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The Lawrence
Investment Group
June 4, 2007, update: What
rocked the boat in Q1? Proceed aggressively, but with caution.
Brief Update: Below is a summary
of the performance of stocks I have recommended in previous letters. The gain is not annual return but rather total
price appreciation since the date recommended. To get total return, you must add the total dividends paid on these stocks.
An interesting point is that the dividend rate reported understates the true rate received on stocks that have had a large
gain. The reason is the percentage reported is calculated on today’s price and not on the purchase price.
For example, SLB paid a dividend of 70 cents on a stock price of $79; the dividend rate is .9%. However, if you
bought SLB when I first recommended it, your price was $35 and the 70 cent dividend is 2%, based on that. I contend
that the true dividend rate is much closer to that calculation than it is to calculations based on current price. To
get true total gain, you must add all dividends paid during your holding period, add that to your total appreciation, and
divide by your purchase price. All of the stocks in my recommended commodity portfolio are contained in this list with
the gain of that portfolio being 27% plus about 2% in dividends. Stock Gain Dividend
XOM 48% 1.7%
COP 23% 2.1%
SLB 124%
0.9%
BP 18% 3.7%
UNH -9%
0.1%
BA 48% 1.4%
WFC 21%
3.1%
ECA 30% 1.3%
GLD 19%
N/A
CMI 45% 0.8%
CAT 16% 1.5%
FLR 24% 0.8%
Several of you have asked what happened in Q1 to
scare the market. To each of you, I suggested you use the downturn as buying opportunities in the stocks I had already
recommended. That is what I did plus added a few names. When the market gets stormy, it is extremely important
that we understand what is happening. In this case, it was clear to me that the fundamentals that underpin the market
were as strong as ever but investors were scared by the sub-prime mortgage dilemma and the yen-carry trade “margin call”
like event. They are explained below so we can be prepared next time the seas get rough.
The sub-prime dilemma:
Sub-prime mortgages are a subset of the mortgage business that focuses on extending credit to borrowers with bruised credit
or who cannot meet standard guidelines. Sub-prime borrowers are risky. How risky? It used to be possible for someone
with a 580 FICO score to get 100% financing with thousands of dollars of open collections; and, they were barely two days
out of bankruptcy. They also didn’t have to verify income.
It is important to know that sub-prime lending has its
place and it has made home ownership possible for a huge number of people who otherwise would have never been given a chance.
The problem arises when stormy economic events rocks the boats of these ill-prepared loan holders. A perfect storm occurs
when all of the right conditions are present to make life miserable. There have been several developments that have been occurring
that are causing this implosion which I am sure will be borne out in the foreclosure statistics as this unwinds.
Rising
Interest Rates: Sub-prime mortgages can be characterized by the interest only loans or the 2/28 or 3/27 mortgage product.
This is industry lingo for an adjustable rate mortgage that is fixed for two or three years. Sub-prime mortgages are almost
always ARMs. What makes them unlike ARMs for prime borrowers is that the margins on these loans are 5 and 6%, if not more.
The margins on ARMs for borrowers with good credit are usually just 2.25%. This means many of these borrowers are going to
see the rates on their mortgages almost double overnight. Keep in mind; these borrowers were marginal to begin with, so significant
increases in mortgage payments are definitely going to cause them problems. This also results in these borrowers making late
mortgage payments which is the death knell for the opportunity to get out of the sub-prime loan into a conventional mortgage
prime mortgage. So because of the rising rates they make a late payment which disqualifies them from being able to refinance
into a lower rate mortgage product. It gets worse.
Elimination of Programs: Since many of these loans have not been performing,
Wall Street does not have an appetite for these loans anymore. Every lender is eliminating loan programs and tightening underwriting
guidelines. What is happening is that where a borrower could have qualified for a mortgage last year, they now cannot. So
not only is this person’s payment going up 50% or doubling, they no longer can refinance into a better loan product
because a better loan product does not exist. But wait, there’s more!
