Investment Rethink

Secure Dividend Stocks Outperformed in 2011

2012-01-19T13:31:00.000-08:00

At the beginning of 2010, the US economy continued to suffer through difficult times and forecasted growth was modest. I suggested at that time that high dividend paying companies with secure cash flow would likely outperform the broad market. Therefore, I created a list of companies that were listed on the Dow 30, the S&P 500, or the Nasdaq 100 indices that had a minimum dividend yield of 4% and had at least 40% excess levered free cash flow compared to the amount of money paid out as dividends.

During that year, the 22 companies that I identified had an average return of 27% including dividend yield, which was approximately 12% higher than the S&P 500 index return in 2010.

Again at the start of 2011, I created a similar list of stocks that met the secure dividend yielder criteria. These companies were:

Pfizer
Verizon
CenturyLink (now merged with Qwest Communications, another qualifier)
Pitney-Bowes
R.R. Donnelly
Lorillard
Integrys Energy Group
Eli Lilly
Cincinnati Financial
Leggett & Platt
Phillip Morris International
People’s United Financial
Lockheed Martin

With continuing slow economic growth in the US, these secure dividend yielding companies have again significantly outperformed the broader market. As expected, the dividends for the 13 companies proved to be secure. Many of them increased during the year and none fell.

In 2011, the S&P 500 finished the year virtually unchanged and had a dividend yield of 1.8% for a total return of 1.8%. Meanwhile, the Dow 30 experienced a 5% gain and a dividend yield of 1.7% for a total return of 6.7% in 2011.

Of the 13 secure dividend yielding companies, eight outperformed the S&P index while five fell short. However, the average return of these stocks, including the dividend yield, was 11.1%, or approximately 9.3% higher than the S&P 500 index return and 4.4%higher than the Dow 30 return.

Note that I did not adjust the returns of the indexes or the dividend yielding companies for any measurement of risk. The average beta for this group of stocks was 0.90, suggesting relatively low volatility. However, I did not calculate the covariance of volatility compared to the index stocks.

If sluggish growth continues in 2012, then secure dividend yielding stocks should once again outperform the market benchmarks. For 2012, the companies that meet the criteria of a minimum dividend yield of 4% and at least 40% excess levered free cash flow compared to the amount of money paid out as dividends are as follows:

Pfizer
Merck
Verizon
Conoco Phillips
Hasbro
Bristol-Myers Squibb
Kimberly-Clark
Federated Investors
R.R. Donnelly
CenturyLink
Pitney-Bowes
Ventas Inc.
Whirlpool Corp.
Cablevision Systems
Supervalu Inc.
Waste Management
Lorillard Inc.
NYSE Euronext
Eli Lilly
Ameren Corp.
Leggett & Platt
Lockheed Martin

Nine of the 13 companies from last year’s list remain and are joined by nine new companies that meet the criteria. Time will tell whether these companies perform as well as their list predecessors.

Secure Dividend Yielders Continue to Impress

2011-08-02T14:24:00.000-07:00

In 2010, I created a list of companies that were listed on the Dow 30, the S&P 500, or the Nasdaq 100 indices that had a minimum dividend yield of 4% and had at least 40% excess levered free cash flow compared to the amount of money paid out as dividends. I posited that these were companies that would be able to continue to pay their dividends through difficult economic times. During the year, these companies had an average return that almost doubled the S&P 500 index return.

At the beginning of this year, I identified the following companies that met the same criteria:

Pfizer
Verizon
CenturyLink (now merged with Qwest Communications, another qualifier)
Pitney-Bowes
R.R. Donnelly
Lorillard
Integrys Energy Group
Eli Lilly
Cincinnati Financial
Leggett & Platt
Phillip Morris International
People’s United Financial
Lockheed Martin

In that post I stated that “if economic growth is slow in 2011, these stocks could outperform the general market.” Now seven months later, in a tepid stock market environment, how have these stocks performed compared to the general market?

Once again, the relative return for the secure dividend stocks is impressive. From the beginning of the year to August 1, 2011, the S&P index has increased by 2.33%, while the secure dividend stocks have risen by an average of 4.09% during the same period, which represents a return over 75% higher than the market benchmark. As well, these returns only consist of capital appreciation and do not include dividend payments. On an annualized basis, the secure dividend stocks have an average dividend yield of 5.5%, compared to a 2.2% average dividend yield for S&P 500 stocks.

If the current uncertain economic climate continues for the balance of the year, I expect this trend to continue. I will reassess these returns again at the conclusion of the year.

Changes to the Blog

2011-08-02T13:44:00.000-07:00

When I commenced my blog in May 2010, I addressed topics involving the interrelation of investing, financial analysis, law, and corporate ethics. Over time, I began discussing issues that had some implications for corporations, but predominantly involved ethical issues relating to society at large. Because "Investment Rethink" doesn't encapsulate many of these topics, I have decided to create an additional blog named "Ethic Edge" that will specifically address topics relating to ethics that do not have a strong relation to investments. You can reach that website by clicking here. My posts on this website will now focus primarily on investments and financial analysis.

Black Headed Back to Jail

2011-06-24T14:28:00.000-07:00

Further to my previous posts (June 5, 2011, October 10, 2010, and August 9, 2010) regarding Conrad Black and his fraud and obstruction of justice charges, today the Court sentenced him to a 3.5 prison term for his remaining convictions. Lord Black will receive credit for the approximately 28 months he previously served, so his remaining sentence length will be just over one year.

Ethical Anonymity in the Information Age

2011-06-21T10:51:00.000-07:00

Information technology has not been kind to people prone to ethical lapses. As cell phone cameras, portable Internet access, and social media websites become more pervasive, the amount of time between ethical transgressions and their public exposure is decreasing drastically. In the past month, society has witnessed some interesting examples of this phenomenon:

1. In late May, Congressman Anthony Weiner accidentally posted a picture of himself sporting very little clothing on his public Twitter account. Very quickly, other similar pictures surfaced in the press and on social media websites. While Weiner initially denied the authenticity of the photos and claimed that his Twitter account had been hacked, he quickly learned that his various clandestine messages sent via the Internet left a digital trail that formed a portfolio of his impropriety.

2. On June 10, 2011, Philip Baker, the Dean of Medicine at the University of Alberta, gave a stirring convocation speech to school graduates. The problem was that the Dean plagiarized the content. It was almost identical to a speech that Dr. Atul Gawande gave at a Stanford University medical school convocation in 2010. What is especially noteworthy is that students in the audience used their iPhones and Blackberrys to conduct Internet searches of some of Dean Baker’s speech phrases while he was still speaking and found the original speech that Dr. Gawande crafted. Thus, before his speech even ended, Dean Baker’s unethical behavior was exposed due to the audience’s immediate access to information.

3. Following the Vancouver Canucks’ loss in the final game of hockey’s Stanley Cup Playoffs last week, people took to the streets of Vancouver and commenced a riot that resulted in mass vandalism, looting, arson, and violence. One thing struck me about all the footage and photographs of the incident that began flooding the Internet: in most pictures, there were more spectators in the background taking pictures of the activity with their cell phones then actual participants.

Even before the mayhem had ceased, people began posting pictures of perpetrators on websites such as Facebook and Twitter, asking the public to identify those involved in criminal activity so that the information could be forwarded to the police. By the next morning, people had created new websites and Facebook pages that the public could view in the hope of identifying criminals caught in the act. Suddenly, law breakers were no longer simply part of a large, anonymous crowd.

Yesterday, the Globe & Mail newspaper reported that Vancouver police have received over 3,500 emails with tips regarding those who committed crimes following the hockey game, many of which included links to photographs, video footage, or social media websites such as YouTube and Facebook. While a similar riot occurred in Vancouver following its last hockey finals loss in 1994, bystanders played a less substantial role in aiding law enforcement. Today, the ever evolving digital age swiftly exposes those who publicly display unethical and illegal behavior.

We live in a time when our ethical missteps may be preserved for all to see. While this is very apparent in the examples described above, even less public incidents may be recorded for posterity on various websites and blogs. Background checks were once the monopolistic tools of the government, police, and potential employers. Now practically anyone can glean some of the history of a new business contact or potential date through a simple Google search. Today, more than ever, acting unethically comes with consequences resulting from information that spreads and is stockpiled like never before.

Is "Pet" a Dirty Word?

2011-06-13T13:34:00.000-07:00

The editors of the Journal of Animal Ethics recently criticized the use of the words “owners” and “pets” to describe the relationship between humans and domesticated animals. Instead, they prefer the terms “human caregivers” and “animal companions”. In its guidelines for publishing articles, the Journal advises authors to avoid using words that are derogatory to animals such as “beasts”, “vermin” or “critters”. Not surprisingly, this position has elicited a fair amount of controversy. Critics claim that the announcement is yet another example of political correctness gone awry. As author and psychologist Christopher Thurber jests, this can lead to a slippery slope where eventually we will be referring to “pet rocks” as “mineralized family members” so as not to offend someone.

The idea that language influences peoples’ attitudes toward groups in society is nothing new. The feminist movement, in particular, brought attention to the fact that a principal message embedded in our language is that women are inferior to men. Whether it was male generic language that failed to recognize the existence of females (e.g., policeman standing as a proxy for both male and female officers) or terms that defined women in terms of their relationships with males (e.g., women receiving the moniker “Miss” or “Mrs.” compared to “Mr.” for males regardless of a man’s marital status), the underlying message was that women were subordinate to men.

Because we develop our thoughts and communicate using language, feminists argued that attitudes toward women would not change until facets of our language did. I would argue that the opposite was true as well: people would not change the way they used language until their attitudes toward women began to change. Thus, over time there has been incremental progress in both the reduction of language that is derogatory toward women and in gender inequality. Granted, in both respects, there is still much improvement to achieve.

Should we expect to witness a similar transformation in the treatment of animals and the language used to describe them? Compared to the success of the feminist movement, changes in the language used to describe animals have lagged advances in animal welfare. In the aftermath of Peter Singer’s groundbreaking book Animal Liberation, treating animals as creatures deserving our moral consideration gained credence. Since then, society has questioned practices such as factory farming, puppy mills, and killing animals for sport that historically received little attention. The view that animals should be treated ethically is now the predominant opinion.

Now, the Journal of Animal Ethics is calling attention to the language we use to describe animals. However, it is questionable that the terms its editors identify are on par with the ones that denigrate women. While the etymology of the word “pet” is not certain, it appears to be related to the term “petty”, which implies being lower in rank or importance. Regardless of what the word’s origins were, today “pet” is generally used as a synonym to “animal companion” and is not meant to demean animals. In fact, one can claim that the word “animal” itself has a negative connotation. If someone calls a person an animal, he or she likely won’t consider it as a compliment. The term “owner” should cause greater concern than the word “pet” since it unequivocally indicates a superior/subordinate relationship. However, this may simply reflect reality: under the law, domesticated animals are chattels that people own. If there is a concern with the term “owner”, then perhaps the best course of action is to attempt to change the law rather than language. Otherwise, despite a change in semantics, the law will remain.

Any time that a group questions our use of language that has become entrenched in our daily usage, there is likely going to be public resistance to change since language is the way in which we express ourselves and is considered to be an important aspect of freedom of thought and speech. However, language is always evolving and adjusts to reflect new beliefs and values. Recently, we have witnessed the modification of the meaning of words such as “sustainability” and “green” that mirror our growing concern about the environment. Perhaps there will come a time when attitudes toward non-human life forms will change in such a manner that our language referencing animals will change as well.

Further Update on Conrad Black

2011-06-05T10:59:00.000-07:00

On October 30, 2010, I provided an update on Conrad Black’s ongoing appeal of his convictions on three counts of mail fraud and one count of obstruction of justice stemming from his tenure as C.E.O. of Hollinger International. I originally discussed his situation in my August 9, 2010 post entitled “The Reoccurring Paradox of Fraud and Philanthropy”, which listed ten individuals that were involved in corporate wrongdoing and charity work.

