Monthly Archives: January 2014

Living on the Edge, Part II—Make Mine a Large (Cap)

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Late last month, we asked if you can get a real edge on individual equities in general. This week we ask if you can get an edge on large cap stocks in particular. We think yes. We think there are lots of ways to get an edge on large cap stocks—more ways than we can fit in here. So we’ll discuss just one of our favorites: Looking beyond the next handful of quarters in earnings estimates.

One of the toughest parts of an analyst’s job is deciding whether to use a short-term or long-term outlook as he or she develops an investment thesis. Often—perhaps too often—the shorter view wins out for less-than-the-best reasons. Because analysts usually are judged on quarterly performance, for example. Or because there are so many voices chattering about the same issues concerning a particular security.

Those short term perceptions are often what drive a stock, but in our experience, short term noise and thinking can create biases in analysts’ financial models—particularly in forecasting next year’s earnings estimates.

For instance, if an analyst is convinced that shorter-term factors are going to have a negative influence on a particular stock, chances are that perception will bias his-or-her longer-term estimates. Such a bias can keep estimates artificially low, as the analyst may have a difficult time explaining to clients a negative thesis on a stock with accelerating longer-term forecasts.

Simply being aware of the potential for such a bias can be a powerful tool, especially when an analyst believes the longer term potential of a stock outweighs the short-term risks.

So when we hear that most investors are waiting for that “one last negative factor” to subside before getting more constructive with a security, we get interested.  Usually, with well-known products and names, the negative factors are already well-known and anticipated—and factored into short-term forecasts.

But longer-term recoveries from those negative factors in subsequent year’s numbers are often overlooked. The result is a potential edge for the investor willing to cultivate the long term perspective.

There is, of course, the risk that those shorter term factors will drive down the price after one purchases a security. But if your long term investment thesis is unchanged after those events such a price dip often is a great time to add to a position.

Indecision Time

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In spite of the much-heralded cold snap over the past week, credit markets have not cooled off. Maybe market sentiment is just frozen in place along with everything else, but 2014 has started on a positive note.  Or did it? We find ourselves going back and forth between the good and the bad.

On the good side, the new issue calendar was active, which was expected after a holiday hiatus of several weeks. $50 billion priced this week, about $20 billion of which came from sovereign issuers, and the rest from corporate issuers. Bank and finance dominated, which is typical to start the year, including deals from GE, Toyota Motor Credit, and a number of Yankee banks. They were joined by industrial issuers Mondelez, American Tower, Union Pacific, and French oil producer Total. Demand was solid, with deals generally pricing inside of guidance, and performing well once they were free to trade. Spreads have also remained firm – intermediate bonds are a few basis points tighter, and longer duration corporate spreads unchanged so far this year. Not a bad start to the year for Credit.

On the other hand, we are starting to see some weakness in a few areas. Long duration industrials are a little wider, following an unusually strong performance in December. CDX spreads are a few basis points wider (CDX are indices based on Credit Default swaps of a set group of issuers), also following a generally strong December. Investors began selling bank/ finance and telecom paper after the first couple of trading days, and spreads there also moved a little wider. There haven’t been any big cracks yet, so maybe we can chalk up some of the movement to profit-taking.

There are a few worries still in the market, like the never-ending budget battles in Congress. But we have sailed through taper from the Fed, new rules from Dodd Frank, and we are no longer concerned about the collapse of any European Banks. It looks like we’re set up for a solid year with low volatility and good performance from credit.

My mind is going to keep me up at night. Crisis in credit just wasn’t that long ago.

Husker Du?

Rebuilding Trust in the Financial System

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Tom Brakke, CFA

The CEO of Barclays recently acknowledged the damage to the firm as a result of its transgressions and said:  “Trust is a very easy thing to lose, and a very hard thing to win back.  In my view it will take several years – probably five to ten – to rebuild trust in Barclays.”

Meanwhile, J.P. Morgan has been on a treadmill of settlements, resulting in tens of billions of dollars of costs to the firm (or, if you will, to its shareholders).  Once viewed as having skated through the financial crisis relatively unscathed, its reputation has been tarnished by subsequent revelations.

The list could go on but, given the performance of bank stocks over the last few years, you might ask, “Who cares?”  Many observers have come to the belief that the firms are specifically in the business of stepping over the legal and regulatory lines – and that fines and damaged reputations are just a cost of doing business for them.

Surveys show that trust “in the financial system” has collapsed over time.  But that “system” is very complex and involves a wide range of firms and professionals.  Those in research and asset management, for example, might feel that they have been tarred unfairly with the same brush as the banks.  But we are all in this together.

The natural governors on the investment banks are the large asset management firms.  But they have been missing in action – in fact, they tend to exacerbate destructive trends rather than impede them.  Consider the subprime mess.  Had there been a buyers’ strike when underwriting standards deteriorated, we wouldn’t have had much of a crisis.  An absence of buyers would have meant that the paper-making machines would have shut down well before reaching the level of insanity that was attained. Continue reading →