Checking on Past Rec’s.

A little over a year ago (June 2011), I blogged about “Dead Money” stocks.  I felt the time for a revival was coming.  Some of the stocks I recommended were WMT, ABT, GE, TEVA,  MRK, HPQ, INTC, CSCO, PFE, and MSFT.  Here are the returns of these stocks since, then (not including dividends) as well as the S&P 500 return since June 2011:

SPY: 9%

WMT: 33%

ABT: 28%

GE: 21%

TEVA: -20%

MRK: 22%

HPQ: -52%

PFE: 20%

MSFT: 22%

CSCO: 16%

INTC: -2%

The two big losers on the list were TEVA and HPQ.  I still like TEVA (and I’m still invested) but I’m not a fan of HPQ.  Something I’ve come to realize over the past year is that it’s really hard to predict tech.  From this list, the only tech stock I really like is MSFT, simply because it’s so stable, and so cheap.  INTC really dropped the ball on mobile technology, and as a result, I’m not sure what the growth prospects for it are.  MSFT is throwing the kitchen sink at its Nokia Windows 8 phone, and is determined to make it happen.  My number 2 tech stock would probably be CSCO or ORCL.  Because I think tech is fairly cheap as a secgtor, but have no clue which players will survive and which players are going to be left behind, I’m invested in VGT.

Wal Mart, Abbott, PFE, and GE have has such good runs since the summer of 2011, I’d venture to say that they are fairly valued, and possibly overvalued.  Wal Mart at a PE of 11 or Wal Mart at a PE of 16 are two completely different investments.  I’m not good enough at predicting patent cliffs, and I’m not confident in calculating a margin of safety for ABT or PFE at these levels.  GE is pretty debt-laden, and high debt companies are something I’ve tried to stay away from lately.  Not to mention, a PE of 18 for a conglomerate is too much.  I’d look at Siemens right now, instead.  Siemens, at $85, is a good deal if not a great deal.

So overall, my picks did pretty well.  7 of my picks beat the S&P 500, while 3 didn’t.  I think my second year of business school, and studying valuation over the past year has been pretty valuable, and I think I’m a better investor now than I was a year ago.

From this list, I still like TEVA, MSFT, and maybe INTC, since it’s fallen back to $23.  I’m currently invested in TEVA and MSFT.

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People are starting to catch on regarding “Dead” stocks.

A few weeks ago I spoke about “dead money” stocks that have been trading flat over the past decade.  The reason they have traded flat for so long is that their valuations in 2000 were ridiculously high.  Whenever you invest in blue chips at 25-30 times earnings, you can expect your investment to remain flat over the long haul.  Now, however, these blue chips are finally trading at valuations that value investors love.

“Complain all you want to about [Wal Mart] going nowhere since 2001, but don’t blame the company — it’s done its part. The $15.5 billion the world’s largest retailer earned in the past four quarters completely trounces the $6.4 billion in profits this discount chain cleared in the same four quarters ending in the middle of 2001. In fact, only once in that 10 year timeframe has trailing 12-month revenue fallen (mid-2009), and it’s more than made up for the dip since then.

“At the heart of Wal-Mart’s success is the pricing power that comes with sheer size. It’s the world’s largest retailer, and as such, it’s also the world’s biggest single wholesale buyer of everything from toys to food to apparel. Therefore, it can afford to call the shots as a buyer, and it can afford to beat its competitions’ prices — or even take a loss — as a seller.

“So why has the stock been stagnant? Because investors ran it up to 45 times its annual earnings in 2000, which was a valuation the company never had a prayer of justifying anytime in the foreseeable future. The stock is now priced at a palatable 12.6 times its trailing 12-month earnings now though, so we may finally be at the point where shares and profits start to move in tandem again.”

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Andrew Lyon on total amount of corporate deferred taxes: “We have not looked at that data.”

Well, I have.  And it’s not pretty.

[You would think a former treasury secretary and current PwC employee would have actually considered this “data” to be a little important.  Evidently not.]

Corporations paid roughly $190B in federal taxes in 2010 (,  yet the S&P 100 added $42.5B in deferred taxes to their balance sheets.  So what did the S&P 500 add?  $100B?  Can this be right?  Are companies collectively deferring well over one-half of their federal income taxes?  As it stands, companies “report” their deferred taxes and actual paid taxes together as total income taxes:

“Total income taxes are defined to be the sum of all taxes imposed on income by local, provincial or state, national, and foreign governments during the year. It is the total tax provision and includes current taxes as well as the change in net deferred tax liabilities for the year.”

So your average bear, you would just take the total income taxes “paid” at face value.  I’m not.