This past week, the U.S. Supreme Court refused to grant leave to appeal on Black’s two remaining convictions. The court did not provide any comments with its decision. Black will now be re-sentenced on June 24, 2011. He originally spent 28 months in jail prior to being released in connection with his appeal.

Assessing Advice from Investment Experts

2011-05-17T19:17:00.000-07:00

Internet websites and television programming that focus on investment strategies are replete with expert advice, stock picks, and general market predictions. Unfortunately, experts with the most extreme and polarized opinions seem to receive the most exposure. Someone who claims that oil will reach $200 a barrel by year end or that the stock market is due to plunge 10% or 20% in the next month generate more interest than a common sense advisor who suggests that the market will rise marginally in line with modest economic growth.

Novice investors may be tempted to act on expert recommendations, especially when the education, experience, and track record of a pundit is impressive. However, while investment experts are constantly making predictions regarding stock performance, the media and public do not usually revisit these predictions at a later date to determine the accuracy of such forecasts.

In May 2010, I recorded several expert predictions from well-respected analysts that reflected divergent views about where stock markets were headed. Now that almost a year has passed, it is interesting to analyze their accuracy:

Nouriel Roubini

Nouriel Roubini is a professor of economics at the Stern School of Business at New York University. He holds a doctorate degree in international economics from Harvard and has held many prestigious positions with the World Bank, the Federal Reserve, and the International Monetary Fund. He correctly predicted the real estate bubble’s dire impact on the stock market years before it occurred.

However, on May 20, 2010, Mr. Roubini predicted that stocks would fall another 20% from their current levels at the time and that a double-dip recession was likely. The U.S. stock market, as represented by the S&P 500, did fall in the months following Roubini’s prediction, but the lowest close of 1028.06 on July 6, 2010 only amounted to about a 5% drop from the prediction date. Almost a year later, the S&P 500 sits at 1329, representing a 24% increase since the date that Mr. Roubini suggested that a market drop was imminent.

Richard Russell

Just four days after Mr. Roubini’s prediction, Richard Russell stated that the “losses in this bear market are going to be phenomenal.” Mr. Russell has written a financial newsletter called The Dow Theory Letters since 1958. His investment approach is based upon the Dow Theory, a form of technical analysis that was devised by Charles Dow, the founder of the Wall Street Journal and co-founder of the Dow Jones & Company.

At the time of Mr. Russell’s prediction on May 24, 2010, most of the losses in the bear market had already occurred. Since that time, the market has risen about 25% and the further losses he predicted did not occur.

David Kotok

Mr. Kotok is the founder of Cumberland Advisors and has acted as its Chief Investment Advisor since its inception in 1973. He holds three degrees from the University of Pennsylvania, including a Bachelor of Science in Economics from the Wharton School of Business. He is a regular contributor on CNBC and has written articles in the New York Times and the Wall Street Journal about financial market issues.

In May 2010, Mr. Kotok boldly predicted that the S&P 500 would reach between 1250 and 1300 by the end of 2010, which represented an increase of about of between 15% and 20%. In fact, the S&P 500 closed at 1257.64 on the last trading day of 2010 and had reached an intraday high of 2062.60 earlier in December.

The above discussion serves as a warning that well-respected experts in financial analysis are often wrong. People tend to remember their successful predictions rather than their misses. Though some predictions will be correct, it is usually difficult to choose the winners. Rather than placing a bet that the market will either rise or fall dramatically in a short time period, it is more prudent for investors to take a longer term approach that includes investing in a range of asset classes with a risk profile that is suitable for an individual’s unique situation. Otherwise, investing starts to look a lot like gambling.

Moral Issues Surrounding In Vitro Meat

2011-05-10T13:19:00.000-07:00

Last fall, I began writing an article for Arizona State University's The Science in Society Review journal about the ethical issues surrounding the potential commercial introduction of laboratory grown meat. After a significant editorial process, the article has now been published in print and online and can be accessed by clicking here. The article has also been published as an international selection in the Cambridge University, Cornell University, University of Chicago, and University of Melbourne editions of the journal.

Subway Surpasses McDonald’s: Clever Marketing Eludes Ethical Questions

2011-04-24T11:06:00.000-07:00

The Wall Street Journal recently reported that Subway Restaurants has surpassed McDonald’s in the total number of restaurants operated under a single brand-name. The article, written by Julie Jargon, credits Subway’s strategic move of locating its restaurants in non-traditional locations for part of its expansion success. However, I believe that it has been the company’s ability to market itself as a healthy alternative to traditional fast food offerings that has primarily facilitated its growth. While McDonald’s has been a lightning rod for ethical questions about its unhealthy products, Subway has escaped such scrutiny. However, a comparison of the two firm’s key menu items suggests that Subway’s healthy reputation may not be warranted.

As America became more health conscious, Subway successfully modified its image by portraying itself as a fast food chain for waistline watchers. This marketing approach culminated in “The Subway Diet” campaign that featured Jared Fogle, a customer who had lost 245 pounds in less than a year purportedly due to a diet consisting primarily of Subway sandwiches. He ate a six-inch turkey sub plus a bag of chips for lunch each day, and then consumed a foot-long vegetable sub for dinner. As part of Subway’s promotional program, it emphasized its menu that contained seven six-inch sandwiches with under six grams of fat each. The sandwiches on this menu did not did not contain any cheese or sauces, which limited the fat content.

I have eaten at Subway frequently and I cannot remember ever seeing a customer order a sub without cheese or condiments. As well, most customers appear to order sandwiches that are not part of the low-fat menu. Despite straying from the low-fat menu, I think that most of these customers believe that they are consuming a healthier meal than they would receive at McDonald’s or other traditional fast food restaurants. They have simply accepted Subway’s marketing message regarding its healthy product offerings and have failed to examine the calorie and fat content of their most popular subs.

Many of Subway’s six-inch sandwiches contain over 500 calories and have over 20 grams of fat, including in excess of ten grams of saturated fat. Consider the following six-inch subs:

Meatball marinara with cheese: 570 calories; 22 grams of fat; and 9 grams of saturated fat.

Tuna sub with cheese: 530 calories; 30 grams of fat; and six grams of saturated fat.

Spicy Italian with cheese: 520 calories; 28 grams of fat; and eleven grams of saturated fat.

Subway Melt with cheese (one of the lower calorie offerings): 370 calories; 10 grams of fat; and four grams of saturated fat.

Keep in mind that the above menu items do not include any sauces, which most customers order. The addition of the most popular condiments can add an additional hundred calories and ten grams of fat and turn a seemingly healthy sub into a calorie laden lunch. For example, one of Subway’s six-inch sandwiches from its low-fat menu is the turkey breast sub with 290 calories, five grams of fat, and one gram of saturated fat. However, if a customer adds ranch sauce and Monterey Jack cheese, the resulting sandwich contains 440 calories, 19.5 grams of fat, and 5.5 grams of saturated fat.

This makes a McDonald’s cheeseburger, with its 300 calories, 12 grams of fat, and six grams of saturated fat seem like diet food. Other McDonald’s menu items have nutritional profiles that are not much different than the Subway sandwiches with cheese and condiments:

Quarter Pounder with cheese: 510 calories; 26 grams of fat; and 12 grams of saturated fat

McChicken: 360 calories; 16 grams of fat; and 3 grams of saturated fat

10-piece McNuggets: 460 calories; 29 grams of fat; and 5 grams of saturated fat

So a customer who decides to eat a foot-long turkey sub with cheese and ranch dressing believing that he or she is eating a healthy meal is consuming the caloric and fat equivalent of a Quarter Pounder with cheese and a McChicken sandwich.

I am not suggesting that Subway has done anything ethically improper by emphasizing its low-fat menu items. The company clearly states in its advertising that these sandwiches do not include cheese or condiments. It also provides detailed nutritional information regarding all of its subs on its website. What is notable is that Subway’s marketing approach has allowed it to escape the ethical scrutiny that has plagued McDonald’s and other fast food restaurants. By marketing its products to children through its Happy Meal promotions and advertisements, and by sourcing some of its ingredients from factory farms, McDonald’s has received the negative attention of consumer watchdog and animal rights groups that question the company’s moral compass.

It remains to be seen whether or not Subway’s rapid expansion will result in greater examination of its products and business practices, or whether the continued success of its marketing message will allow Subway to maintain its reputation as the healthy fast food.

Searching for Takeover Targets: A HP Case Study

2011-03-28T10:03:00.000-07:00

Software Advice (website at www.softwareadvice.com) recently invited me to comment on an article that Christopher Baum published on March 14, 2011 entitled “HP Mergers and Acquisitions: Who’s Next?” (located at www.softwareadvice.com/articles/enterprise/hp-mergers-acquisitions-who-is-next-1031401/). The article provides a good review of past Hewlett Packard acquisitions and an overview of current potential acquisition targets.

Mr. Baum’s article primarily focuses on the possible synergies between HP and potential targets with an emphasis on gaps in HP’s current product and service offerings. This is a logical place to commence such an analysis. Most corporate acquisitions fail because the acquiring company pays too much for the company being acquired. If markets are efficient, then a company such as HP should only be able to acquire a target company for a premium to its market price (assuming the target company’s shares trade publicly). Otherwise, target shareholders have no incentive to accept an offer from HP because they could obtain the same share price from selling their shares in the market. However, in order for HP to be willing to pay more than the market price for a target company’s shares, it must be aware of synergies between it and the target that have a value in excess of the premium that HP must pay to successfully acquire the target.

Typically, the shareholders of the target company are the ones who benefit most from a merger or acquisition. In their book “Mergers & Acquisitions”, Fred Weston and Samuel Weaver found that target shareholders gain an average of 30% from acquisitions, while the acquirer’s shareholders suffer an average loss of between 1% and 3%. A longer term evaluation of corporate acquisitions also suggests that acquiring companies usually fail to realize the synergies that justify the acquisition price.

Accordingly, there is an investment incentive to determining which companies may be takeover targets since their stock prices rise significantly once an acquisition is either rumored or announced. The key aspect of such an analysis is the one that Mr. Baum and commenting readers have identified: identifying companies that have the greatest potential synergies with HP, or for that matter, other possible acquirers. I do not intend to comment on these views since Mr. Baum and his readers are far more knowledgeable about this sector than I am.

What I hope to add to the discussion is the other key aspect of selecting a target company: the cost of the acquisition. Buying a corporation is akin to any consumer purchase, such a buying a car. A customer’s review of various vehicles may result in the determination that the best car to purchase is a Lamborghini or a Ferrari. However, the decision to buy one of these vehicles without further analysis omits a key factor: price.

Likewise, the acquisition of a company is not made in a vacuum. The cost of purchasing a target company is a fundamental determinant of whether a particular takeover is likely. In fact, some evidence suggests that the ratio of enterprise value to EBITDA can successfully identify takeover targets. Enterprise value consists of the market value of a company’s outstanding stock (common and preferred) and debt, less its cash and short-term investments. Cash and equivalents are removed from the enterprise value calculation because the purchaser of the company will have access to that cash once the acquisition is complete.

EBITDA stands for earnings before interest, taxes, depreciation and amortization. It represents funds that the firm generates that are available to both debt and equity holders. This amount can overestimate cash flow in certain circumstances, but is much easier to calculate for an initial evaluation. A serious investor with significant free time would favor discounted cash flow analysis of the target firm in order to compute and project free cash flow to the target firm.

