A Proper Inflation Hedge

As we all know the Federal Reserve on Wednesday voted to cut the federal funds rate to 2.00% and the discount rate to 2.25%.  While market commentators have been somewhat mixed on their views towards future rate decisions, they have for the most part come to the consensus that a pause is likely.  The Federal Reserve is clearly struggling to balance the demands of a slowing economy, an increasing unemployment rate and surging food and commodity prices.  With the latter two being exasperated by the weak dollar, with the dollar of course depreciating in part because of the Federal Reserve’s aggressive rate cut policy.  While I would not describe the situation as a vicious cycle quite yet, we are certainly close.

However, if food and commodity prices continue to spiral higher, I firmly believe that the Federal Reserve will have to begin raising rates to fight inflation even if it means hurting the economy in the short run.  As a result, I think that it is important for investors to have at least some inflation hedges in their portfolio.  While commodities, real estate, certain stocks and TIPS have been viewed as good inflation hedges for sometime there are a few interesting securities now available to the investing public that should be able to protect one’s portfolio from inflation with a greater degree of success then their predecessors.

The security that has caught my eye is the Profunds Rising Rates Opportunity Fund (RRPIX).  The fund is designed to return 125% of the inverse of the daily return of the most recently issued 30-year U.S. Treasury Bond.  The fund’s expense ratio is less then 1.5%; however, it requires a minimum investment of $15,000 so it has a rather steep entry requirement.  With the current yield of the 30-year U.S. Treasury Bond at less then 4.5% it is all but assured that the price on the bond will begin to move lower once the Federal Reserve begins to raise interest rates.  For those of you reluctant to place $15,000 into an investment of this type it should be noted that Rydex offers a similar fund (RYJUX) with a much smaller initial investment; however, its expense ratio is three times as high as its Profunds peer.

Having an investment in your portfolio such as the Profunds Rising Rates Opportunity Fund allows you to hedge your portfolio from inflation.  Should food and commodity prices continue to increase the Federal Reserve will undoubtedly begin to raise rates sometime in the future.  This security from Profunds will undoubtedly allow you to prosper from such an event.  If nothing else owning this security adds some diversification to your portfolio while at the same time reducing its correlation to the markets in general.    

For Further Review:

Profunds Website

Hopper, Homer & the American Economy

Last weekend, I had the pleasure of going through two of the Art Institute of Chicago’s best exhibitions in years.  The Edward Hopper and Winslow Homer showings were remarkable for not only their all-encompassing nature but also their profound ability to show the viewer an America that for better or worse no longer exists.  For those of you not quite up on your art history (and I am no expert) Winslow Homer was an American landscape painter from the late 19^th century.  While Edward Hopper, the primary artists of the exhibition, was an American realist painter from the early to mid 20^th century.  While wandering the halls of the Art Institute admiring the works of these two artists, I was surprised by two things that I noticed.  First, these two men managed to show in their art a vibrant rural America that no longer exists and secondly the crowd in the museum viewing these great works of art was composed of a large number of Europeans. 

These two observations I believe show us a lot about the current state of the American economy.  The paintings of Hopper and Homer of rural America showed well kept family farms, vibrant communities and a simpler way of life.  For the most part these characteristics can no longer be used to describe rural America.  Our family farm for example, while fairly prosperous, is surrounded by farms with houses on them that are pealing paint, collapsed buildings and broken fences.  For the most part the majority of our neighbors are likely to be the last generation of their family to own land that has in some cases been in their family for generations, as their children have no desire to return to the land.  The closest community to our farm is a far cry from what can be imagined from the paintings of Hopper and Homer as it is full of abandoned store fronts, empty manufacturing plants and eerily quiet schools.  This despite high crop prices, welcomed subsidies from the federal government and surging land prices.  It is clear to me that something more needs to be done to ensure that rural America doesn’t become a complete shell of what it once was. 

