Fagan Associates Archive for March, 2011

During February 2009, the Federal Reserve conducted a stress test of sorts, one in which evaluated the capital levels of the nineteen largest U.S. bank holding companies, those deemed “too big to fail.”  As a result of this test and according to a press release from the Federal Reserve, “the Federal Reserve advised bank holding companies that safety and soundness considerations required that dividends be substantially reduced or eliminated.  Since that time, the Federal Reserve has indicated that increased capital distributions would generally not be considered prudent in the absence of a well-developed capital plan and a capital position that would remain strong even under adverse conditions.”

In laymen’s terms, the Federal Reserve was attempting to make certain that the largest U.S. Banks had adequate capital to take them through another financial crisis without being bailed out by the U.S. Treasury.

Speed forward to present day.  A week ago Friday, the Federal Reserve announced that it had completed a second stress test, called the Comprehensive Capital Analysis and Review (CCAR) and as a result announced that “some firms are expected to increase or restart dividend payments, buy back shares, or repay government capital.”

One of the banks that have since announced dividend increases include J.P. Morgan whom raised their dividend from $0.05 per share per quarter to $0.25 per share per quarter for a yield of 2.18% based upon the closing price Thursday, March 24.  Prior to the whole financial mess that came to a head during early 2009, J.P. Morgan was paying a quarterly dividend of $0.38 per share resulting in a yield of more than 3.00%.  We believe that if an investor were to own only one bank, it would be J.P. Morgan.  We believe that they provide the best opportunity for capital appreciation relative to the risk that you would be assuming.  In addition, we believe that further dividend increases are likely and would provide a hedge against inflation.

Another bank that responded to the recently concluded CCAR by raising their dividend was Wells Fargo which announced a special $0.07 per share dividend for the first quarter in addition to their normal $0.05 per share dividend for a total dividend of $0.12 per quarter.  We believe that this “special” dividend may be incorporated into their normal dividend for the second quarter and beyond.  If so, Wells Fargo will now pay an annual dividend of $0.48 per share for a yield of 1.50% based upon their closing price Thursday, March 24.  In addition, the Board of Directors of Wells Fargo announced a 200 million share buyback plan totaling $6.4 billion.

Finally other financial institutions either announced dividend increases, share repurchases or plans to begin to repay the TARP funds borrowed by banks from the Federal Government.

THE BOTTOM LINE – It appears as if the Federal Reserve believes that the worst is behind us for the economy and as such the banks.  However, more so now than ever, there will most likely be a wide moat between the winners and the losers.  We believe that J.P. Morgan is a winner.  Another bank we are high on that is not cited in this column is First Niagara, a bank that combines the potential for capital appreciation along with solid income from dividend payments.

Many investors purchase or sell securities at precisely the wrong time.  Specifically, they buy high and sell low!  We believe that part of the reason behind these untimely transactions has to do with the rational expectation that one should accentuate the positives and reduce or eliminate the negatives in life.  Unfortunately, many times this does not work when investing money.  Let’s take a look at a couple of examples how this natural reaction works against you when investing.

We have many clients who own common stock in Ford Motor.  Ford has recently been trading at approximately $14.50 per share, twenty-five percent below its fifty-two week high of $19.00 set within the past twelve months.  In our opinion, the stock has been weighed down by a number of factors, not the least of which being the slowdown in the economy as well as the tragedy in Japan.  This drop in value has generated several telephone calls from individuals who think that Ford Motor may be a timely buy at these levels.  To bolster their case, they justifiably cite many reasons why business should remain strong for Ford, including their long-term global business outlook.  The question as to whether or not Ford is a good buy, in part because the share price has dropped is an appropriate manner of investing.  One may believe that the price has fallen to a point that more buyers than sellers will step in and, given the current economic environment, the share price will begin to rise.  Conversely, we are also receiving contacts from individuals who are concerned that the recent decline in share price is not yet over and are deciding whether or not to unload their shares.  They believe that the uncertainty surrounding the issues noted above will continue to weigh down the stock.  Only time will tell which investor has made the correct decision, the one who perhaps buys shares at this time or the one who sells.  However, both are making decision based upon the share price fluctuation and many times, this is a mistake.  Just because a stock you buy goes up, it does not mean you made a wise investment and conversely, just because a stock declines after your purchase, it does not mean you have made an unwise

decision.  We suggest that investors make informed decisions based upon the fundamental outlook for the company, the industry it operates in and the macroeconomic outlook both domestically and, the case of Ford Motor, globally.