Warren Buffett calls the deferred income tax an “interest free loan” and has used it as one of his primary methods of financing since the early 1990s.  Companies are essentially allowed to tell Uncle Sam to wait a while until they’re ready to pay those taxes.  But when?  ExxonMobil and Berkshire Hathaway collectively have around $70B in deferred taxes on their balance sheets.  That’s just TWO companies.  Exxon has more deferred income taxes than Total Debt.  Think about that.  This means that the government is their largest creditor, and they’re loaning money without demanding interest.  And all the while, the Federal Reserve targets 2-3% inflation YOY.

If the government decides to alter this rule, and forces companies to start reducing this balance because of our federal revenue crisis, it’s going to have two collective hits on the markets.  The first will be when the official ruling comes out.  The second will be when companies purposefully write down billions of dollars of bad assets (predominately goodwill and intangibles) to create “paper losses.”  This will allow them to write down sizable chunks of their deferred tax liabilities without actually paying out these taxes in cash.  This is exactly what happened to companies like Time Warner, Freeport McMoRan, and AT&T in 2008.  Their income statement will look like a train wreck while their cash flow statement will still stay relatively intact.  But because the morons on Wall St. love to push “earnings,” the markets will freak out and panic selling will occur.

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Deferred Taxes – a Sneaky Form of Cheap Financing

One of my latest engagements has been to dig a little deeper with deferred tax liabilities.  The initial spark for this study was my noticing that Intel’s deferred tax liabilities jumped by $850M during their most recent quarter, on earnings of $3.16B – a sizable portion of their earnings.  My next endeavor was literally tallying the deferred income taxes for the S&P 100 over the past 3 and half years.  The sum of deferred income tax liabilities are as follows:

2007:  $304.56B

2008:  $244.01B (60.55B)

2009:  $292.15B +48.14B

2010:  $334.68B +42.53B

2011 (so far):  $348.90B +13.21B

These numbers are pretty sizable, considering this is only the S&P 100.  (These numbers are probably not completely accurate, however.   Google Finance has some of the crappiest balance sheet data on the planet.  If I had to guess, I’d say that these numbers are probably slightly understated.)

Companies are steadily bolstering the amount of deferred tax liabilities on their balance sheets to the tune of about 15-20% YOY, with the exception being 2008.  Being that I really didn’t know what deferred tax liabilities were, I found this intriguing, yet confusing.

In the “Owner’s Manual” for Berkshire Hathaway, you’ll notice that Warren Buffet says that he uses deferred taxes (along with insurance float) as his primary source for financing because it’s literally an interest free loan from the government.

“Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets than our equity capital alone would permit: deferred taxes and “float,” the funds of others that our insurance business holds because it receives premiums before needing to pay out losses. Both of these funding sources have grown rapidly and now total about $100 billion. Better yet, this funding to date has often been cost-free.  Deferred tax liabilities bear no interest.”

So in essence, deferred taxes are – indirectly – money that the government is “lending” to companies – free of interest.  Apparently, this payment deferral is commonly used by corporations who are in the midst of mergers and big buys.  And Mr. Buffett, living up to his word, has fully taken advantage of it.  Berkshire Hathaway’s deferred income taxes jumped from $19B in 2009 to $36B in 2010.

While many, many companies are currently taking advantage of deferred tax liabilities in large fashion (PEP, AAPL, GG) two companies that have taken advantage of this “loan” that I’ll elaborate on are Coca-Cola and Exxon.  XOM acquired XTO and KO bought and sold some stuff to CCE during 2010. During the 4th quarter of 2010 (the same quarter that KO reported ridiculously good net earnings) a $3B spike in deferred taxes popped up.  Historically, KO has kept their deferred taxes near $1B – total.  Exxon is no stranger to deferring income taxes.  Like BRK, their deferred tax liability balance stands at $36B dollars, partially due to a $10B dollar addition in deferred taxes in the 2nd quarter of 2010.  The Total Debt that Exxon carries currently stands at around $16B, just to put things in perspective.  They’ve done a fantastic job of taking the government up on interest-free money.

While the Federal Reserve purposefully targets 2% inflation YOY, the government allows companies to defer paying taxes free of charge.  What a great deal for these large corporations and shareholders – and what a horrible deal for taxpayers!

When I initially saw this spike in deferred taxes, I thought that they were associated with the money hoards that companies keep overseas.  However, a PwC report I dug up states that almost all of the money made overseas, that is intended to stay overseas, does not fall into deferred income taxes.