In his article, Christopher Baum identified 14 target companies that have potential synergies with Hewlett Packard. Some of these are private companies that do not publicly disclosure their financial information. Of those companies that do disclose such results, CA Technologies and Symantech Corporation have significantly lower EV/EBITDA ratios than the others, suggesting that their current stock prices may be relatively undervalued compared to their peers. These two companies may be potential takeover targets for HP or other large companies in the sector. At the other extreme, VMWare, Inc. and Red Hat, Inc. had the highest EV/EBITDA ratios suggesting that they are relatively overvalued compared to the other identified targets.

Some readers identified SAP as a suitable takeover candidate since Hewlett Packard’s new CEO, Léo Apotheker, used to hold the same position at SAP. He would be in a great position to assess the potential synergies between the companies and understand aspects of unrealized value in SAP. However, as some readers noted, SAP is a large company and HP has a history of undertaking smaller acquisitions, with Compaq and EDS being the exceptions. While HP has an enterprise value of $101.57 billion, SAP’s enterprise value is $68.41 billion. In contrast, CA Technologies and Symantec have enterprise values of $10.81 billion and $13.94 billion respectively, which would suggest that HP could integrate their smaller operations more easily.

One interesting thing to note is that using multiples analysis, HP’s stock (symbol: HPQ) appears to be undervalued relative to CA Technologies’ (symbol: CA) or Symantec’s (symbol: SYMC). Despite a similar risk profile between the companies as measured by beta, HP has lower price-to-earnings, price-to-book, price-to-sales, PEG (price-to-earnings-to-growth), and EV/EBITDA ratios than the other two companies. As well, HP generates far more free cash flow per share than either CA Technologies or Symantec. This may impact how HP acquires additional companies. When a company’s stock is undervalued relative to its potential takeover targets, then it is usually advisable that the acquiring company pay for the target’s shares with cash rather than through a share exchange.

At this part of the business cycle, merger and acquisition activity tends to increase. Larger technology companies with significant cash holdings (HP has cash on hand of $9.9 billion, while Microsoft has $41.5 billion) are likely to go bargain hunting in order to increase shareholder value. However, history shows that the shareholders of the target companies are the ones who fair best. While valuation is only one tool available for predicting the parties to corporate mergers and acquisitions, it is an important one.

The Japan Earthquake and the Ethics of Nuclear Energy

2011-03-15T11:08:00.000-07:00

For the past decade, the world has experienced a nuclear energy renaissance fueled by society’s desire for alternative sources of clean power. However, due to the recent nuclear calamities following the Japan earthquake and tsunami, this resurgence may be over. The disaster has reopened a debate that has spanned generations regarding whether the use of nuclear technology for our energy needs is sensible. Some supporters and opponents even view the issue as a moral one. Proponents argue that refusing to employ nuclear technology in an energy-starved world is unethical. Others believe that the use of nuclear energy, with its potential for catastrophic accidents and radioactive by-products is wrong. This discussion raises key questions: is the use of nuclear energy a moral issue, and, if so, how do we tell if its use is ethical or unethical?

Philosophers generally identify moral issues with decisions or actions that involve possible benefit or harm to oneself and others. The outcomes of such decisions are right/good or wrong/bad. The issue of nuclear energy use meets this requirement. Those on both sides of the nuclear technology issue would likely agree that use of this form of energy does involve potential benefit or harm. However, they disagree about which outcome is accurate.

If deciding to use or eschew nuclear energy is a moral decision, how does one determine whether either decision is right or wrong? This depends on what a person believes is the basis for morality, which is referred to as a moral theory. There is no universal moral theory, and therefore, many different ways to judge the morality of a particular action. However, most of those engaged in the debate regarding the ethics of nuclear energy speak of the consequences of its use. This implies a consequentialist viewpoint.

Consequentialism refers to moral theories that are based upon the view that the morality of actions is based on their outcomes or consequences. For example, one of the most well-known consequentialist moral theories, utilitarianism, is that view that an action is morally obligatory if it maximizes well-being. If one applies a consequentialist perspective to the issue of nuclear energy use, the key question is: does society’s use of nuclear power as an energy source maximize well-being, or is there another source, or combination of sources, of energy that accomplish this? The answer is subject to great debate.

Proponents of nuclear energy state that the nuclear accidents in Japan should not dissuade us from using this significant source of energy. They emphasize that nuclear technology has progressed significantly since the days of Three Mile Island and Chernobyl and is generally very safe. They also highlight that the boiling water reactors in operation at the Fukushima Daiichi plant in Japan are dated models installed in the 1970s that were the subject of safety concerns decades ago.

While there have been casualties due to nuclear accidents, compared to pollution-related deaths and deaths related to procuring other sources of energy, they are certainly fewer. Nuclear accidents are somewhat akin to airplane crashes. They both garner significant media attention while smaller, everyday disasters such as oil rig and traffic deaths go virtually unnoticed.

The problem with nuclear energy is that its characterization as a clean source of power is misstated. Even ignoring the accident risks due to mishaps such as the Japan earthquake or potential terrorist attacks on nuclear facilities, reactors have significant environmental impact. While nuclear energy results in relatively low greenhouse gas emissions, even including indirect sources, it does produce nuclear waste.

The OECD estimates that a typical 1,000 megawatt nuclear power stations produces about 300 cubic meters of low and intermediate-level waste and 30 tonnes of high level, solid, packed waste per year. This waste remains radioactive for approximately 200,000 years. The best current solution for its disposal is to bury it deep underground. It is difficult to see how an energy source that produces so much highly toxic waste maximizes well-being particularly when compared to renewable energy sources such as wind and solar power. Though, in terms of practicality, such renewable resources cannot meet the entire world’s growing energy demands. Without more technological innovation in the energy sector, we must rely on some power sources that cause environmental harm, or vastly reduce global reliance on energy, which is not realistic.

What emerges from a consequentialist analysis of the nuclear energy issue is the idea that scientific assessment of the consequences of society’s actions determines what ethical conduct is. This is a fairly recent and controversial claim that Sam Harris champions in his 2010 book “The Moral Landscape”. He argues that the scientific method can be used as a yardstick for measuring value and morality.

I would expand this view to make an even more controversial claim: science, and particularly technological advances, can change morality. For example, one can argue that using nuclear power as an energy source is unethical due to the radioactive waste it produces. However, if technology changes and we are able to dispose of this waste without any potential adverse consequences to the environment, the morality of the technology can change. Perhaps there is a moral truth about energy sources that society has not yet discovered. Perhaps there is a completely clean energy source that we have not yet discovered. However, from a practical standpoint, if we are unaware of this potential source, it is irrelevant to our current moral decisions. Our current decisions must be based on the facts before us. These facts come from our observations in applying the scientific method. In an applied ethics environment, science has something to say about morality.

The Dubious Value of Discounted Cash Flow Analysis

2011-03-07T12:28:00.000-08:00

Novice investors often make the mistake of purchasing stock in a company because they believe it is well run or they see lots of customers buying that company’s products or services. For instance, many people remark to me that Apple seems like a good investment because their stores always seem to be packed with customers and their products, be it the iPhone, the iPod, or the iPad, seem to be everywhere.

The problem is that such investors fail to differentiate between good companies and good stocks. A well-run company may have a stock that is overvalued because its price is higher than its present and foreseeable business operations justify. Is Apple worth $360 per share, or is its value much more or less than that? How can an investor determine this?

Many financial analysts rely on a method known as discounted cash flow analysis to answer this question. This method typically involves forecasting a company’s future financial statements, often over a five year period, in order to project a company’s future cash flows. These cash flows are then discounted using the company’s weighted-average cost of capital (i.e., the proportional cost that the company incurs to obtain debt and equity financing). This takes into account that possessing a dollar today is worth more than receiving a dollar several years from now. A dollar received now is worth more because you can earn interest on it, or reinvest it at a potentially higher rate of return.

Whether an analyst can accurately project a company’s financial statements and free cash flow five years into the future is subject to debate. Growth rates revenue, cash flows, expenses, and other items are not constant and are influenced by factors such as the business cycle stage, industry structure, and corporate strategy. These influences can be forecasted as well, but I find that economic and stock market forecasts are anything but definitive. Noted economists and financial pundits are often wrong and the ones that forecast the most dramatic scenarios receive the most media attention.

Despite these reservations, my experience has been that five year free cash flow projections are typically quite accurate. They may not anticipate extraordinary events, such as an uprising in Libya or an oil spill in the Gulf of Mexico, but no one ever suggested that financial analysts hold a crystal ball. When such incidents occur, free cash flow forecasts can be revised to incorporate new, material information.

My larger concern relates to how one addresses free cash flow beyond the five year forecast period. Usually, financial analysts employing discounted cash flow analysis of this nature incorporate a terminal period or a series of them into their model. In order to forecast free cash flow for a terminal period, it is necessary to multiply projected free cash flow in the final year of annual forecasting by the expected perpetual growth rate and then divide that by the company’s weighted-average cost of capital less the projected perpetual growth rate using the following formula:

FCF x (1 + g)
------------------
WACC -g

Herein lies a key problem: what is a company’s growth rate into the infinite future? From now until forever, what will Apple’s growth rate be? 3%, 5%, or some other number? Will Apple exist in 20 years, 50 years, or 100 years? In the context of predicting major events, I stated that financial analysts do not have a crystal ball. So why do they think that they are able to forecast a perpetual growth rate with any accuracy?

More alarming is the importance of this projection in determining the appropriate price for a company’s stock. While many analysts suggest that the accuracy of cash flow projects into infinity are not important because their present value falls exponentially over time due to discounting, the terminal value often still represents over 50% of a corporation’s calculated stock price, and sometimes much more. More importantly, a slight change in the terminal growth rate often has a dramatic impact on forecasted stock price. This leaves an analyst more susceptible to potential biases. For example, if the current stock price of Apple is $360, an analyst is probably less likely to submit a discounted cash flow model to his or her manager that shows a price projection of $600 per share value for the stock than a $400 value even though this was his or her initial calculation. The easiest method for adjusting this result is to adjust the terminal growth rate. What manager is going to quibble over a half percent change in this figure given the difficulty of projecting infinite cash flows? However, who is to say that the original projection is not more accurate simply because there is a large difference between the current and forecasted price of the stock?

In October 2008, in the midst of a recession, I prepared a detailed financial and competitive analysis of Boeing Corporation with Steven Maxfield, who is now an analyst with Intel Corporation. At the time, Boeing was trading around $40 and our analysis suggested that the appropriate price for the company’s stock was $95. This seemed like a very high price estimate at the time.

Two and a half years later, Boeing’s stock price has increased by about 80%, but is still below our projected price. While we employed discounted cash flow analysis as part of our report, I believe the key to determining that the stock was undervalued was due to our qualitative analysis that Boeing was in a good competitive position rather than our quantitative analysis. The important lesson to learn is that there are limitations to discounted cash flow analysis and that it is only one tool in determining the appropriate value of a stock.

If you would like to receive a copy of our Boeing Corporation analysis, please email me at greg@yankelaw.com.

Business Schools Begin to Focus on Ethics

2011-02-26T10:03:00.000-08:00

In my October 5, 2010 post entitled “Is Business School Broken?”, I stated that while business schools were aiming to restore their reputations in the wake of the recent economic crisis, the importance of ethics instruction was notably absent from the discussion. This has quickly changed.

This month, both Harvard Business School and Wharton School of Business at the University of Pennsylvania announced major MBA curriculum changes that shift the focus from earnings to ethics and teamwork (see http://www.cnbc.com/id/41516538/). These changes follow on the heels of last year’s appointment of Nitin Nohria, a specialist in leadership, sustainability, and ethics, as Harvard Business School’s new Dean. Many believed that this choice represented a change in ideological emphasis for the school and these recent curriculum changes appear to substantiate this. A similar change in teaching philosophy at the Wharton School of Business is also not surprising: the program has offered the nation’s only Ph.D. program in ethics and legal studies in business since 2003.