Stagnation of Home Values: The nail in the
coffin has been the overall housing market. The one savior for most borrowers has always been increasing equity in their homes.
If you have enough equity, there is a mortgage lender that will be willing to take the risk. However, a lot of borrowers who
bought with 100% financing, or kept refinancing to take out equity, now find themselves either upside down or with very little
equity. So, not only are they unable to make the payment or refinance, they also are having a hard time selling their homes,
and may even owe more than the home is worth. Checkmate. Just another foreclosure statistic.
So there you have it. The
perfect storm.
The Yen-carry Trade Dilemma:
The Bank of Japan’s zero interest rate policy since early 2001
has created an incentive to borrow in Japan at very low interest rates (sometimes 0%) and employ the borrowed money to buy
high yielding assets such as US 10 year Treasury Notes. For instance, an individual borrows 106,200 Yen from a Japanese bank
at 0.5 percent interest rate, which he then exchanges for US$900 (the exchange rate is 118 yen per US$).
He
uses the $900 borrowed money together with his own $100 to invest in US Treasury Notes for a yield of 4.5 percent.
After one year, the $1000 becomes $1045, implying that after interest expenses of $4.5 our investor makes a profit
of $40.5, which amounts to 40.5 percent return on his $100. As long as the dollar stays stable, or does not fall against
the Yen, our investor is going to make a hefty return on his money.
However, the whole thing could reverse quite rapidly
should the US$ depreciate against the Yen. Let us say that the Yen has appreciated against the US$, and it is trading
at the end of the year at 115 Yen per US$. In this case, on the maturity date, one-year after, our investor must repay
$928 — this means that his profit falls to $17, or 17 percent. Obviously, should the Yen appreciate much more,
let us say to 112 Yen per US$, then his repayment to the Japanese bank in dollar terms will amount to $953 implying
a loss of 8 percent.
This example used an investment in US 10 year Treasury Notes which is very low risk. In reality,
much of this borrowed money is invested in US stocks, which are much more volatile. If our investor leveraged his borrowed
money to buy US stocks or a US stock index only to see that investment fall say 5% to 10% while the Yen appreciated, he would
be faced with the compound problem of a loss in US dollars and loss on a Yen loan payback. Thus, when the exchange rate
dropped to 114 Yen per US$ in Q1, the result was a rapid sell off of US investments to pay the Yen loans before damage
was done in the exchange rate. That sell off undercut market confidence and precipitated the Q1 down turn.
The
length of this letter precludes specific new recommendations; but, I remain bullish on all the holdings (except UNH) listed
above. It is always okay to take some profit and put it in a safe place. However, if you are planning to invest it in
wealth growing stocks, I cannot find better buys than what we are already in. The world economy continues to grow and
this year, for the first time ever, 50% of the profits of stocks that make up the S&P 500 will come from foreign activities.
We are an international market. China’s growth is erratic; but, recall, they are trying to slow growth to a sustainable
level. Q1 earnings again were just above 10% and PE ratios are not historically high. I see the Dow at 15,000
by Q3 of next year and want to remain long while watching for storm clouds. Oil prices dropped below $60 for a brief
time in Q1 only to return to the mid sixties where I expect them to remain or rise above. We will not have another year
with no hurricanes and the Middle East is not getting more stable. By Q4 of this year, world demand for oil will be
greater than the oil the world can pump. Boeing is early in the seven year aircraft cycle and will split by this time
next year. Watch the fundamentals and do not be scared off by localized storms. I wish you good luck in your investment
strategy; and remember that good growth lies with those who do their homework. Sources: 1. Yen-carry trade:
http://www.alliancebernstein.com/investments/us/StoryPage.aspx?nid=5344&cid=43894
2. Sub-prime dilemma: http://smartmortgageadvice.wordpress.com/2007/03/05/a-perfect-storm-the-sub-prime-lending-implosion/
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