“US GAAP permits a company to overcome the presumption of repatriation and forgo recording a deferred tax liability, as long as it can support the assertion that management has the intent and ability to indefinitely reinvest the profits or otherwise indefinitely postpone taxation in the home country market.  This is known as the indefinite reinvestment assertion.”


“Asserting indefinite reinvestment traditionally has been a widespread practice among multinational businesses.  A majority of companies make the assertion with respect to much, if not all, of their foreign earnings.”


“In a recent study of the 2009 list of Fortune 500 companies, it was reported that more than 300 US multinationals asserted indefinite reinvestments and disclosed the amount of undistributed earnings in the notes to their respective 2008 financials.”

So from my understanding, these spikes in deferred taxes are not overseas profits that companies refuse to repatriate.  Deferred taxes are indeed money that the company “intends” to pay taxes on – at some point in the future.

As an investor in the stock market, the most important question is: why did companies collectively reduce their deferred income tax liabilities in 2008 during the middle stages of the credit crisis? Take a look at T, FCX, TWX, GE, and PFE.  The operating section of their income statements and the long-term liabilities section of their balance sheets in 2008 show pretty good correlation.  And speaking of Pfizer, they happened to make a pretty big acquisition in 2009.  It was accompanied by a $15B increase in deferred taxes.

Emil Lee points out that the nature of some deferred tax liabilities will prevent a company from likely ever having to pay those taxes back, which is likely the case for Berkshire Hathaway.

But for most companies, I’m guessing that at times, they will need to reduce their deferred income taxes.  By writing down all of their crappy assets and recording a huge paper loss, they are able to drastically reduce their deferred tax liability – in one fell swoop.  This seems to be what happened in the fourth quarter of 2008.  But my question is why did everyone decide that 4Q 2008 was the time to do it?

As we inevitably go through periods of busts and booms with the economy, should we expect earnings to swing even more wildly to the high side and low side as a result of this sneaky form of cheap financing, and the subsequent need to collectively reduce it from time to time?  As Wall Street has completely shunned Balance Sheet valuation methods in complete favor of earnings valuation methods, you can bet huge earnings swings would come with some pretty drastic swings in the stock market as well.  Go over to Shiller’s website and take a look at the S&P 500 earnings swings that have occurred over the last 10-15 years.  You think early 2009 was your only opportunity to get companies on the cheap?  Probably not.

Speaking of earnings valuation methods, what do you plan on using for your risk-free rate in your DCF now?  What’s the yield on Scandinavian debt?

While cash as a percentage of debt may be at historically high levels, cash as a percentage of deferred tax liabilities are likely at historically low levels.

I’m also thinking that in the midst of a federal budget crisis, what politician has the intestinal fortitude to step up to the plate and eliminate most deferred income taxes and set a true corporate tax rate?  (That’s rhetorical)  If the S&P 100 collectively has a deferred tax liability of $350B, what does the S&P 500 currently check in at?  A trillion dollars?  What does the Wilshire 5,000 check in at?  The aggregate debt of the S&P 500 is somewhere in the ballpark of $3T, I think.  So roughly 25-30% of corporate leverage comes from deferring tax payments to the government.  Is our country in any position to be leaving trillions of dollars on the table?

So in summary (and other takeaways):

  • Deferred taxes are a source of government, interest-free financing.  Many companies have higher deferred tax liability accounts than total debt.
  • While there was a collective reduction of deferred income tax liability in 2008, these accounts are significantly on the rise again.  Large spikes in deferred tax liabilities typically come with acquisitions and are accompanied by increases in PP&E, goodwill, and/or intangibles.  Large reductions in deferred taxes often come with increased debt and the writing down of bad assets.
  • Deferred tax liabilities have little to do with overseas profits.  Overseas profits are almost always considered “indefinite reinvestment” earnings and are not added to deferred taxes.
  • There may be some correlation to the excessive reduction in deferred income taxes in 2008 and the “unusual expense” charges that came in 4Q 2008.  While some companies swapped out their deferred income taxes with actual debt in 2008, but accepted large write-downs on assets nonetheless (T, PFE, and GE), many companies simply accepted severe write-downs on assets without increasing their debt (FCX, TWX, DVN).  Will this collective deferred tax and asset reduction simultaneously happen again, plunging reported net income as it did in 2008?
  • When companies decided to shift their deferred tax liabilities to actual debt in late 2008, it caused a quick spike in bond yields – the last time that AAA debt yielded over 6%.  The 40% increase in deferred taxes over the past 2 years has greatly reduced the need for corporate debt, and has driven down interest rates to pathetic levels.  If a collective shift from deferred taxes to corporate debt happens again, can we expect another spike in bonds yields?
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Notes from “How Quickly they Forget” – Howard Marks