Can an increased emphasis on ethics in business school actually change executive behavior after graduation? Many academics have argued that a person’s ethical beliefs and behavior are formed well prior to attendance at business school and are therefore difficult to influence by that time. However, there is likely value in teaching future business leaders to fully consider the implications of their decisions and the outcomes they may have.

As I have mentioned previously, seemingly minor ethical transitions can grow into massive ones that eventually end with the perpetrators in jail. The Bernie Madoff case is a perfect example. It is unlikely that Madoff simply woke up one day and devised a massive Ponzi scheme that he knew would eventually implode. He probably made successive ethical and legal violations that he thought he could rectify until the shortfall in capital that he created could not be rectified.

Introducing business school students to a large number of case studies that illustrate how small ethical transgressions lead to progressively larger ones or unintended consequences should send the message that ethical choices can preserve and possibly create economic value. Hopefully, this will impact their decision making after graduation.

So much class time is business school is spent assessing every potential outcome of capital budgeting decisions and the likelihood of each choice. Students use statistical and financial tools such as sensitivity analysis, decision analysis, and simulation to determine the likely cash flows from each financial decision. Every assumption is critically evaluated. Yet, when it comes to assessing the impact of having or failing to have ethical leadership and an ethical business culture, most business schools do not offer any analytical tools.

If professors can devote significant class time to calculating every conceivable future cash flow from an investment decision (which I will critically analyze in my next post), why can’t professors develop a quantitative method for evaluating corporate governance and ethical decisions that is just as viable? With the apparent move to a business school curriculum that emphasizes the importance of an ethical business culture, perhaps we are moving in that direction.

Secure Dividend Stocks for 2011

2011-01-08T10:20:00.000-08:00

In my last post, I noted that companies that I described as secure dividend yielders had a return in 2010 that almost doubled the S&P 500 index. To be a secure dividend yielder, a company had to be listed on the Dow 30, S&P 500, or Nasdaq 100 index with a minimum dividend yield of 4% and with at least 40% excess levered free cash flow compared to the amount of money paid out as dividends. I contended that these were companies that would be able to continue to pay their dividends through difficult economic times.

At the beginning of 2011, the 13 companies that meet these criteria were as follows:

Pfizer
Verizon
CenturyLink
Pitney-Bowes
R.R. Donnelly
Lorillard
Integrys Energy Group
Eli Lilly
Cincinnati Financial
Leggett & Platt
Phillip Morris International
People’s United Financial
Qwest Communications
Lockheed Martin

Of these, Pfizer (pharmaceuticals), CenturyLink (telecom), Integrys Energy Group (gas utility), and Lockheed Marin (aerospace and defense) are new to the secure dividend yielders group. The rest of the companies also met the criteria in 2010. Note that one of the companies, CenturyLink, is in the process of acquiring another member, Qwest Communications.

As I mentioned previously, growth oriented stocks may perform substantially better than these secure dividend stocks if the economy gains strength. However, if economic growth is slow in 2011, these stocks could outperform the general market.

Obviously, identifying these companies based on dividend yield and levered free cash flow was just the first step in analyzing whether they are appropriate investments. I currently own two of these companies, Verizon and Phillip Morris International. Time will tell whether these stocks will outperform the market in a changing economic environment.

Update: Secure Dividend Stocks Outperform in 2010

2011-01-03T18:54:00.000-08:00

In my post of May 23, 2010, I argued that regardless of whether or not we were headed for a double-dip recession, investing in companies with secure dividends would be prudent. I identified 22 companies listed on the Dow 30, S&P 500, and Nasdaq 100 indices with a minimum dividend yield of 4% and with at least 40% excess levered free cash flow compared to the amount of money paid out as dividends. I contended that these were companies that would be able to continue to pay their dividends through difficult economic times.

I suggested that, for a long term investor, market conditions would not ultimately matter for these stocks. If the market fell, investors would earn dividend income while they waited for a recovery. If the market rose, investors would earn the dividend and benefit from a potential capital gain on the price appreciation of the stock.

A return to market lows has not reoccurred. In fact, the S&P 500, the usual proxy for US equity returns, realized a total return of 15.06% in 2010. Did the high dividend companies that I identified keep pace with the general market?

Of the 22 companies that I identified, 16 outperformed the S&P index while six fell short. The average return of these stocks was 27%, or approximately 12% higher than the S&P 500 index. Interestingly, even without the dividend payments included in the stock returns, the average return was still 21.65%. Results were slightly skewed by Qwest’s massive return of 98.1%, but even when this stock was removed from the calculations, returns still exceeded 25%. Even though high dividend stocks are often considered to be conservative, they outperformed the S&P 500 index in a strong stock market environment. Note, however, that I have not adjusted the returns of the S&P 500 index or the returns of these 22 stocks for any measurement of risk. The average beta for this group of stocks was 0.87, suggesting relatively low volatility. However, I did not calculate the covariance of volatility compared to the index stocks.

Just as important, dividends for these 22 companies prove to be secure. In fact, 10 of the 22 companies raised their dividend payments during the year. The rest remained the same, except for Cincinnati Financial, which dropped its annual dividend very slightly from $1.60 per share to $1.58. Note that the average return of 27% for this group of 22 stocks does not include the increase in dividend payments that companies made during the year.

Have I discovered a new means for selecting stocks that will outperform the market year after year? Not likely. This “portfolio” did well in conditions when many of these companies were undervalued given their impressive cash flow. As economic recovery continues, more growth oriented stocks may perform substantially better than these secure dividend stocks. However, in times of economic uncertainly, this method of identifying suitable stocks may have some merit.

At the time of my original post, I mentioned that identifying these companies based on dividend yield and levered free cash flow was just the first step in analyzing whether these stocks are appropriate investments. More in depth analysis would be necessary prior to investment. Personally, on the basis of additional research, I invested in three of the companies in the list (Verizon, AT&T, and Phillip Morris), which produced an average return of 24.2% for 2010. The irony is that my extra research produced a slightly lower return than investing equal amounts in each of the 22 companies that my criteria produced.

In my post, I also mentioned that I purchased GlaxoSmithKline, a company that met the same criteria as the 22 companies, but was not listed on the indices I analyzed because it was a UK-based company. So far, on an annualized basis, that stock has returned 23.3%, including its 5.5% dividend payments.

I intend to produce another list of stocks that meet these dividend and levered free cash flow criteria for 2011 in order to observe how they perform in this changing market environment.

Update on Lord Conrad Black

2010-10-30T14:53:00.000-07:00

In my August 9, 2010 post entitled “The Reoccurring Paradox of Fraud and Philanthropy”, I provided a list of ten individuals that were involved in corporate wrongdoing and charity work. One of these was Lord Conrad Black, the former C.E.O. of Hollinger International that was convicted of three counts of mail fraud and one count of obstruction of justice in 2007. I mentioned that he was out on bail pending a U.S. Supreme Court review of his case.

On Friday, the Supreme Court overturned two of the four convictions and upheld one count of mail fraud and one count of obstruction of justice. Black will be re-sentenced. He was originally sentenced to 6.5 years in jail. Black is also dealing with legal proceedings that the IRS has launched against him this year for $71 million in unpaid taxes relating to income he failed to declare from 1998 to 2003. Black, who is not a U.S. citizen or resident, denies this tax liability.

Is Business School Broken?

2010-10-05T15:11:00.000-07:00

CNBC recently published an article written by Nicole Lapin that discussed the plight of business schools and their aim to restore integrity. The article mentioned that the recent economic crisis has resulted in society blaming the financial sector for its woes. This blame has extended to questioning the value and the relevance of the MBA program.

To me, it seemed odd that a discussion of the relevance of the MBA program would exclude any mention of curriculum, particularly the role of business ethics courses. Lapin interviewed various representatives of Fordham University’s Graduate School of Business who provided her with little more than generic platitudes. They spoke generally about the role of business schools, developing students’ passion for the MBA program, and the recent increase in MBA graduate hiring. However, no one addressed the primary reasons that people are questioning the value of the business school education.

The first key reason that many are skeptical about the value of the MBA is the failure of the financial sector to recognize the formation of the real estate bubble and the inevitable demise of mortgage backed securities. Many investors lost their retirement savings because financial advisors, many of whom had business school degrees, failed to foresee the financial crisis even though warning signs were there. It seems as if no one in the sector learned anything from the previous stock market collapse related to the dot-com bubble.

While business schools focus on the use of models and metrics to make decisions, there is not enough emphasis on common sense. Students may become adept at using discounted cash flow models and other tools to value stocks, but if the numbers inputted into the models are based on poor assumptions, then these valuations are going to be flawed. This is simply a case of garbage in, garbage out. During the high tech boom, common sense suggested that companies with ever increasing losses and little revenue that were trading at astronomical prices would eventually collapse. More recently, it was apparent that something was wrong when people were securing mortgages that allowed them to simply pay interest and no principal. This type of financing could not be maintained and would likely have dire implications once real estate prices reached a plateau.

In such unique situations, analysts will often argue that things are different this time. During the high tech boom, some financial pundits said that the rise of Internet companies made past methods of valuing companies obsolete. This was a new economy that could not simply be analyzed on the basis of cash flows or ratios. The price-to-earnings ratio was of little use since most of these companies did not have earnings! In reality, nothing about valuation had really changed except the segment of the economy involved. In 1637, it was the tulip bubble. In 2000, it was the dot-com bubble. The Internet companies that did survive are evaluated on the same basis as others in the high tech sector.

Instead of simply ensuring that business school students can properly construct spreadsheets to determine the net present value of cash flows, more time should be spent considering whether the numbers that are inputted are justified. The problem is not just a matter of the models used; it is with the assumptions that the model users are making.

The second reason for people’s cynicism towards business school graduates is the recent prevalence of unethical conduct in the sector. We have witnessed a string of constant scandals over many years, including very high profile cases such as Enron’s collapse and Bernie Madoff’s Ponzi scheme. Society has watched mismanaged financial institutions collapse, receive government bail out money, and then continue to pay high wages to those responsible for their downfall.

Financial institution CEO’s are now met with as much disdain in public circles as used car sales persons were in the past. Are business schools to blame for this as well? Can ethical behavior even be taught? Most business schools must believe that there is some value to ethics courses since they offer them. In fact, many of these courses are mandatory, though it is interesting to note that business ethics is not part of Fordham University’s core courses.

If nothing else, ethics training in business schools should serve to warn future managers that small ethical transgressions can snowball into massive ones that expand beyond repair. It can also demonstrate how financial statements can be manipulated to achieve earnings targets. As I will suggest in a future post, it may also be possible to quantify ethical decision making much in the same fashion that quantification is currently used in corporate finance. However, to my knowledge, this is not part of any existing business ethics program.

Hindenburg Omen Update

2010-08-22T15:44:00.000-07:00

This past week, technical analysts were waiting with bated breath to see if the original Hindenburg Omen signal that occurred on August 12, 2010 would be confirmed (refer to my post dated August 15, 2010 for an explanation of the theory). This, in fact, occurred on August 20, 2010 as all of the theory’s criteria were again met. It is thought that the more signals that occur in quick succession, the more likely it is that we will witness steep stock market decline.

In his article dated August 21, 2010, Robert McHugh provides a chart of all Hindenburg Omen signal occurrences in the past 25 years, including the number of signals that occur within 36 days of the first signal and the subsequent drop in the Dow Jones Industrial Average. For some reason, his data only includes one instance of a lone signal occurring, even though he notes earlier in his article that there have been eight sole signal occurrences in the past.

During this time period, if there has been a confirmation of a Hindenburg Omen signal, the average subsequent drop in the stock market has averaged 12.11%. Of course, the extent of the drop is always measured in hindsight. When an investor is in the midst of a falling market, there is no means of knowing whether a drop will continue or whether a bottom has been reached. After all, these declines have occurred over periods as long as nine months and there have been significant market recoveries within these market drops. Thus, if an investor was shorting the market upon the occurrence of a Hindenburg Omen signal, the average returns he would realize would be lower than this figure.

