The Rude Awakening
Sonoma County, California
Wednesday, June 27, 2007 ------------------------- - Your A.F. editors chime in on a crisis in the making,
- Where to Park some cash in economic downturns,
- Hunting forgotten sectors with low, low valuations and plenty more…
------------------------- Eric Fry, sipping a Pinot Noir in Sonoma County, reports… Immediately after publishing yesterday's edition of the Rude Awakening, a couple of our colleagues checked in with their own observations about the CDO/credit market/stock market crisis-in-the-making. Christopher Hancock, editor of the Free Market Investor remarked, "Hey Eric, I thought I would throw this your way. It might make a good follow-up story to today's Rude Awakening. I read a blurb in the Financial Times a while back where the big three ratings agencies [Moody's, S&P and Fitch] are deep between the sheets with the investment banks on these new whiz-kid financial instruments. It's sort of like an Enron/Arthur Anderson deal. "The Big Three really don't know how to rate these things," Chris continued. "They're good at rating industrial credits like IBM, but not so good at rating things like CDOs and other financially engineered products. But the agencies get fees for ratings… and good ratings mean good business with Wall Street. [Editor's note: This flagrant conflict of interest does not mean that the ratings are flawed, only that the risk of compromised judgment exists…in a big way]. Both parties can claim they acted in 'good faith.' The banks can say the agencies issued the ratings, while the agencies said they 'did the best they could.'" Unfortunately, as Chris' remarks imply, "good faith" may not be all that good. As the imploding CDO market compounds the systemic stresses of the imploding sub-prime mortgage market, investors may discover - to their chagrin - that a monkey with a dart board could have provided better financial guidance than the Big Three rating agencies. But readers should not confuse our cynicism with prophecy. It may well be that a PhD with dart board will beat a monkey almost every time. A few moments after receiving Chris Hancock's email, we received an email from Dan Amoss, editor of Strategic Investment. Dan offered the following observations about the potential of a credit-derivative contagion: "Fears of subprime loan contagion have once again spooked the Street. A few hedge funds managed by mortgage-backed security hotshots at Bear Stearns are now liquidating, albeit at a measured pace. According to The Wall Street Journal, as of Jan. 31, Bear Stearns' High-Grade Structured Credit Strategies Enhanced Leverage Fund had '$699 million in investor capital, but had over $12 billion in investments. A month later, its investor capital had dropped to $667 million, but its bets on the market had increased to $15 billion.' "No matter how smart or sophisticated a manager may be," Dan continued, "levering portfolios of illiquid securities with too much debt usually leads to trouble. We don't know exactly how much of the HGSCSEL Fund's $15 billion asset base was allocated to subprime mortgage-backed securities. But layering 10-to-1 leverage onto securities that have thinly traded secondary markets reminds me of the behavior that brought down Long-Term Capital Management in 1998. "'The losses at Bear Stearns' two misleadingly named hedge funds -- the High-Grade Structured Credit Strategies Enhanced Leverage Fund and High-Grade Structured Credit Strategies Fund -- could match or exceed LTCM ($4.6 billion), and maybe even Amaranth ($6.5 billion),' writes economist Ed Yardeni in his morning briefing. "While Yardeni doesn't think these losses will lead to a financial meltdown, he also notes: 'Reading the WSJ stories on the Bear funds reminded me of the technology companies that boosted their sales during the late 1990s by lending their customers the money they needed to buy their products. In the current case, Wall Street firms and money center banks financed the leveraging up of hedge funds that purchased the exotic and illiquid fixed-income securities produced by the very same Wall Street firms and money center banks.' "What's really scary about these exotic asset-backed securities portfolios," says Dan, "is that they are 'marked to model,' rather than 'marked to market.' This means that they're carried on the books at whatever the in-house math geeks think they're worth. There's no liquid secondary market for many of these securities, so this often serves as the only way to account for them. "Complicating the situation even further," Dan explains, "the rating agencies like Moody's and Fitch generate many of their fees from the same brokerage houses whose mortgage-backed securities they rate. Do you think Moody's would give a completely truthful, independent rating to a huge MBS pool if it meant losing future ratings business? "This is a major conflict of interest. "Therefore, the institutional investors who thought they were buying 'investment-grade' securities, stamped with Moody's or S&P's seal of approval, will soon begin whining about their loses. And you can be sure that they will whine in traditional American fashion: hiring lawyers and suing every party in sight, especially the ratings agencies. "If this mortgage-backed security mess gets worse," Dan concludes, "there's a good chance that a 'ratings agency' scandal could unfold in the coming months." Your editors here at the Rude Awakening will be watching this unfolding drama with keen interest. While rooting for the triumph of justice, we will prepare ourselves for alternative outcomes…like falling share prices that punish unwitting victims. Be careful out there, dear investors. This situation might get ugly. But even in the midst of perilous circumstances, some stocks are better bought than sold. Our colleagues over at the Survival Report, for example, believe the pharmaceutical sector offers some enticing opportunities, at least relative to the rest of the stock market. Take a look at their analysis below… --- Survival Report Housing Paper --- Why Your House Could be Worth 43% Less by 2011 Thought you were "done" with the property bust? Think again -- then get ready as a whole "second wave" of falling prices sparks the worst property-led recession of the last 76 years! Grab Your Copy Here: Survival Report Housing Paper ------------------------------------- Big Pharma Gets Small