As I mentioned above, the exhibitions themselves were filled with Europeans who I imagine could not resist traveling to the U.S. on the back of the strong Euro and Pound.  In the three hours I spent at the Art Institute, I heard Spanish, Italian, French, German and an occasional English accent.  If I had to guess I would say that as much as a third of the visitors to the Museum on that particular Saturday were from a European country.  How long this will continue I have no idea but I would imagine that we will know shortly depending on what the Federal Reserve does this week.  If the Fed Governors choose to lower rates, we will likely see a continued decline in the dollar, on the other hand if the Federal Reserve chooses to keep rates flat we should see a slight recovery in the dollar.  Personally, I think that the Federal Reserve should have begun cutting rates much sooner and in light of the aggressive cuts this year has positioned our economy to be incredibly vulnerable to the horrors of inflation.  As such, I hope that Bernanke and friends choose to keep interest rates flat with perhaps a new mechanism designed to promote liquidity in the credit markets.   

If you are in Chicago anytime between now and May 10^th I strongly recommend taking the time to go through the Hopper & Homer exhibitions as I doubt we will see anything of this magnitude assembled together in one place for sometime.  These are two truly great American artists who despite their different styles chose similar areas of focus, in an effort to describe an America that they were intimately familiar with and one that we will likely never be able to fully grasp again.      

For Further Review:

The Art Institute of Chicago's Website    

Compelling Value in GFI Group

GFI Group (NSDQ: GFIG) is one the worlds leading inter-dealer brokers specializing in over the counter derivative products. The firm, while being quite successful in the past, has had by all accounts a rough start to the year. Its stock price has been hurt by a variety of factors, whether it is because of rouge traders at its competitors, the threat of a raid on its staff by its competitors or the fear that uninspiring financial markets will limit the firm’s clients ability or willingness to use its brokerage services. The quarterly report put out by GFI Group earlier this week for the first quarter of 2008 should put to rest all of these concerns as it shows a company hitting on all cylinders despite a decline of over 45% in its common stock for the year.

For the quarter the company reported revenue up nearly 31% year over year to $314.6 million and net income up nearly 46% year over year to .30 cents a share (.32 cents a share if you exclude extraordinary items). This was a substantial earnings beat and it positions the company to do quite well in the year ahead. GFI Group is expecting revenue growth for the second quarter to be in the range of 18-23% on a year over year basis. A substantial part of this growth will come from Europe and Asia where the firm grew 39% and 60% respectively. Currently, 48% of the firm’s revenue is derived from European operations, 42% from North America and a mere 10% from Asian operations leaving substantial growth possibilities.

The break down of their brokerage revenue for the quarter is quite positive and shows the company well positioned for the coming year. The robust trading by its clients in all areas shows that the firm’s franchise is strong despite the turbulence in the financial markets.

	1Q 2008 Year of Year Revenue Growth	% of Revenue as of Dec. 31, 2007
Credit	31%	36%
Financial	16%	19%
Equity	40%	25%
Commodity	22%	20%

These figures along with the companies recent acquisitions of Trayport, a commodity broker, along with European acquisitions in 2007 should continue to allow the company to move away from its slight dependence on the credit derivative market. Another interesting development going on at GFIG Group is the company’s efforts, in collaboration with CB Richard Ellis, to refine and further develop a product and market that will allow companies to use derivative products to hedge their real estate exposure. It should only be a matter of time before this product is actively used.

Over the last several years, net income at GFI Group has generally had a faster growth rate then its revenue growth rate. This trend should continue this year as the firm continues to apply leverage to its extensive infrastructure. This coupled with the significant decline of the stock price this year make shares in GFI Group particularly compelling and represents a rare opportunity to buy a growth stock at value prices. The trailing P.E. is approximately 15 while the forward P.E., by my calculations is below 10. If the company can grow revenue and net income somewhere between 20 and 30% this year, the shares could easily double during that time.

In the mean time, while you wait for this investment to bare fruit, the firm’s $270 million in cash on hand, .03 cent a share quarterly dividend and a large level of insider ownership will ensure that there is limited downside risk to the stock at this time.

For Further Review:

GFI Group's Quarterly Report

The Article of the Week

In order to beat the market, investors must avoid significant losses to keep them in the great game of investing and give themselves a chance at out doing the markets.  Diversification is as a result one of the most important tool investors have at their fingertips to achieve this goal.  A recent article at the blog Abnormal Returns takes a look at diversification and what additional areas of exposure investors should take on in order to ensure the adequate protection and growth of their portfolio. 