This small data set does suggest that this Hindenburg Omen phenomenon is worth examining given its predictive success. Note, however, that the data also suggest that whether more signals occur or not is immaterial to the potential for an imminent stock market plunge. My regression analysis of the historical Hindenburg Omen data indicates that there is no significant relationship between the total number of signals that occur and the resulting market performance. For statistics fans, the R-squared value of the regression was less than 2% and the standard error was 6.84. Therefore, if you believe that the Hindenburg Omen is a good indicator of a stock market decline, there is no reason to wait for the occurrence of additional signals. It’s time to place your bets!

Is a Hindenburg Omen Signal a Cause for Concern?

2010-08-15T14:03:00.000-07:00

Many in the community of stock traders that rely on technical analysis are clamoring about the Hindenburg Omen signal that occurred on August 12, 2010. The Hindenburg Omen refers to a series of criteria that supposedly occur prior to all significant stock market declines and crashes. A signal is said to occur if the following happen on a single trading day on the New York Stock Exchange:

1. The number of New York Stock Exchange trading companies whose shares close at 52 week highs, as well as those that closed at 52 week lows, must each exceed 2.2%of the total number of companies that traded on that day;

2. The New York Stock Exchange ten week moving average must be rising;

3. The McClellan Oscillator must be negative. It is calculated using an exponential moving average of the daily differences between the number of companies whose stock prices rose less the number of companies whose stock prices declined. The exponential moving average gives recent data greater weight. If the oscillator provides a negative number, it is considered to be bearish in outlook since it reflects money leaving the market; and

4. The number of New York Stock Exchange trading companies whose shares close at 52 week highs cannot be more than twice the number of companies whose shares close at 52 week lows.

Others have added to or revised these criteria in order to increase the accuracy of the Hindenburg Omen or have required that it occur more than once in quick succession in order for the signal to be a “confirmed” one.

A Hindenburg Omen is said to have preceded every stock market drop of 15% or more in the past 25 years. Does this mean that investors should sell all of their stock holdings and head for the hills? Probably not. While Hindenburg Omen signals have occurred before market plunges, they most often result in Type I errors (false positives where the signal occurs, yet the stock market does not decline). These false signals occur 75% of the time, according to the Wall Street Journal.

Another concern that critics of the Hindenburg Omen have overlooked is that this indicator is relatively new. It is attributed to mathematician Jim Miekka who formulated it in 1995, although initial formulations of similar signals date back farther. Since the Hindenburg Omen is only about 15 years old, there is very little data upon which to analyze its accuracy. There have only been 27 confirmed signals in the past 25 years and many of these predate Miekka’s indicator.

Signals that occurred prior to Miekka’s formulation of the indicator are troublesome. The odd assortment of the signal criteria (e.g., why 2.2% of new highs and lows, why a rising ten week moving average?) suggest that Miekka resorted to backtesting. Backtesting involves evaluating signal criteria on the basis of prior trading data. Criteria are altered until the best fit with prior data is obtained. In this instance, Miekka likely adjusted his Hindenburg signal criteria until the maximum number of possible signals occurred just prior to major stock market declines. However, such a theory relies on the assumption that what occurred in the past will happen in the future. It also often results in what is known as data-mining bias, the practice of determining signal criteria by extensive searching through a dataset until one finds a combination that appears to be significant.

The accuracy of the Hindenburg Omen in the recent past has been intriguing. However, the predictive value of the Hindenburg Omen signal can only be evaluated after more time has passed and a statistically significant number of signals have occurred. In the meantime, do not bet the farm that a double-dip recession is imminent.

The Reoccurring Paradox of Fraud and Philanthropy

2010-08-09T16:49:00.000-07:00

After details of the Bernie Madoff Ponzi scheme came to light, many observers questioned why someone who had donated so much money to worthy causes would concurrently destroy many charities through his fraudulent actions. Madoff’s family foundation had donated over $19 million to various health care, cultural, religious and educational charities. He also contributed about $6 million to lymphoma research. Yet, Madoff’s firm, Bernard L. Madoff Investment Securities LLC, was simultaneously orchestrating a massive investment fraud that destroyed a multitude of charitable foundations and resulted in massive losses for many others.

Rather than being a rare occurrence, this odd partnership of corporate wrongdoing and philanthropy has been quite common. The following is a list of ten well known examples:

1. Bernie Ebbers, Founder and former C.E.O. of Worldcom: The man behind Worldcom’s financial deception that cost investors about $100 billion was convicted of fraud and conspiracy in 2005. Yet, prior to his convictions, Ebbers had donated over $100 million dollars to various charities, though approximately $35 million of this related to his Worldcom stock, which had achieved great value due to Ebbers’ wrongdoing. Ebbers is currently serving a 25 year prison sentence and will not be eligible for release until 2028 when he will be 87 years old.

2. Cliff Baxter, former Vice-Chairman of Enron: Baxter pled guilty to various counts of fraud and conspiracy in connection with the Enron accounting scandal that preceded its bankruptcy. He was known for his generous donations to organizations such as Junior Achievement of Southeast Texas, the American Diabetes Association, the American Cancer Society and Sunshine Kids, a charity dedicated to providing activities and trips for young cancer patients. Baxter committed suicide in his car in 2002 in the wake of the Enron debacle. He was 43.

3. Ken Lay, former C.E.O. and Chairman of Enron: Lay was found guilty of ten counts of securities fraud and related charges in 2006 for his role in Enron’s accounting scandal. He had donated more than $2.5 million to more than 250 organizations through his family’s foundation and was behind Enron’s policy of donating 1% of its profits to local charities. Lay died of a heart attack while awaiting sentencing.

4. Dennis Kozlowski, former C.E.O. of Tyco International: In 2005, Kozlowski was convicted of grand larceny, securities fraud and other crimes related to his receipt of $81 million in unauthorized loans and bonuses, improper payments and Tyco’s fraudulent financial disclosure. He gave generously to charities, though $106 million of his donations were made with Tyco’s money. He is eligible for parole in 2014.

5. Michael Milken, financier known as the junk bond king: Milken was charged with 98 counts of racketeering and securities fraud in 1989. He reached a plea bargain agreement whereby he admitted guilt to six securities violations and was sentenced to ten years in prison. He also paid a $600 million fine. Milken was released after serving just two years behind bars. At the time of his misdeeds, Milken was known as a generous philanthropist. His Foundation of the Milken Families has donated millions of dollars to various causes including $60 million dollars in educator awards and sizable donations to educational institutions such as the University of Pennsylvania and charities such as the United Way. His philanthropy has led to a Fortune Magazine cover story calling him “The Man Who Changed Medicine” due to his large health care donations.

6. Richard M. Scrushy, founder and former Chairman and C.E.O. of HealthSouth Corporation: Scrushy was convicted of bribery and mail fraud in connection with payments he made to Alabama’s governor in exchange for appointment to the state board that regulated hospitals. He was sentenced to 82 months in federal prison and was fined $2.87 billion. Scrushy co-founded Computer Help for Kids, a charity that collected, refurbished and donated computers to school students and community groups. He also established a ministry to feed African children, though this occurred as he was awaiting trial. Scrushy is appealing his conviction.

7. Lord Conrad Black, former C.E.O. of Hollinger International: Black was convicted of mail fraud and obstruction of justice in 2007 and was sentenced to 78 months in prison. He is currently out on bail pending a Supreme Court review of his case. His Black Family Foundation has donated millions of dollars to charities, including $3.4 million to Toronto’s Hospital for Sick Children and significant amounts to various educational institutions.

8. John Rigas, founder and former C.E.O. of Adelphia Communications Corporation and majority owner of the Buffalo Sabres ice hockey team: Rigas was convicted of multiple counts of fraud and tax evasion for concealing $2.3 billion in liabilities from shareholders and making personal use of corporate funds. When these misdeeds were uncovered, many people came forward to provide anecdotes portraying Rigas as a giving person who constantly helped needy neighbors. However, many of Rigas’ donations were made with Adelphia funds. At his sentencing, Rigas pled for leniency and noted his charity work. The judge responded by stating, “To be a great philanthropist with other persons’ money is not very persuasive.” Rigas was sentenced to 15 years in prison. He is scheduled to be released in 2018 when he will be 93 years old.

9. Ivan Boesky, businessman and stock trader: Boesky became famous by amassing a fortune by trading on inside information regarding pending corporate takeovers. He admitted to insider trading through a plea arrangement that involved him testifying against Michael Milken. He was sentenced to 3.5 years in prison and paid a $100 million fine. Boeksy became involved in insider trading schemes even though he had more money than he could spend at the time. Boesky donated $20 million for the Jewish Theological Seminary’s library that was named for him.

10. Gary Winnick, founder and former Chairman of Global Crossing Limited: Winnick made over $700 million by selling his shares of Global Crossing shortly before the company collapsed. While the SEC decided not to bring charges against him, shareholders brought a class action lawsuit against Winnick and others alleging fraud. The defendants settled the lawsuit by paying the shareholders $325 million. Winnick, to his credit, also donated $25 million to employees who lost their 401K’s as a result of Global Crossing’s demise. Through his family foundation, Winnick funded the Winnick Family Clinical Research Center at Cedars-Sinai Medical Center. He also donated $40 million for the Simon Wiesenthal Center’s international conference center in Jerusalem and funded various scholarships.

Why would all these men who were accused or convicted of fraud or criminal activity also have philanthropy as a common denominator? One key factor is that these businessmen all generated millions of dollars through their actions and had the means to make sizeable donations without impacting their standard of living.

Other explanations delve into the psychological realm. For some, making these gifts was a means to attaining greater notoriety. Donations were often publicized and, as in the case of Boesky and Winnick, often led to buildings or scholarships bearing the name of the donator. These businessmen may have simply wanted to draw attention to their generosity. It is also likely that many of these fraud artists also saw charity as a means for offsetting the guilt that they harbored for the harm they had caused investors and others by perpetrating their scams. They felt that if they did something supererogatory with their funds, this would make their ethical transgressions more acceptable.

With respect to Bernie Madoff, I do not believe that he ever set out to create a Ponzi scheme that would ultimately be exposed. It is more likely that his firm was unable to provide the investment returns that Madoff had promised and dipped into other investors’ funds rather than admit to clients that he missed expectations. However, instead of replacing these lost funds with excess future gains, the deficit grew larger until it was insurmountable. Thus, Madoff never intended to bankrupt these charities. It was an unintended consequence of his inability to admit failure to his clients and friends. However, regardless of his true motives, the fact remains that Madoff’s fraud destroyed many charitable organizations. He now joins these other businessman that have mixed fraud and philanthropy. Welcome to the list, Bernie Madoff

Types of Mortgage Backed Securities

2010-07-31T12:22:00.001-07:00

Most people associate the phrase “mortgage backed securities” with the 2008 financial crisis and the real estate bubble. However, most people do not understand what mortgage backed securities are or that there are many different types of them.

When a person purchases mortgage backed securities, he or she is essentially buying a stream of cash flows from a pool of mortgages. This cash flow is comprised of the mortgage payments that the homeowners make to the mortgage lender, typically a bank. Rather than waiting for each homeowner to make his or her monthly payments over possibly 30 years, a bank may decide to sell its interest in a group of mortgages at some discount in order to increase their short-term cash holdings. This allows it to make more loans and thereby expand its business as a lender.

Ultimately, some company or organization will take a group of mortgages and sell bonds to investors that provide them with the right to certain portions of the payments relating to those mortgages. These are referred to as mortgage backed securities (“MBS”). MBS are primarily sold by three government sponsored companies: Ginnie Mae, Fannie Mae and Freddie Mac. However, as MBS investing became more popular, MBS offered by non-government related entities grew substantially over time. While the federal government guaranteed the timely payment of principal and interest relating to Ginnie Mae, Fannie Mae and Freddie Mac mortgage pools, this did not extend to other non-agency MBS. As a result, they contained greater risk due to the possibility of default.

