April 13, 2012 The Silver Hammer

Risk/Reward Vol. 165

THIS IS NOT INVESTMENT OR TAX ADVICE. THIS IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

"Bang, bang, Maxwell's silver hammer/Came down on her head
Clang, clang Maxwells silver hammer/Made sure that she was dead."---lyrics from "Maxwell's Silver Hammer" by The Beatles

"The prettiest people do the ugliest things/For the road to riches and diamond rings
We shine because they hate us/Floss cause they degrade us
We trying to buy back our 40 acres"---lyrics from "All Falls Down" by Kanye West

"When you started off with nothing/ And you're proud that you're a self made man
Yes, I 'm stuck in the middle with you."---lyrics from "Stuck in the Middle" sung by the Stealers Wheel

"Bang, bang!" Another week, another record high for the Dow Jones Industrial Average and the S&P 500...and another two gurus join the list of those gravely concerned by the impact of quantitative easing here (QE3) and abroad (Japan). Sam Zell, the founder of several real estate investment trusts and known as the nation's largest landlord, likened the QE3-juiced stock market to the real estate bubble of 2006. He is convinced that it will burst, but like everyone else he doesn't know when. And Rick Rieder, the head of BlackRock's $752billion fixed income portfolio described QE3 as a "large, dull hammer" "Clang, clang!" Sooner or later, the "silver hammer" will "come down on our heads". Ask yourself, what will happen to interest rates once the Federal Reserve stops buying $45billion worth of Treasury securities and $40billion worth of home mortgages each month (which equates to 64% of all net Treasury debt and 34% of all home mortgages) ? Frankly, we are in uncharted waters, and no one knows. However, many gurus fear that quantitative easing has perverted our credit markets and that its inevitable cessation will cause a negative ripple throughout the financial world. In other words, unless we are nimble, our gains could "for sure be dead."

But, hey, while QE3 lasts, "we shine"! One consequence of QE3's cheap debt financing is the proliferation of stock "buy backs". Properly played they can provide a "road to riches and diamond rings." Allow me to explain. The classic means of valuing a stock is to apply a multiplier to a stock's projected earnings on a per share basis. If a company has projected earnings of say, $4 per share (determined by dividing the projected annual earnings by the number of shares outstanding) and the company trades at the S&P 500 average multiple of 15 times earnings, the stock will be valued at $60. A company can increase its share value in three ways: by increasing its total earnings; by aggressively growing its business (which typically results in the market applying a higher than average earnings multiple); or by reducing its share count. During times of low interest rates (like now thanks to QE3), corporations often borrow money and use it to repurchase their shares. This lowers the share count which increases earnings per share which in turn results in higher stock prices. For example, over the past 12 months, AT&T has borrowed more than $5billion at rates as low as 1.5% which it has used to repurchase shares carrying a 5% dividend. This 3.5% interest rate/dividend arbitrage has been a win/win for shareholders. In the past year, AT%T's stock price has risen 26% (while increasing its dividend) even though its projected earnings multiple is only the market average of 15, typical of a company experiencing only moderate growth. Look for massive buy backs as a signal to buy.

As the search for yield becomes more difficult, give consideration to buying business development company (BDC) stocks. As discussed in earlier editions, the primary business of BDC's is providing senior and mezzanine financing to companies that are "stuck in the middle" market: typically entrepreneurial entities run by "proud, self made men who started off with nothing"; but entities that are still too small to be deemed credit worthy by the public markets. Since the financial crisis of 2008, banks, the traditional funding source for the "middle market" have shied away from lending to these enterprises. That lending void has been filled in part by BDC's. I like them because in order to maintain their pass-through tax status, BDC's must distribute 90% of their earnings to their shareholders. Despite their outsized yields, BDC's have trailed the general market significantly so far this year, and thus they may present a buying opportunity. As noted last week, my favorite is ARCC. I also like the closed end fund FGB, which holds positions in several BDC's. A recently launched exchange traded fund, BDCS, is also worth a look.

Several times over the past few weeks, I have been contacted by Readers inquiring whether it is time to exit the market. I have no special insight on this, but I do listen to The Beatles. Ms. Market has "done right by me" even if "I don't know why she is riding so high." And although someday "I think I'm goin' to be sad", I "don't think it's today." So, I'm stickin' with her so long as she appears to have "a Ticket to Ride.".