In their article entitled, “Radical diversification and the 200 day moving average” Abnormal Returns suggests a few areas that investors should explore in their quest for diversification.  These areas of exploration range from commodities, frontier emerging markets to buy write option products and hedge fund investments.  With the primary focus of being invested in areas that have no correlation to each other.  As a result, those willing to undertake serious portfolio diversification or what Abnormal Returns descirbes as “radical diversification” should in my opinion be willing to invest in all of the areas advised by Abnormal Returns along with their typical stock, bond, etf and mutual fund investments.   These investments should be spread across different countries, currencies and industries in an attempt to reduce correlation.  Often times investors tend not to know how much to put in each individual investment, a figure that I would suggest would be something between three and five percent and that these figures be strictly adhered to.  One of the first major mistakes I made in my investing career was to concentrate my investments in industries that were without a doubt extremely correlated to each other.  When these industries began to face a severe headwind, the losses were severe as there was nothing left pull the portfolio’s rate of return up.  It did not help that I kept buying more as the industry collapsed either but that is another story.

Returning to the article I would like to point out another fascinating point that Abnormal Returns makes by way of the blog Random Rodgers Big Picture.  Abnormal Returns suggest that it is important for investors to become defensive once the markets cross below their 200 day moving average.  A quick check of the graphs for the S&P 500 show this to be quite an important concept as they would have kept investors defensive (and possibly profitable) from October 2000 to March 2003 and from November 2007 to the present day.  Both bogs are well worth the effort to read on a frequent basis with the article from Abnormal Returns, highlighted above, being especially interesting.    

For Further Review:

Article on Abnormal Returns

Random Rodgers Big Picture

You Paid a 50% Premium for What?

I am sure that those of you who saw the news that Liberty Mutual was paying a 50% premium to buy Safeco (NYSE: SAF) had to take a second look.  After all, we are talking about the property and casualty business here, which is not exactly accustomed to monstrous premiums like say the biotech industry.  An eventual buyout of Safeco was to be expected as the last several management teams have been preparing the company for a buyout and it has been a well known fact for sometime that the company was on the block.  Liberty Mutual in purchasing Safeco is getting a regional insurance firm at a fair earnings multiple and at a slightly expensive book value but nonetheless they increases their regional diversity and they should be able to trim a fair amount of staff due their regional office's location in Portland, which will likely absorb much of Safeco’s employees.

The management of Safeco was without a doubt forced into this sale as they were simply running out of options to boost shareholder value.  Over the last several years the management of the company has reduced the share count by well over 40 million shares (17 odd million coming in the last year) and significantly expanded the dividend.  While these are all admirable accomplishments management undertook these actions without any growth in the company’s business and with an insurance company that can only mean a shrinkage of the firms assets and that is it exactly what Safeco did.  This can be seen in the high single digit declines of the net earned premiums over that last 4+ years and the dramatic decrease in the firm’s investment portfolio.  Safeco, while not levered to large amounts of debt, although they do have a fair amount, has significantly reduced the safety of its policy holders by its actions and I doubt that they could in the future continue with such large buybacks.  Furthermore, the quarterly results they announced after the deal were absolutely terrible and I don’t think I quite by their excuse that the weather was returning to “normal,” there must have been other issues.  For the first quarter of 2008, the company earned $1.57.  This compares to a $1.71 a year ago quarter.  It should be noted that this years results occurred even though the share count over the course of the year had declined from 106.7 million to less then 90 million after the repurchase of 17 million shares.  If the share count had stayed the same over the course of the year the earnings fall off this quarter would have be massive and the stock would have likely been under extreme pressure.  This is why I believe that the actions undertaken by management and the poor results soon to be announced left Safeco with only one alternative to boost shareholder value: to sell out to a bigger competitor, and that is what they have done.  Executives of companies that are either facing negative revenue growth or are in declining/stagnate industries should only engage in massive share repurchases if they see their growth potential improving in the future otherwise they will surely leave themselves with little option but to sell out as soon as they have exhausted their capacity to buyback stock.  Then again if you're going to sell out in the first place why not sell the company before you engage in the share repurchases, especially if there is a risk that your stock price will not appreciate significantly in the interim as happened with Safeco.  Although maybe I'm just to old school about buying back stock as I don't think companies should do so unless their stock are trading near book value anytime else is just a waste of the firm's capital. 