The government sponsored MBS, referred to as agency MBS, do not have default risk. This was questionable during the recent mortgage backed securities crisis when some believed that the U.S. government might refuse to assume the obligations of Ginnie Mae, Fannie Mae and Freddie Mac if they became insolvent since the amount involved was possibly huge. However, this concern disappeared as the extent of the financial crisis became known. Even when there is default risk, as in the case of non-agency MBS, it is diversified significantly due to the investment consisting of many mortgages rather than just one or a few.

However, even if there is no default risk, investors in agency mortgage backed securities are subject to prepayment risk. Unlike many types of loans, mortgages generally permit the borrower to prepay up to the entire loan amount early. When this occurs, no more interest accrues on the mortgage. While an investor in MBS will receive his or her allocation of the principal payment relating to the prepaid mortgage, this usually puts the investor at a disadvantage. This is because mortgage prepayments typically occur when a homeowner refinances his house because mortgage rates have dropped. Yet, if this occurs, the MBS investor is left with his or her cash position again with less promising bond investment opportunities due to the drop in interest rates.

Just like a birthday cake, the cash that flows from a pool of mortgages can be cut into many different sized “slices” depending on an investor’s appetite for risk and desired return. Those who issue MBS have been very creative in creating different types of investments that appeal to different investment goals. Some of principal types available include the following:

1. PACs (planned amortization class tranche): a class or tranche that has priority in receiving payments from the mortgage pool provided that mortgage prepayments occur within a specific range. This reduces the prepayment risk, which is absorbed by the other classes, typically referred to as companion or support tranches. Because the support tranches assume higher risk, they have higher yields.

2. TACs (targeted amortization class tranche): a class or tranche that is similar to a PAC in that it is protected from higher than anticipated mortgage prepayments. However, TACs are not protected if prepayments fall below a certain level. Thus, there is more risk associated with a TAC investment.

3. Floaters: a class or tranche that has a variable interest rate that is based upon some reference rate plus a spread, subject to specific minimum and maximum ranges. This investment essentially acts like an adjustable rate mortgage, except it is an asset rather than debt. Because payments adjust with fluctuations in interest rates, interest rate risk is minimal. Since this risk is reduced, yield is lower. Non-floating tranches of a mortgage pool assume the interest rate risk that the floating tranche avoids, thus they are very interest rate sensitive.

4. Inverse Floaters: a class or tranche that receives payments that are inversely related to interest rates, which is essentially the opposite of a floater. Thus, as interest rates fall, the price and yield of an inverse floater increases. They are often issued in combination with floaters as tranches in a mortgage pool since their payouts can offset each other.

5. Strips: to create two types of bond classes from a pool of mortgages, the mortgages are divided, or stripped, into their two constituents: principal and interest.

a) The PO, or principal only tranche, receives just the principal portion of the mortgage payments. The yield of a PO strip depends on how quickly mortgages are prepaid by the borrowers. The quicker they are prepaid, the higher the yield. This investment gains value if interest rates fall and prepayments increase due to increased mortgage refinancing.

b) The IO, or interest only tranche, receives just the interest portion of the mortgage payments. The yield of an IO strip also depends on how quickly mortgages are prepaid by the borrowers. The quicker they are prepaid, the lower the yield. This investment retains or gains value if interest rates increase and prepayments are low since borrowers continue to make interest payments each month.

Keep in mind that there are other types of mortgage backed securities as well and that some of the types mentioned can be combined to form other new types. For example, one could purchase inverse IO floaters or PAC inverse floaters. In essence, the division of mortgage pool payments into various types of cash flow streams is only limited by the creativity of the human mind.

Mortgage Backed Securities and Financial Reform

2010-07-25T19:24:00.000-07:00

On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law. The bill was primarily meant to address the factors that led to the financial crisis of 2008. While an Act that contains 533 regulations will certainly be subject to criticism, there are some who argue that any financial reform is completely unnecessary and simply creates more regulatory burdens for corporations. Yet, the abuses related to mortgage backed securities that ultimately led to the real estate bubble demonstrate why at least some financial reform is required.

The need for the regulation of banks and financial service companies stems from the fact that they have one primary objective: to make money. If this is a corporation’s principal aim, then the interests of others may be adversely impacted in order to maximize profit. The mortgage backed securities fiasco provides a good example of this. At the height of the real estate boom, banks were motivated to make as many mortgage loans as possible in order to increase revenue without assuming risk. This was because banks were able to package a group of mortgages and sell them almost immediately to other companies for a tidy profit. Demand for these mortgage pools were high, so banks had an incentive to grant as many mortgages as possible and even loan mortgage funds to people that could not realistically afford to purchase a home. Mortgage payment default was not a concern to the banks since the companies that bought the mortgages from them would suffer the losses from default.

However, the companies that purchased mortgages from banks also transferred this risk to others by quickly re-packaging and selling the mortgages. These companies then divided the cash flows from the mortgage pools (i.e., the principal and interest payments that the home owners would pay) and sold them to investors. The result was essentially an investment “hot potato”. The investors holding the mortgage backed securities after the real estate bubble burst got burned.

Investors were interested in these mortgage backed securities because they wanted to receive substantially higher interest rates than low risk securities such as CDs and government bonds. However, many investors did not understand that these often complex investments were very risky since banks were loaning money to people who could not afford escalating mortgage payments. Ratings agencies compounded the problem by giving these securities investment grade ratings even though they should have realized that the chance of mortgage default, and therefore investment risk, was high.

The banks were in a “no lose” situation since they were able to sell these high risk mortgages almost immediately for a profit. They had no legal obligation to the ultimate investors. However, stakeholder theory suggests that the banks did have an ethical obligation to these investors and those to whom they provided mortgages.

Historically, business ethics theory took a much narrower view of corporate obligations to third parties. Dr. Milton Friedman held a typical opinion when he stated that companies only have an obligation to make a profit within the framework of the legal system and nothing more. Yet, if the laws are not sufficient to protect parties such as investors and home owners in the mortgage backed securities situation, the end result for the entire economy can be catastrophic, as we have seen in the past few years.

A Friedman proponent may argue that the fault for the real estate bubble lies not with the corporation, but with the investors and the home owners. Perhaps the investors failed to investigate investment risk because they were so fixated on obtaining higher yield. A prudent investor would know that with higher yield comes higher risk. As well, one could argue that it is not the bank’s responsibility to ensure that people can afford the homes that they purchased. People should learn to live within their financial means.

While Friedman supported the corporation’s maximization of profit, it was subject to the absence of deception or fraud. In the case of these bank mortgages, the banks’ hands were often not clean. They lured potential home owners with teaser rates that resulted in lower payments early in the mortgage term. However, it was clear that many banks were not as clear about the eventual large increase in payments that would occur after a number of years passed. Instead, they avoided detailed discussions of these ballooning payments and simply asked people to sign complex mortgage documents that were incomprehensible to a layperson.

Stakeholder theory goes even further. While Friedman’s view emphasizes a corporation’s duty to its shareholders, stakeholder theory asserts that a company should consider the effect of its decisions and actions on all impacted parties. This is not merely an altruistic corporate act. Paying attention to stakeholders should benefit the corporation in the long run. A bank that provides a customer with a mortgage that he or she cannot afford is liable to hold the bank in disdain when foreclosure occurs and it is revealed that the bank made the loan to generate revenue with no regard to the customer. Repeat business is unlikely.

While stakeholder theory seems rational, not all corporations will abide by its implications. As a result, financial regulation is necessary in order to compel businesses to avoid acting in ways that will be detrimental to the entire economy. With respect to mortgages, this reform in included in Title XIV of the new Act, which, among other things, requires financial institutions to verify a mortgage applicant’s ability to pay. Without imposing some potential liability on banks for the mortgage loans they grant, the catastrophic consequences that we have seen in the past several years from the real estate bubble bursting could reoccur.

Sad News for the Happy Meal

2010-07-21T10:34:00.000-07:00

On the heels of my post regarding the ethics of selling fast food, The Center for Science in the Public Interest (“CSPI”) served notice on McDonald’s to cease using toys to market its Happy Meals to children or face litigation. CSPI claims that this practice promotes poor eating habits and leads to obesity, diabetes, and other diet-related diseases. This announcement follows the recent enactment of a law in Santa Clara County, California that banned kid’s meals in restaurants that include a toy and exceed certain thresholds for calories, salt, fat, or added sugar. The law impacts very few restaurants in the county and seems squarely aimed at McDonald’s and its Happy Meal.

Why does McDonald’s seem to be the focus of this negative attention? Certainly the Happy Meal is not the only food product marketed to children that includes a toy and has questionable nutritional value. Perhaps CSPI should consider adding Tony the Tiger, Sugar Bear, Cap’N Crunch, Count Chocula, and Toucan Sam as defendants in its proposed lawsuit. Aren’t breakfast cereals, Cracker Jacks, and a host of other foods that are filled with sugar and fat and contain toys just as bad as a Happy Meal? Is McDonald’s being unfairly singled out?

Comparing the nutritional facts of the Happy Meal to these other products that are marketed primarily to children is a bit eye-opening. As a typical representative of a sugar laden breakfast cereal, Fruit Loops has 118 calories per one cup serving and has high levels of iron, certain B vitamins, vitamin A, vitamin C, and zinc due to fortification. It is also very high in sugar content with 12.5 grams in a serving. A box of Cracker Jacks contains a similar amount of calories without the vitamins and minerals and almost 20% more sugar.

In comparison, the McDonald’s Cheeseburger Happy Meal with french fries and apple juice is a fat and sugar bomb. It contains 630 calories, 24 grams of fat, 28 grams of sugar, and 930 milligrams of salt. McDonald’s does offer slightly healthier alternatives, such as apples and caramel sauce instead of fries, but these only improve the nutritional data slightly. The bottom line is that hamburgers are not diet food. The typical fast food meal is not nutritional and as the company at the top of the fast food pyramid, McDonald’s is likely to suffer the brunt of watchdog groups’ ire.

Yet, should a county be able to prevent parents from allowing their children to consume Happy Meals or an organization such as CSPI be able to bring a legal action against fast food companies on behalf of consumers? These are more controversial issues. Certainly, we have allowed paternalistic government regulation to infiltrate other aspects of our lives as evidenced by seat belt and motorcycle helmet laws. Most people accept these restrictions on our freedom of choice. Yet, telling parents what they cannot feed their kids meets more resistance. This is especially true when most of these parents ate similar fast food on occasion as children and have not suffered irreparable harm.

The ability of CSPI to sue McDonald’s for unfair marketing practices raises the issue of legal standing. Standing refers to a legal doctrine that requires a plaintiff, among other things, to have suffered injury or damages in order to proceed with a lawsuit against a defendant. In many jurisdictions, organizations such as CSPI are granted standing under consumer protection legislation since it would be unlikely that individual consumers could prove sufficient damages to justify the expense of a lawsuit. While this sounds reasonable, class action suits seem to alleviate this concern. Allowing CSPI, which has not suffered any damages, to initiate legal actions clogs an already backlogged court system. While CSPI has some admirable aims, using the threat of lawsuits as a public relations tool is not appropriate.

In the end, parents must bear primary responsibility for the eating habits of children. To CSPI’s credit, it has allocated a significant amount of its resources to giving advice to parents regarding the way food is marketed to kids. Educating parents, and children as well, is the best method for ensuring that children consume a balance diet, which can include the occasional fast food or breakfast cereal indulgence. After all, going cuckoo for Cocoa Puffs is part of being a kid!