Howard Marks from Oaktree Capital occasionally puts out a letter to his investors.  Marks, and his fund, are very value oriented.  Here are several notes from his latest letter:

  • Rather than balancing greed against fear, euphoria against depression, and risk tolerance against risk aversion, investors tend to swing wildly between these extremes.
  • Past patterns will recur.  Speculators who ignore these patterns will tend to lose money rather than gain from them.
  • Reasons investors fail to remember the past:
  • Demographics – new investors enter the market who’ve never experienced long-term stock cycles (and don’t bother to study them).
  • The human mind tends to suppress bad memories.
  • The human mind doesn’t do a good job with fighting greed.
  • A quote from Charlie Munger: “Nothing is easier than self-deceit.  For what each man wishes, that he also believes it to be true.”
  • We must look at other investors’ sentiment when assessing the current value of assets.  During panics, many investors are reluctant to lend, driving up interest rates.  This provides good opportunities for return.  If investors are very willing to lend at low rates, it could signal trouble ahead.
  • Leading up to 2007, many overly risky behaviors were taking place.  The issuance of non-investment grade debt was at record levels.  Companies were borrowing money to pay out higher dividends.  Leverage was being used increasingly for company buyouts.  The yield spread between high-yield bonds and treasuries sank to record lows.  (Why invest in anything other than treasuries if the yields are similar?)
  • Marks now goes on to say that he feels 2011 is beginning to feel much like 2005.  (Note, however, that the bubble didn’t burst until 2007.  Is Marks again a little too early?)
  • The portion of buyouts that is done with equity or debt fluctuates depending on the sentiment of the market.  After the fallout of the financial crisis, 38% was the average amount of equity that went into a buyout.  This year, its already back down to 30%, and quickly approaching the 2005-2009 average of 25%.  Companies are already willing to use more debt down to make a buyout.
  • Here is an 8 year timeline of the YTM/spread vs treasuries on high-yielding bonds:
  • Normal – Dec 2003 – 8.2%/443bp
  • Bubble Peak – June 2007 – 7.6%/242bp
  • Panic Trough – Dec 2008 – 19.6%/1,773bp
  • Recovered – March 2010 – 9.0%/666bp
  • Now – April 2011 – 7.5%/492bp
  • (While we might not be in “bubble territory” yet, I’d keep an eye on the spread – as it approaches 3%, that could be where the market begins to turn.)
  • While there are some areas of the market that are seemingly overvalued – high-tech stocks, social network sites, emerging markets every now and then, and possibly gold and commodities, most investors are moving toward low-risk portfolios.
  • Stocks aren’t cheap, yet stocks aren’t “bubbly.”
  • Right now, investors are being pushed toward more risky assets due to the weakness of returns in safer investments.
  • Many pension and investment funds are still trying to achieve the coveted 8% return YOY.  This handcuffs them to risky assets.
  • As others are willing to indulge in more risk, the savvy investor should be even more prudent when assessing risk.
  • While many seasoned investors assumed that the detriment of the 2008 crisis would be lasting, the huge amounts of government intervention immediately revived investors’ appetite for risk.
  • The huge fed rate cuts meant that anyone holding cash or low-yield bonds were going to get smoked by the market.  Investors and fund managers were (are) literally forced into taking on risk.  Much of the bond market has been removed as an investment vehicle, leaving equities and other non-traditional types of risky investments.  As more money flows into fewer types of asset classes, bubbles can form.
  • The attractive buying time during the financial crisis lasted only 15 weeks.  A short-lived crisis may mean a quickly-forgotten crisis.
  • During the early innings of the recovery, as a result of no demand for treasuries in favor of corporate debt, companies were able to quickly roll over the high-interest debt to lower yielding debt.  The default rate fell from 10.8% in 2009 to 1.1% in 2010.  This was the greatest one-year decline in history.  As a result, bond prices went up (yields went down) and people who were invested made money.  But this has led to a rush to “join the party,” and people are convinced that the situation is improved.
  • As more and more investments become lower-yielding, many investors will reach for return – go out even further on the risk curve.  This is likely the most flawed approach, unless extreme diligence is conducted.
  • Will we return to the days of the 1980s and 90s when economic growth was strong and eager to spend?  No.  During those days, initially clean consumer balance sheets led way for leverage via credit cards.  During the mid 2000s, the consumer then levered up through their home equity, which at the time was growing.  Now, the average consumer is already levered up on credit (or can’t get credit because they’ve already defaulted), and home equity has evaporated.  The growth of the 1980s and 90s is long gone (at least for 5-10 years.)
  • Other investors’ seemingly risky behavior says its time to begin getting conservative.
  • Uncertain macro issues existing today: a weak US recovery, the US deficit and the political process in general, the fallout due to inevitable deleveraging and austerity, the debt levels of many eurozone nations, the possibility of high inflation, and the uncertain outlook of of USD and the euro.
  • Because of the multitude of potential negative issues, and the fact that stocks are fair- to over-priced, the assumption that stocks will greatly appreciate from here because everything will “work out fine” seems a little foolhardy.
  • At the conclusion of the shareholder letter, Marks suggests going back to one of his previous letters from the mid-2000s for a better picture of past events.  I’ll be recording those notes soon.
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Bearish sentiment is on the rise