By Mike "Mish" Shedlock and Brian McAuley Bill Miller, the manager of the $21 billion Legg Mason Value Trust Fund, has spent 15 of the last 16 years beating the market by finding value in places that are overlooked by the market. That's an easy thing to say, but when you manage billions of dollars, you aren't as nimble as the average $100 million hedge fund. So you have to take a step back, rise above the short-term noise, and look at the long-term trends that most don't bother with. In order to find real value in our over-analyzed market, Miller first looks in sectors that haven't been performing for a while. In this case, "a while" means at least six or seven years - long enough for most investors to have completely forgotten about the sector. This can take a while, and during that time, the stocks within "forgotten sectors" often fall to unreasonably low valuations. Just as valuations can reach absurd heights when investors are enamored with a sector, valuations can reach absurd lows when a sector is forgotten and drifting from lack of attention. And "drifting" is certainly how you could describe pharmaceutical stocks over the past nine years. After peaking with the market in 2000, the Amex Pharmaceutical Index currently trades at a level it first reached back in 1998. The components of this index are some of the largest pharmaceutical research and manufacturing companies in the world. They sell their products all over the globe, which means a good portion of their earnings are protected from a continued decline in the dollar. In fact, as the dollar declines, these companies will benefit directly from the more favorable exchange rate when they report their offshore earnings. Pharma companies are also extremely resilient during times of economic downturns. When patients buy their medications, one of the last things on their minds is whether or not the housing market is going to continue to soften and take us into a recession. If there is a medical need, people go to the pharmacy - end of story. In addition, there is also a demographic story to this sector. The aging of the baby boomer population is projected to increase the demand for everything from so-called "lifestyle" drugs to lifesaving cancer drugs in the coming years. According to Bloomberg, market research firm IMS Health estimates that by 2010 the market for cancer drugs alone will double to $66 billion. And that is likely just the beginning of the coming increase in demand from demographic trends. Despite these favorable trends, many Big Pharma have been lagging behind the overall market. While the Dow Industrials have rallied beyond their 2000 high, for example, one major Dow component remains far below its bull market peak: Pfizer (PFE). This stock hit a high of $50 in April 1999, but then started a six-year slide that ended at $20 in December 2005 - a 60% decline. Looking at the stock price alone, you'd be tempted to think Pfizer's earnings had also been cut in half - but that is hardly the case. Since 1998, sales have almost doubled from $3.49 per share to $6.79 per share in 2006. Earnings have more than tripled from 67 cents per share in 1998 to $2.02 per share in 2006. So the stock decline was accompanied by an enormous decline in valuation. In 1998, the price-to-earnings ratio of PFE peaked at 72, but today, PFE trades at just 12 times 12-month trailing earnings. Pfizer has many important product names out there, including well-known drugs such as Lipitor, Zoloft, Viagra, and Celebrex, among others. But part of the decline in valuation has come as generic manufacturers have taken market share from Pfizer after its patents expire. When patents expire, revenue from existing blockbusters falls as the cheaper generics come onto market. In 2005 and 2006, Pfizer's patents expired on two drugs that generated $4 billion in combined sales. In 2007, Pfizer will lose exclusivity on another two drugs that generate $4.1 billion in sales. This loss of sales to generics has resulted in a stagnant top-line revenue forecast for PFE out to 2011. However, we all know that stocks almost always make important long-term bottoms when all visible prospects seem dim - and that appears to be the case here. Although Pfizer's near-term revenue growth prospects are dim, two positive developments are likely going to drive PFE stock higher from here. First, Pfizer has embarked on a streamlining of its operations, which will reduce costs and allow earnings to grow a projected 20% over the next two years. Second, and more important, Pfizer is entering the market with cancer drugs that will compete with traditional biotech companies like Genentech. In January 2006, the FDA approved Pfizer's Sutent for treatment of kidney and stomach tumors. In addition to those indications, it is currently testing Sutent for additional indications in treating breast and lung cancer. Pfizer is also working on axitinib for the treatment of thyroid cancer. These are just a few potential cancer treatments we currently know about. Outside of cancer, Pfizer has much more in the pipeline, including recently launched Lyrica and Chantix, as well as yet-to-be-launched Maraviroc, dalbavancin, and fesoterodine. In other words, even though competition from generics has taken a bite out of Pfizer's top-line growth, there is much more in the pipeline that will drive sales down the road. In 2006, 47% of Pfizer's sales came from outside the U.S., which is a big safety net in case the dollar declines significantly from here. Pfizer had $28 billion in cash and $5.5 billion in debt at the end of 2006, and a book value of near $10 per share. This huge war chest gives Pfizer a lot of room to fund research and make possible acquisitions in the coming years. It has also been buying back stock to the tune of $8 billion in 2006 and a projected $10 billion in 2007. PFE stock also pays a dividend of 4.2% at current prices, which will add to the total return of the stock in the coming years. 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