BP’s Stock Price and the Importance of Diversification

2010-07-05T10:32:00.000-07:00

On April 20, 2010, the Deepwater Horizon drilling rig exploded in the Gulf of Mexico. Concurrently, the price of BP’s shares began to implode. On April 20, BP’s stock price closed at $60.48. By May 10, it had dropped to $48.75. During this time, the company’s market capitalization (calculated by multiplying the stock price by the number of trading shares outstanding) dropped by over $36 billion.

At this point, many financial advisors began recommending that investors purchase BP stock. They believed that the amount of money that it would take to clean up the oil spill would not come close to the $36 billion that BP’s aggregate share value had lost. Even Jim Cramer, CNBC’s high profile stock guru and host of the show Mad Money, stated that the stock was a buy for this reason. Yet, about a month and a half later, BP’s stock now sits at about $29 per share, representing a market capitalization loss of close to $100 billion. The initial investment advice seemed rational, so what went wrong?

The first thing to note is that the stock market does not always behave rationally. As John Maynard Keynes pointed out, the markets can remain irrational longer than you can stay solvent. This is especially true when a company constantly receives negative media attention as BP has. Investors become nervous and often will sell their shares in a company that is consistently in an adverse spotlight.

As well, the market typically dislikes uncertainty. When market analysts recommended investing in BP in early May, they assumed that the flow of oil into the Gulf of Mexico would soon stop. Many pointed to how Exxon’s stock performed after the Valdez disaster and uncategorically stated that BP’s situation would not be worse than this. However, there was no basis for this faulty assumption. The BP disaster has been worse and it is still uncertain when the flow of oil will cease. In addition, no one knows for certain what BP’s total cost in dealing with the ramifications of this disaster will be. Many news agencies are reporting that clean up is costing BP about $100 million per day and that total costs have now surpassed $3 billion. Yet, until the oil flow stops and the damage is surveyed, it will be difficult to know how much money BP will lose as a result.

Does this mean that investing in BP’s stock is a poor decision? Not necessarily. Assuming that the stock was fairly priced prior to the disaster, it seems very unlikely that BP will incur costs nearing the $100 billion market capitalization loss. As well, BP generates about $30 billion in operating cash flow annually, which should allow it to cover ongoing clean up costs and make it easier for the company to raise additional funds they need through loans or equity sales. One caveat is that BP may be forced to cut its dividend in order to cover clean up costs. Perhaps this is already priced into the stock, but it is likely that the share price will fall if and when a dividend cut is announced.

One of the lessons of BP’s stock slide is the importance of portfolio diversity. Even financially strong companies, such as BP, are subject to what is known as event risk. If BP stock represented a small percentage of your total investments, it should not have had a significant impact on your overall return. Research suggests that most of the gains that you achieve from diversification come from investing in about 30 different securities provided that you hold relatively equal positions in each one. This diversification protects you from almost all firm specific risk. A diversified investor should not have suffered any significant losses from BP’s plight.

The Confusion Over Martha Stewart's Insider Trading

2010-06-23T13:13:00.000-07:00

Although it has been almost ten years since Martha Stewart made her fateful decision to sell her shares of ImClone Systems Incorporated, the misconception still persists among the public, and many journalists, that she went to prison because of insider trading violations. However, Martha Stewart was never convicted of insider trading. While she was alleged to have committed this offense, the judge dismissed the general charge of securities fraud. Understanding what her illegal actions were is a key to seeing the reoccurring business ethics lesson: an attempt to cover up a small transgression can lead to a series of larger lies and, ultimately, prison.

Martha’s path to incarceration began when her stock broker informed her that, Dr. Sam Waksal, the C.E.O. of ImClone, was selling all of his shares in the company. Martha owned almost 4,000 shares of the company, which were trading around $58 each. Based on the broker’s information, Martha instructed him to sell her ImClone shares. It is not clear whether Martha knew the reason that Waksal was selling his shares. He had discovered that the Food & Drug Administration was about to deny approval of ImClone’s cancer fighting drug, Erbitux.

Clearly, Martha Stewart’s decision to sell her ImClone shares was not well thought out. Compared to her net worth, the value that her ImClone investment represented was inconsequential. Hindsight would certainly confirm this. By selling her shares one trading day before the FDA announced that Erbitux was not receiving approval, she saved about $45,000.

Insider trading occurs when people trade on the basis of non-public information that would likely have an impact on the trading price of a company’s stock. It typically occurs when directors or officers trade on such information, though it also applies to third parties that rely on the information. In Martha’s case, there was no evidence that she knew of the FDA denial or that she had any direct contact with any representative of ImClone. While it is arguable that the information from her broker still constituted inside information, in and of itself, this evidence was insufficient to justify a conviction and probably would not have led to any charges.

Thus, if Martha simply admitted to authorities that she did sell her stock on the basis of the broker’s information, it may have been the end of the matter. Instead, she conspired with her broker to cover up the trades. They concocted a story that she had an arrangement with the broker, called a stop-loss, to sell the ImClone stock if its price fell below $60 per share. Others were asked to participate in the charade and the lies continued to grow. However, further investigation unraveled this lie and criminal charges resulted. Martha was eventually convicted of conspiracy, obstruction of an investigation, and making false statements to federal investigators.

Just as the executives in companies such as Enron and WorldCom initially made small adjustments to accounting assumptions in order to meet earnings expectations, Martha Stewart lied in order to conceal a relatively small transgression. In all of these situations, initial lies blossomed into larger ones, with the end result of imprisonment. The reoccurring lesson is to avoid taking the first step of concealing the truth since it too often leads to much more serious, life-changing implications.

Fast Food Frenzy

2010-06-09T08:33:00.000-07:00

Last week I participated in the Fast Food Frenzy. It involved attending nine fast food restaurants in one day and consuming as many calories as I could. During the day I ate at Burger King, Jack in the Box, KFC, McDonalds, Wendy’s, Arby’s, Taco Bell, Sonic, and Dairy Queen. I consumed over 5,500 calories, which amounts to more than twice the recommended daily caloric intake for an average man. I did not feel very good that evening and still felt pretty lethargic the next day. Shockingly, there are some people in the nation who eat more calories then I did everyday.

Given that most fast food choices are unhealthy ones, it led me to question whether fast food companies are being ethical in offering the products that they do. The standard response from companies that sell products that harm their consumers is that the product is legal. However, ethical claims differ from claims about what is legal or illegal. For example, adultery, lying, and cheating are generally considered to be unethical activities, yet they are not against the law. Likewise, in certain states, it used to be illegal to marry someone of a different race, yet few would see this as an unethical act. So the claim that fast food companies make that they are simply offering a legal product to the public does not mean that they are acting ethically.

That being said, I do not believe that fast food companies are immoral just because they do not act in a paternalistic fashion towards their customers. Consumers have the choice to avoid these products, consume them in moderation, or eat them everyday. The key to me is that each company provides adequate disclosure regarding its products so that consumers can make reasoned decisions. Although it was not always easy to find, each of the nine fast food restaurants I attended have websites that disclose nutritional information about their food items. As well, two of the companies, Burger King and Wendy’s, actually had large, nutritional charts readily visible in their restaurants. Given that consumers have access to this information, I do not believe that there is anything morally wrong with these companies selling fast food.

One could take issue with the fact that many of these companies market their products to children. Mascots such as Ronald McDonald, the Burger King, and Jack from Jack in the Box are essentially modified cartoon characters that hock fast food to kids. As well, most of these restaurants also promote meals especially designed for children that include toys. While these actions are arguably questionable, parents ultimately control whether and what children eat at these restaurants. They should be able to assess these products regardless of the advertising hype and act accordingly.

BP’s Gulf Oil Spill: Where Ethics and Legal Advice Collide

2010-06-02T15:32:00.000-07:00

As oil continues to rise to the surface in the Gulf of Mexico, BP’s public reputation continues to fall. Its name is becoming synonymous with this environmental disaster much in the way that Exxon’s name was tainted in the wake of the Valdez tanker catastrophe in 1989. This is especially ironic given the recent effort that BP has made to brand itself as a “green” company that balances oil and gas exploration with the development of alternative energy technology.

I believe that the problem BP is facing in the aftermath of this disaster is a result of a lack of strong ethical guidance. Instead of doing the right thing, it appears that BP’s management has resorted to arguing the issue of liability in the court of public opinion. BP’s C.E.O., Tony Hayward, has recently said, “This was not our accident.” He has pointed to Transocean, the rig owner, and Halliburton, the company that constructed the concrete encasement that sealed the well, as the true culprits.

While company lawyers would be negligent if they failed to advise BP to avoid accepting legal responsibility for the disaster, this does not mean that BP should publicly blame others. It appears that the company’s public relations and legal positions have become entangled with BP resorting to finger pointing as its chief strategy. Such actions should be reserved for the courtroom, not the media. People are expecting BP to express sorrow and regret for the disaster, not cast blame and divert attention from its own actions. Its reputation is suffering as a result.

Modern business ethical theory and corporate responsibility emphasize the importance of taking stakeholder interests into account. Stakeholders are those parties that a company’s actions affect. In developing a public response to the gulf oil spill, BP had failed to properly place its stakeholders at the center of its strategy.

Instead of being fixated on legal liability, which primarily impacts internal stakeholders (i.e., management, employees, and shareholders), BP should have empathized with external stakeholders that will suffer from the oil spill. These include Gulf Coast fishers, nearby residents who rely on tourism dollars, those concerned with harm to wildlife, and those who simply enjoy the physical beauty of the area. Proper corporate responsibility could have involved BP, Transocean, and Halliburton working together to formulate a relief package to address these economic and environmental factors, regardless of who was ultimately responsible for the spill. By focusing on corporate liability in its public statements, BP has hurt all of its stakeholders.

Bernie Madoff: The Slippery Slope to Disaster

2010-05-27T17:48:00.000-07:00

Next month will mark the one year anniversary of Bernie Madoff’s 150 year jail sentence for defrauding investors of billions of dollars. Much has been written about how the former Chairman of the NASDAQ stock market was able to perpetuate his fraud without significant regulatory or investor scrutiny. However, few have properly discussed the motivation behind Madoff’s Ponzi scheme.

Many reporters have suggested that Madoff was simply motivated by monetary greed. Somehow, this explanation doe not ring completely true. Madoff’s investment scheme certainly was not structured to maximize profit for his firm. In fact, Bernard L. Madoff Investment Securities LLC did not even charge management fees that were customary in the business, despite the fact that it was providing clients with jaw-dropping, 15% annual returns. If Madoff’s investment ruse was purely established for personal gain, he could have made more money from it.

Other pundits have pointed to a psychological explanation for Madoff’s behavior. He has been labeled with a series of related diagnostic terms such as psychopath, sociopath, and narcissist. These characterizations lie in sharp contrast to those of Madoff’s friends and associates who described him as honest, generous, and big-hearted.

While I believe that these colleagues probably did not know the real Madoff, I think that classifying him as a psychopath, although it may be accurate, takes the focus off of an important ethical lesson: many seemingly normal people slide down the slippery slope of unethical conduct until they end up in prison. It usually commences with a minor ethical transgression and ultimately grows into an uncontrollable monster.

Many of the key business scandals of the recent past have exhibited these same characteristics. In the case of Enron, management resorted to “earnings management”, a nebulous term that is often used by those committing accounting fraud, in order to meet profit expectations. The company manipulated mark-to-market accounting rules in order to recognize income early. However, because future income was recognized early, there would ultimately be less income to meet expectations in subsequent accounting periods. Thus, the same problem continued to occur for Enron management. This led to more and greater accounting irregularities that compensated for the impact of past earnings management and growing investor expectations. Though this earnings management seemed modest at first, it quickly blossomed into a nightmare that led to the company’s downfall and great misery for management, employees, and shareholders.

