My Two Cents - "Dominos and Themes"

11/21/2008

With the most recent two day crash in the Dow Industrials average, we are once again poised at the precipice of oblivion. Two important dominos have been toppled in the past two days. On Wednesday, the Dow closed below the psychological mark of 8000. Granted, the 7997.28 level was not the most pronounced of breaches, but it is worth noting. However, yesterday, we solidified the drop below 8000 and blew right through the October 10th low of 7773.71 going all the way down to 7552.29. In totality, the listed market has now lost approximately half of its value – in 12 months.

While it would be easy to digress into an analysis of the sheer magnitude of the losses over the past year, it is perhaps more worthwhile to take a look at some of the different investment themes that have been prevalent over the past year and see how they’ve fared. This is an important exercise since there is still plenty of fuel for more declines, but at the same time there are also overriding fundamentals that will drive things moving forward.

While it is very true that virtually every possible portfolio has in some way been affected by the liquidation over the past 6 months, it is important to note that some areas have done much better than others even though, in most cases, this still means some sort of loss. Hedging strategies can be used to mitigate such losses. The obvious drawback of hedging strategies is that they tend to mitigate gains during times of upward price movements.

Another important consideration in any portfolio is dividends. In the three sample themes we’ve constructed, we provide the returns with and without dividends. There is an old investing adage with regard to dividends that goes something like “If you’re going to have to wait, you might as well get paid for doing it”. The past year has been a shining example of this logic. For those investors who chose to try to ride out the current situation, dividends have provided a nice cushion. The biggest problem with dividends is that they’re being cut all over the place. A drastic example of this would be the financial stocks. In many cases, dividends have not only been cut, but eliminated altogether.

Because of this reality, it is important to look not only at the current and prior dividends, but whether or not the cash flow will exist to support future dividends. A good example of this analysis would be the Canadian energy Trusts. A good many of the Trusts are paying the same distributions now as they were when oil was $60/bbl on the way up. And they paid those same distributions even when oil was $150/bbl. The obvious conclusion would be that the funds exist to maintain current levels. However, analysis of the cash flow of these firms is required to either support or refute the ability to continue distributions at current levels.

To construct our exercise, we’ll take a look at 3 major themes that have been prevalent over the past year: Consumer Staples, Energy, and Basic Materials. The securities selected were not necessarily part of the S&P Sector Index, but rather they were companies that have been talked about in the media and financial websites, and therefore, were likely to make it into many portfolios. While it would be easy to point to November 2007 price levels, May’s levels more completely encompass the rally in the US Dollar, which has been an important direct and indirect driver in the price of many of these stocks.

Consumer Staples – ‘Recession Proof’ Model

The choices for this model were obvious except for Merck & Co., Inc. and DuPont. Merck was chosen because pharmaceuticals represent a fairly steady portion of consumer spending, and this is likely to be the case moving forward. DuPont was chosen mostly because many of their products support the production of consumer goods. In particular, their fertilizer, seed, and various paints and coatings all contribute to the production of consumer goods.

• Of the 9 companies in this model, all 9 experienced a loss over the period from 5/19/2008 through today. The hedge used was the Proshares Ultrashort Consumer Goods (SZK).
• Unhedged, this model lost 27.44% ex-dividends, and 26.03% with dividends.
• Hedged, this model lost 13.24% ex-dividends, and 12.01% with including dividends.
• The model paid $6.39/share in dividends during the course of the period studied.

Energy – MLP/ Canadian Royalty Trust Model

This model contains 4 Canadian Royalty Trusts, an oil service company, two Master Limited Partnerships (MLP’s), and an express Trust. The model is heavy on the side of Canadian Royalty Trusts because they have been a popular vehicle for individuals to invest in oil and natural gas.

• Of the 8 issues in this model, all 8 experienced a loss from 5/19/2008 through today. The model is hedged with the US Oil/Gas Short ETF (DUG).
• Unhedged, this model lost 51.16% ex-dividends, and 46.32% with dividends.
• Hedged, this model lost 41.93% ex-dividends, and 37.42% with including dividends.
• The model paid $16.94/share in dividends during the course of the period studied.

Base Materials Model

This model contains basic materials producers including mining, chemical, paper, steel, and fertilizer/seed companies. The simple logic used to make the case for Base Materials over the past year has been that a growing world requires more and more resources. The idea of a US recession has been used to attack this rationale over the past 6 months in particular.

• Of the 9 issues in this model, all 9 have experienced a loss over the period studied. The model is hedged with the Ultrashort Basic Materials ETF (SMN).
• Unhedged, this model lost 65.68% ex-dividends, and 64.57% with dividends.
• Hedged, this model lost 50.00% ex-dividends, and 48.94% with including dividends.
• The model paid $7.57/share in dividends during the course of the period studied.

Conclusions and take-home ideas

It is imperative for investors to understand at this point the purchasing power of cash. We have been on the stump talking about purchasing power for the past two and a half years, but contrary to the normal trend, we are now seeing Dollars become more valuable in terms of stocks, housing, and many consumer goods. Even the most durable of the three themes presented in this article has lost more than 12% just in the past 6 months. While there have been brief rally periods combined with much volatility, the overall trend has been down. And looking at the fundamentals, there are more reasons stacked on the side of further decline right now than reasons arguing for an increase. However it must be noted that perhaps the biggest ‘fundamental’ arguing for increases in equity markets is the trillions of Dollars in new money and credit which has been pumped into financial institutions over the past few months. For whatever reason, that money has largely stayed on the sidelines for the meantime. It is our firm belief, however, that this will change, and when it does we’ll have ourselves another epic paradigm shift, and cash will once again become trash. Identifying the inflection point will be the key. Stay tuned.

Graham Mehl is a pseudonym. He is not an ‘insider’. He is required to use a pseudonym by the policies of his firm when releasing written work for public consumption. Although not an insider, he is astonishingly bright, having received an MBA with highest honors from the Wharton Business School at the University of Pennsylvania. He has also worked as an analyst for hedge funds and one G7 level central bank.

Andy Sutton is a research and freelance Economist. He received international honors for his work in economics at the graduate level and currently teaches high school business. Among his current research work is identifying the line in the sand where economies crumble due to extraneous debt through the use of economic modelling. His focus is also educating young people about the science of Economics using an evidence-based approach.