Our second situation pertains to the individual who contacted us during 2010 and wished to

purchase shares of Ford Motor because it had moved from ten for fourteen dollars per share.  Or the individual who wishes to purchase shares because his neighbor has made a ton of money with Ford or the individual who won’t sell his or her shares because “Ford has been good to me over the years.”  All of these situations may be accurate, but it does not answer the prevailing question when deciding whether or not to make an investment.  That is, what is the potential for the stock price to appreciate?  Again, to answer these questions, one must once again look at the fundamental data surrounding business conditions for Ford Motor.

In our opinion, the change in the share price over a period of time is not nearly enough of a reason to purchase or sell the security.  You purchase a stock because you believe it has potential.  You sell when you believe there is a lack of potential or to move on to a company with more potential.

The potential for an investor to buy high and sell low is clearer when analyzing cash flows into mutual funds.  Mutual funds experience their greatest net inflows after having beaten their peers on a total return basis over a given time frame.  However, many of these same investors are buying high only to experience pain as those investments that made the mutual fund successful correct back down to a reasonable price.  For example, the emerging market funds during the year 2010.

Finally, cash outflows from bond-based mutual funds are at their greatest after interest rates rise.  This occurs because the trailing returns are subdued by the inverse relationship between bond prices and interest rates (as interest rates go up, the value of bonds decline and visa versa).  However, poor returns on bond funds are usually an indicator that the bond fund will perform better in the future.  This is once again due to the inverse relationship described above.  Therefore, generally speaking you should sell bond funds after a period of good performance and buy bond funds after a period of underperformance.

We revert back to our initial observation that when investing, it is often prudent to accentuate the negative and reduce the positives.  This translates into buying low and selling high.

As he does every year, famed investor, Warren Buffett, the “Oracle of Omaha” and Chief Executive Officer of publicly traded Berkshire Hathaway, writes a letter that precedes the Annual Report.  Needless to say, due to the historical stellar investment returns that Mr. Buffett has achieved at this conglomerate, what he has to say and what Berkshire has done is closely monitored.  We thought it might be of some benefit to investors to relate some of what Buffett has to say.

One of the more popular tenets Warren Buffett adheres to is one in which “we simply attempt to be fearful when others are greedy and greedy only when others are fearful.  This can be illustrated in the fact that during 2010, “in the face of widespread pessimism about our economy – we demonstrated our enthusiasm for capital investment at Berkshire by spending $6 billion on property and equipment.  Of this amount, $5.4 billion – or 90% of the total – was spent in the United States.  Certainly our businesses will expand abroad in the future, but an overwhelming part of their future investments will be at home.  In 2011, we will set a new record for capital spending — $8 billion – and spend all of the $2 billion increase in the United States.”

Should there be any doubt as to what this investment means, Mr. Buffett follows up this paragraph with “money will always flow toward opportunity, and there is an abundance of that in America.  Commentators today often talk of ‘great uncertainty.’  But think back, for example, to December 6, 1941, October 18, 1987 and September 10, 2001.  No matter how serene today may be, tomorrow is always uncertain.”

Why do we focus on the day-to-day deafening negative noise filling our airwaves, newspaper columns and internet when someone with the business acumen of Buffett observes that “throughout my lifetime, politicians, and pundits have constantly moaned about terrifying problems facing America.  Yet our citizens now live an astonishing six times better than when I was born.  The prophets of doom have overlooked the all-important factor that is certain:  Human potential is far from exhausted, and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective.”  Wow!

Buffett wraps up the less Berkshire specific section of his letter with “we are not natively smarter than we were when our country was founded nor do we work harder.  But look around you and see a world beyond the dreams of any colonial citizen.  Now, as in 1776, 1861, 1932 and 1941, America’s best days lie ahead.

Why do we believe they do not?  Do we listen to, read and then draw conclusions from those that have a vested interest to disseminate such negative information?.  As we often say, the Weather Channel has to sell advertising and can only do so by providing exciting, riveting weather-related information, sometimes regardless of the fact that perhaps it is 75 degrees and sunny outside with a forecast of more of the same.  We can say the same thing of the Business Channel.  All this said, we do believe that America is faced with many challenges.  However, over the long haul, we’re with Buffett.  We’d rather be on the side of America then bet against it.