’s historic 5% cancellation rate.


What’s behind the sudden drop in demand for homes and for home selling services…? Rising mortgage rates, of course.

Fixed rates have moved from around 5% in early 2003 to over 6% today. Adjustable rates have moved much more, in percentage terms, from 3% to over 5%. And a bunch of those adjustable rates will “reset” this year, costing consumers a lot more cash in interest payments.



As you can see from the S&P retail index above, retail stocks haven’t begun to feel the pressure that’s already apparent in the housing market. But other kinds of businesses that depend on large amounts of discretionary income have begun to feel the impact – most notably providers of online secondary education.

The biggest of these companies, Apollo (APOL), has grown rapidly over the last five years as white collar workers seeking MBAs and higher salaries paid top dollar for convenient (and easy) online education.



But now Apollo – after years of outstanding growth – is suddenly a company in trouble. Its CEO left abruptly in January. It has missed its revenue targets for the last five quarters in a row. Its allowance for uncollectible tuition increased 120% year over year, to $20.1 million (3.2% of all revenues!). The company acknowledges that this bad debt figure will increase throughout this year.

Apollo’s new CEO will not give revenue guidance, will not comment on the total number of students enrolled currently and has withdrawn this year’s earnings guidance. A company like Apollo, with a steady growing business shouldn’t suddenly hit a wall of this magnitude unless something bigger is affecting its market. And that something bigger is easy to see: consumers can no longer afford big ticket items like Tollbrothers’ houses and online private colleges.

The chart above shows Apollo's stock price compared to the S&P retail index. Will retail follow Apollo down the way it followed Apollo up. I bet it does. And I wonder how this trend will affect buyers of other types of expensive online information…like newsletters…

We’ll see.

Friday, March 03, 2006

MUTUAL FUNDS I'D BUY

Morningstar Inc. calculates … so-called hard-asset funds now have combined assets of almost $104 billion,” up from less than $19 billion five years ago.”
-- Jonathan Clements, WSJ March 1, 2006



Oh boy…the lemmings are piling into commodity mutual funds. This is probably the beginning of a very ugly ending…

Here’s what happened last time one sector of the market got this popular.


The chart is Firsthand Fund’s Technology Innovator’s mutual fund. It closed its doors to new investors in November 1999 because it was flooded with new money – getting $80 million in only 11 days. We all know what happened next: like everything else associated with tech, it crashed.


You could look at almost any tech-centric mutual fund and you’d see the same thing.

There are a lot of reasons why I despise mutual funds – I hate the way lousy mutual fund managers can still earn millions of dollars. I hate the way people who own mutual funds smugly assume they’re being smart about their finances. I hate the way mutual funds spread their commission dollars around Wall Street, corrupting analysts and bankers, creating myriad conflicts of interest. But…at the very core of my violent distaste for 95% of all mutual funds is the fraudulent promise at the heart of the industry: the lie that you can get rich by doing nothing and knowing nothing about investing.

It’s simply not true.

Nor is it reasonable to believe that you can trust someone at an institution to handle your finances alongside thousands of other investors with any genuine fiduciary care. It’s a myth – one of the most valuable myths of the modern financial era. The lie they tell is very compelling: just send us all your money and we’ll take care of it. Investors go for it because it relieves them of their second biggest worry – that they’ll lose their wealth. (The first worry is losing your health…)

When you buy a mutual fund, you’re buying the fund, as it’s comprised today, at current prices. But no mutual fund only owns securities that it considers to be attractive at today’s prices. No, in fact most of the assets of the fund should be long-held investments that should have increased in price significantly since they were added to the fund. But, as a new investor, you’re buying all the assets and the current prices – including all of those stocks whose prices aren’t current attractive to the managers. Or, in other words, you’re buying all of their gems that have faded, but you’re paying full retail.

That’s no good. And from there, it gets worse.

If you’re buying an “index fund,” which typically tracks the performance of the S&P 500 or the Dow Jones Industrial Average, you’re buying a group of the biggest and supposedly best stocks around. This means they’re also the most expensive and the least likely to appreciate much. Even worse, most indexes (like the S&P 500) are “marketcap weighted” which means the bigger the marketcap of a stock is, the more weight it carries in the index. Or, said another way, the more expensive a company is, the more weight it carries in the index. That means when you buy an index fund, most of your money is going into the most expensive stocks. That doesn’t make any sense, does it?