It’s always popular to initiate the bearish bandwagon after the market has taken a 5-10% dip from recent highs (which it currently has), but I’m finding many of the arguments to be incredibly compelling – and from a handful of very credible sources.

On June 20, Barry Ritholtz posted a couple of technical charts that don’t appear to be very promising.  The first chart shows the market cap of the NYSE + NASDAQ actual chart and the long-term trendline of the two.  The market clearly shows three types of movements relative to the trendline – market cap floating above, below, or right on.  These secular movements last anywhere from 100-200 months each.  According to the chart, in 2008 we breached the long term trendline, and unless history is going to be changed, we’ll see the market trade below the trendline for another 70-170 months.  The second chart is a near 100 year chart of Market Cap/GDP.  Its showing a clear downtrend since the market peak in 1999, and the next big leg down should be starting any day now (not any week now).

On Pragmatic Capitalism, JJ Abodeely warns investors about the problems associated with looking at Forward P/E ratios.  Just about every stock market bull right now is using the forward P/E, 20-year low argument to say that stocks are far from overvalued.  Many companies, however, saw abnormal tax breaks and additional profits due to govt stimulus over the past two years.  [AT&T for instance, added about $6B to its reported profits for FY 2010 due to an effective tax rate of -6%.  That’s $6B that will be evaporated from next year’s earnings.  And this is just one company!]  So the gist of the article is that forward earnings for a single company is much more logical than forecasting the earnings of 500 companies.  Unless you take into account the YOY drop in earnings for each company like ATT, forward earnings are pointless, and even dangerous.  Another point in the article is that a company’s reported operating earnings are never what it actually reports.  And historically speaking, operating earnings are 16% higher than reported earnings.  So when an analyst forecasts earnings based on operating projections, predictions are mistakenly high.

Mike Shedlock has been bearish since I started keeping up with his blog about a year ago, and it seems he’s been pretty bearish since the market topped back during the dot com bust.  He very accurately said around 2005 that it would take 7 years for housing prices to bottom (its been about 6.5 and they still haven’t bottomed), and he’s been bullish on gold during its great bull run.  On Feb 7, he first put up an article that caught my eye titled “Negative Annualized Stock Market Returns for the Next 10 Years or Longer?  It’s Far More Likely Than You Think”  He then proceeds to present some absolutely fantastic data showing that investments in market bubbles – when P/E ratios are well in the upper 20’s – will yield negative returns for the better part of not 10, but 20 years.  This would basically mean that the market correction from 1999 should continue with another leg down even after two bull runs from 2002-2007 and from 2009-2011.  The next leg down, depending on the severity, would likely be the last, however.  And on June 20, he states that he thinks Berkshire, at 1.15 P/B is still overvalued, and that C and BAC at 0.5 P/B are both overvalued.

Comstock Partners’ latest “Special Report” was titled, “Why We Believe we are in a Secular Bear Market.”  It was released on June 16.  Their analysis is very economic-based, citing continued deleveraging from the US consumer and monetary and fiscal policy that closely resembles Japan from 15 years ago.  Oh, and by the way, Comstock called the market crash in 1999.

I’ve also seen other highly respected individuals suggest a frothy market – Robert Shiller, who provides a lot of the ammo for the Mish article above, thinks a recession is nearly unavoidable, while TMFBabo, who has been the #1 CAPS player over on the Motley Fool for about a year now, has recently stated that he’s going to avoid the market over the next several months to pay down his debt with his real money portfolio.

Personally, I’ve shifted to about 25% cash and bonds now, and I might shift that to closer to 35%.  Probably 85% of the individual stocks I’m still sitting with are dividend payers, while the rest of my equity holdings are mutual funds or index funds.

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The government refuses to pop the education bubble.

After the DOE ruling that basically allows for-profit schools to continue business as usual, expect the higher education bubble to grow even larger.

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