A similar pattern occurred with Worldcom. Many of the company’s problems appear to have started when its CEO, Bernie Ebbers, was over-extended in his personal business ventures. Because he had secured funding for these ventures by pledging his Worldcom stock holdings, he could not afford to have the share price of the company drop. Accordingly, he also resorted to earnings management to make Worldcom’s financial situation appear more favorable than it was. Revenues were inflated. Costs were capitalized in order to underreport expenses. Accounting irregularities continued and grew until the SEC filed fraud charges and WorldCom declared bankruptcy.

We may never know what motivation led to Bernie Madoff’s massive Ponzi scheme. At his sentencing nearly a year ago, he did not discuss this issue. However, based on similar corporate frauds of the past, one can surmise that problems may have commenced when Madoff used money from new clients to pay the investment returns that his current clients expected. These legal and ethical violations may have seemed minor to Madoff at first. He may have believed that he would make up this shortfall from future trading returns. However, these returns did not materialize and the fund shortage kept growing larger and larger. Eventually, he reached a point of no return where he must have realized that he would never be able to pay all of the amounts due to his investors and could not unwind the mess he had created.

Like many of these scandals, there was a point early on where Madoff could have admitted to clients that he did not realize the investment returns he had promised and dealt with the consequences. Granted, his reputation would have suffered and he would have had to concede that he failed to reach his promised returns. Instead, by covering up his failures, these friends have suffered financial devastation, many charities are in ruins, and Madoff is in prison. Nearly one year down – only 149 years left to go.

Bull Market Correction or Double-Dip Recession? It Doesn’t Matter!

2010-05-23T12:25:00.000-07:00

Given the recent volatility and downward movement in the stock market, many pundits are arguing whether we are in the midst of a bull market correction (a downward movement of 10% or so from recent highs) or whether the market will return to the lows that were experienced in March 2009. Investors are placing their bets by either buying stocks at what they believe are cheap prices or are shorting the market in the belief that it will go lower. Those who believe that the market will recover quickly point to the positive macroeconomic data in the United States. Those who believe that the market will continue to fall emphasize the recent troubles in Europe and the impact this will have on the world economy.

Predicting which way the stock market will move, particularly in the short term, is risky. However, if you are a longer term investor, I believe that you can make money regardless of which way the market will move by investing in companies with sizeable dividends that are secure. If the market goes down, you will be collecting significant income while you wait for a recovery. If the market goes up from here, you will earn the dividend and benefit from a potential capital gain on the price appreciation of the stock. The key is to choose stocks with dividends that are not in danger of being cut.

In order to assess whether a dividend is secure, I like to compare the amount that a company is paying out as a dividend with the amount of levered free cash flow that it is generating. Levered free cash flow refers to the amount of after-tax net operating profit that a company generates less capital expenditures, interest, and principal repayments on any debt. You can calculate this figure yourself by using the company’s financial statements, or find a service that does this for you. For instance, Yahoo! Finance provides levered free cash flow numbers for companies in the “Key Statistics” section of company profiles.

Many financial analysts rely on the dividend payout ratio to assess a company’s ongoing ability to pay dividends at the same rate. This is usually computed by dividing dividends per share by earnings per share. The problem with the dividend payout ratio is that it relies on accounting earnings, which may not equate to actual cash to the firm. As well, it ignores the full impact of a company’s debt.

Many analysts seek companies with dividend payout ratios that are less than 100%. I think that such a threshold is too high. In tough economic times, I believe that levered free cash flow should exceed the dividend payout by at least 40% and preferably more. This way, if a company hits tough times and cash flow suffers, the dividend is not necessarily in jeopardy.

The following is a list of companies from the Dow 30, S&P 500, and Nasdaq 100 indices that I have compiled that provide a dividend yield of at least 4% and have at least 40% excess levered free cash flow compared to the amount of money paid out as dividends:

Company Name (Dividend Yield)

Reynolds American (7.0%)
Verizon (6.8%)
AT&T (6.8%)
Pitney-Bowes (6.5%)
Qwest Communications (6.4%)
Eli Lilly (5.9%)
Cincinnati Financial (5.9%)
CenterPoint Energy (5.9%)
Bristol-Meyers Squibb (5.6%)
R.R. Donnelley (5.6%)
Lorillard (5.4%)
Philip Morris Int'l (5.2%)
DTE Energy (4.7%)
Leggett & Platt (4.6%)
Nicor (4.6%)
Dupont (4.5%)
Maxim Integ Products (4.5%)
Kimberly-Clark (4.3%)
ConocoPhillips (4.3%)
Federated Investors (4.2%)
Genuine Parts (4.2%)
ONEOK (4.1%)

Obviously, this is just the first step in analyzing whether these stocks are appropriate investments. For instance, there are rumors that AT&T may cut its dividend in order to fund projects. This could potentially have a negative impact on the stock when it occurs. This information only comes to light when one conducts a more in depth analysis of each company, which is a time consuming endeavor.

However, my analysis does show that there are companies in diverse sectors that provide significant income through dividends. Keep in mind that high dividend stocks tend to be mature, lower growth companies that will not necessarily perform well relative to other stocks in a strong economy. Yet, they should provide significant return through dividends with less risk than many of their counterparts.

As well, realize that this is a list of large cap companies with very specific characteristics. There may be smaller U.S. companies or international firms that provide significant dividends as well. For instance, I have recently invested in GlaxoSmithKline, a United Kingdom pharmaceutical company, which yields 5.5% and pays out less than half of what it generates in levered free cash flow as dividends. As an added bonus, I think that the market has paid too much attention to GSK’s patent losses and not enough to its strong pipeline.

Keep in mind that investing in a secure dividend yield locks in your rate of return from dividends. For example, if I invest in a stock that is priced at $50 and it pays an annual dividend of $2.50, I will earn 5% from dividends each year provided that the dividend payments do not change. Even if the stock price rises or falls, this rate does not change since the price I paid for the stock (i.e., $50) is still the same. Thus, I’ll continue to earn 5% on my money as long as the dividend payment is secure. So if the market dips in the short-term, it doesn’t matter!

Beware of the “E” in the P/E Ratio!

2010-05-19T13:53:00.000-07:00

One of the most common questions that I get from investors is what criteria I use for stock picking. Often, they will ask me about one of the simplest measures: the price-to-earnings ratio, or “P/E ratio”. The P/E ratio is determined by dividing the current price of the stock by the earnings per share of the company in question. Accordingly, it is very simple to compute.

Most academic discussion that surrounds the use of the P/E ratio to pick stocks relates to whether investing in low P/E ratio stocks, which are often referred to as value stocks, results in higher than average returns. While controversy remains regarding this issue, the evolving consensus seems to be that while low P/E stocks do outperform high P/E stocks, this difference is explained by risk, or more specifically, a higher required rate of return.

There are many problems with using the P/E ratio as an exclusive tool for investing, but I would like to focus on one that is often overlooked: the denominator “E” (earnings per share) value that is used. Many research analysts and newsletter writers fail to differentiate between trailing and forward P/E ratios and do not disclose which they use. The earnings per share figure in a trailing P/E ratio is typically the sum of the four most recent quarters of earnings per share. In contrast, the earnings per share figure used in a forward P/E ratio is a forecast of what earnings will be in the next fiscal year. This distinction is particularly important in the current market environment where earnings for many companies in the past year have been cyclically low due to recessionary conditions.

So when current stock newsletter writers are saying that the current average P/E ratio of the S&P 500 is far too high given historical levels and this implies that the market will drop again, one has to question the data they are using. Trailing P/E ratios seem to be inappropriate because, for most companies, earnings are expected to be higher in the next year. Given that the stock market is typically forward-looking, one would expect high trailing P/E ratios when the economy is exiting a recession. Given the uncertainty in the present day stock market and higher than normal volatility, I also believe that forward P/E ratios are not very helpful either. As I mentioned earlier, forward P/E ratios are based on estimated earnings for next year. However, those who provide forward P/E ratios usually do not describe the basis for these future earnings estimates. They are based on many assumptions, some of which may be incorrect.

I believe that there are much better ways of determining whether certain stocks are undervalued. In future posts, I will describe many of these and also point out potential pitfalls in each investment tool. The good news is that I believe that methods for choosing superior equities exist, and surprisingly, many of the best tools are qualitative rather than quantitative. The bad news is that using these methods to pick a portfolio that will outperform the market is extremely time consuming, and depending on the size of your portfolio, the value of the time you spend on research may offset the extra return you will generate. Still, I believe that some of the simpler tools that I use do have a good track record for beating the market.

In the Goldman Sachs Case, the Media are Asking the Wrong Question

2010-05-17T19:55:00.000-07:00

On April 16, 2010, the Securities & Exchange Commission commenced a civil action against Goldman Sachs and one of its employees alleging that they misled investors that purchased CDOs (collateralized debt obligations) from the firm. The SEC claims that the offering memorandum and related documents that Goldman Sachs distributed to investors failed to disclose that Paulson & Co. Inc. (“Paulson”) played a significant role in the portfolio selection process. The complaint also states that Goldman Sachs failed to disclose that Paulson was concurrently shorting this investment through credit default swaps that it bought from Goldman Sachs. This would suggest that Paulson had an interest in choosing mortgage backed securities that would fail. The end result: investors lost more than $1 billion.

As any lawyer that has dealt with the media likely knows, the press usually treats the alleged facts in a regulatory complaint as true. Thus, it is important to stress that the SEC has made these factual allegations, but they are in dispute. Yet, even assuming that they are true, the media debate regarding this case is focusing on the wrong question. Instead of asking, “Did Goldman Sachs break the law?”, the media, and society for that matter, should be asking, “Did Goldman Sachs act ethically?”

While it is true that the answer to the first question may be more important to an investor in determining the value of Goldman Sachs stock in the short term, the latter question is more important for long term investors. Why? History shows that a pattern of corporate ethical breaches often lead over time to serious legal transgressions, and ultimately, company implosion. This is usually a slow progression, but the warning signs build over time. Then, one day, á la Bernie Madoff, you wake up and realize that instead of being a NASDAQ executive, you’re the head of the world’s biggest Ponzi scheme. Eventually, everything goes wrong and your life has degenerated to prison yard fights. If one compares the Madoff situation to the demise of companies such as Enron, WorldCom, and Tyco, there are reoccurring parallels. One of these is that management in these cases did not set out initially to defraud investors. It happened gradually and began with ethical breaches that compounded over time and led down the slippery slope towards outright fraud, imprisonment, and sometimes death.

Another common thread in these investment disasters was a consistency in what is known as the “tone at the top”, the ethical messages that upper management sends to the corporation, which tend to permeate the firm’s culture over time. For all of these now defunct firms, top executives sent the message to employees that ethical breaches, and ultimately legal ones, were acceptable or required.

So what does this all have to do with Goldman Sachs? During his Senate testimony, Lloyd Blankfein, the CEO and Chairman of the firm, stated that Goldman Sachs does not have a legal duty to disclose its own position in a security, even if it is betting against investments that it is selling. Maybe he is correct. A court will answer that question. However, the more fundamental question is whether Goldman Sachs has an ethical duty to disclose this information to investors. I think that most people’s intuition would suggest that it does. As well, history suggests that Blankfein’s flippant attitude towards such ethical issues could foretell future problems for the company.

In ethical considerations such as these that can impact businesses, many would agree with the following general guide posts:

1. Employees and directors should strive to identify and raise potential issues before they lead to problems;

2. Service to the firm should never be subordinated to personal gain and advantage.
Conflicts of interest should, to the extent possible, be avoided;

3. Information in public communications, including SEC filings, should be full, fair, accurate, timely and understandable; and

4. Firms should not seek competitive advantages through illegal or unethical business practices.

Where did I find such common sense grains of wisdom? They are all contained in the Goldman Sachs Code of Ethics.