There is undisputable evidence that proves small cap value stocks will outperform any other type of similar financial asset. However, these stocks are typically too small for any large institutional investor to buy. Thus, small cap value is out of bonds for index funds and even for most mutual fund families. When you buy a mutual fund, you’re automatically condemning yourself to subpar investment performance, a truth that’s proven in mutual fund performance studies. Dalbar, a Boston consultancy, did a study which showed the average mutual fund investor made less than 6% a year, on average, during the great bull market ever in stocks, from 1981 through 2000.

The incredibly poor showing is due, in part to the contrary motivations of the fund companies. They get paid based on total assets under management, not investment performance. As a result, the fund companies advertise the hottest sectors heavily as they go higher. They know investors will chase performance. Thus, in all the mutual fund ads you see now in the financial magazines, you’ll find the 1, 3 and 5 year performance figures for the fund companies’ hard asset mutual funds. These are the same funds they were trying to hide from you six years ago at the top of the tech boom. Back then all the ads touted the tech funds.

So today you see investors piling into real asset funds just like they piled into tech funds in 1999. And you know what’s going to happen next. It’s sad and pathetic.

However, there are some notable exceptions. There is a relatively small group of top notch managers who because of their tremendous skill are no longer concerned with garnering assets and have the freedom to do the right thing for the current and prospective customers. I’m talking about the guys like Marty Whitman of Third Avenue Value and Mason Hawkins at Southeastern Asset Management. Unfortunately these mutual fund managers aren’t accepting any new clients right now because they’re honest about the dearth of attractive investment opportunities.

Seems like we’re out of luck…

However, I did find a new group of mutual funds that seem like a really good idea. They focus on a broad range of top dividend paying stocks, which I know is a sound long term strategy. They’re ETFs -- low cost, closed-end funds that trade like a single stock and are really holding companies. These ETFs buy high dividend paying stocks and weight their investments according to dividend yield, not marketcap. John Spence wrote about them in last Tuesday’s Wall Street Journal.



The best performing dividend centric ETF is called the PowerShares High Yield Equity Dividend Achievers fund. It trades on the American Stock Exchange, under the symbol PEY. There are a few similar sister funds too, such as an international version, which trades under the symbol PID.



I know a little about the PowerShares family of index funds because my friend and colleague Steve Sjuggerud has recommended their biotech fund. What he noticed about their funds is how smartly they’re put together – they’re not brainless index funds. For example, the biotech fund limits the size of any single stock, preventing all your money going into Genentech and Amgen, which dwarf all the other biotech companies in the index. As a result you’re buying a broader array of biotech companies.

What I like about the idea of a dividend tracking index fund is that such a fund solves the management problem for you – eliminating one of the biggest problems with mutual funds. You don’t have to worry about having some 25-year old MBA managing your money and killing you by trading heavily and generating a big tax bill. You don’t have to worry about some 55-year old manager who is too bored to work anymore putting your assets into the most boring; least risky firms that he knows won’t get him fired.

PowerShares High Yield Equity Dividend Achievers (PEY) is on “autopilot.” Each year it buys the top 50 yielding stocks that have raised their dividends for at least 10 straight years. The index it tracks has garnered a 12.6% total return annually for the past five years. That number – 12% -- rings a bell with me because I publish the 12% Letter, an advisory that seeks to earn 12% a year by investing in dividend paying companies, with most of the returns coming from dividends. I know that’s the most amount of money you should expect to make via dividend investing. That this fund produces that kind of return is significant: they’ve found a formula that works.

Just as importantly, the way these funds are structured insures your money can’t get caught up in a fad. By buying the highest yielding, most stable firms, the fund is automatically buying high quality and relatively cheap equity. The formula makes sure you stay invested in relatively out-of-favor stocks – which, of course, are how these funds generate such nice returns.

Finally, because these funds are “closed” they operated as stand alone businesses – holding companies. You’re not buying into some pile of money; you’re buying a share of a stand alone business, which eliminates a lot of the fiduciary issues of mutual funds.

Owning these funds is very inexpensive: the fees are half of one percent, per year.

Another similar index is the S&P High Yield Dividend Aristocrats Index. Its corresponding ETF (SPDR Dividend: SDY) is managed by State Street Global Advisors, which is a multi-billion investment company. This ETF tracks the performance of the 50 highest yielding U.S. stocks that have consistently raised dividends for at least 25 years. The index has a five year annualized return of 11% -- but its investments are spread out across a wider variety of industries: 13% in healthcare, 20% in consumer goods, 13% in industrial materials, 27% in financial services and 18% in utilities. Owning this fund is even cheaper: it charges only one-third of one percent.



These ETFs are among the few mutual funds I’d ever consider buying.