For Further Review:

Safeco Buyout

Example #1 on How to Build Shareholder Value

Earlier this week I highlighted the factors that have led me to come to believe that Atlas America (ATLS) will outperform the market in the years ahead.  Over the last several days, Atlas Energy (ATN) and Atlas Pipeline Holdings (APL), who are both partially owned subsidiaries of Atlas America, have all announced various corporate actions that will ensure the continued creation of shareholder wealth by these respective companies for the foreseeable future.  Since Atlas America is by far the largest shareholder in both, owing nearly 50% of Atlas Energy and over 60% of Atlas Pipeline Holdings, it stands to benefit immensely from their rise.

 While both Atlas Energy and Atlas Pipeline Holdings have grown considerably through acquisitions this last year, their stock price will primarily be driven by the corresponding increase in the dividends that they pay out to the limited partnership units.  Today is a perfect example of this point as Atlas Pipeline Holdings and Atlas Energy have both increased their dividends considerably for the quarter.  Atlas Pipeline announced that the next quarterly dividend would be $.43 cents a share for a corresponding annual payout rate of $1.73.  This is compared to a payout of only $0.34 cents a share last quarter and only $1.17 over the previous year.  Similarly, Atlas Energy announced that the next quarterly dividend would be nearly $0.59 cents a share for an annual payout rate of $2.36.  The last quarterly payout was .57 cents while during the previous year Atlas Energy managed to payout a $1.98.  In the case of both companies, sound assets in the exploration, production and transportation fields of the energy industry support these dividends.  Furthermore, I firmly expect these dividends to continue to rise on a quarterly basis as a result of organic and acquisition oriented growth.           

The question though is what does this mean for Atlas America, the majority owner of both companies?  The answer is that it means that Atlas America will be able to continue with the current dividend rate on its shares despite the fact that a 3-2 stock split was announced today, with the distinct possibility that it may even be able to raise the overall rate after the stock split.  In addition, I would not be surprised to see Atlas America either buyback stock (which it tends to do after stock splits) and/or increase its investments in Lightfoot Capital Partners.    

For Further Review:

Atlas Energy Press Release

Atlas Pipeline Holdings Press Release

Atlas America Press Release

And You Thought Our Banks Were Bad?

We have all known for sometime that European banks were large buyers of what would become poor performing U.S. mortgage loans prior to the credit crunch. We also all knew that certain European countries like Spain and the United Kingdom had their own internal housing bubbles but did anyone really see Royal Bank of Scotland Group (ADR:RBS) going out and having to raise $24 billion in capital and sell its insurance unit? I was simply stunned by the size of this offering as it shows the manner in which banks across the world are struggling to raise and preserve capital after coming to the realization that they made terrible blunders in checking for credit quality over the last several years. In addition to poor credit quality controls, Royal Bank of Scotland also has spent far too much money on expensive acquisitions during times that appeared to be brimming with prosperity, the most noticeable example being its participation the ABN Amro buyout.

In looking at the company’s balance sheet, it should be apparent that management has made colossal errors recently, as the Tier 1 capital base of the firm currently stands at only 4.5%. In order for U.S. banks to be considered “well-capitalized” they must have a Tier 1 capital base in excess of 6%. It should be clear that at these levels the depositors at Royal Bank of Scotland are in some risk. I would hope that the Bank of England would have some type of bailout plan ready in case the right offering, for whatever reason, does not or cannot occur. With Royal Bank of Scotland’s capital position at such low levels the Bank of England needs to be prepared to support the banking system should something terrible happen in the financial markets as Royal Bank of Scotland has no margin for error right now on its balance sheet.  I would imagine that the Royal Bank of Scotland is or will be one of the largest users of the Bank of England’s government bonds for mortgage bonds program as they simply will be unable to deal with the fluctuation in the value of the mortgage backed securities that they hold in the days and weeks ahead. 

The fact that the mortgage issues, that have been wrecking havoc on large U.S. banks, have now succeeded in nearly bringing down one of Europe’s largest banks shows us the global nature of this credit crisis, if we had not seen it already.   The question now becomes whether or not the move announced today by Royal Bank of Scotland is coming at the beginning or the end of the credit crisis?  I tend to think that we are somewhere near the middle and that the end is only in sight if banks around the globe realize that the need to adjust their balance sheets as fast as possible.  While Royal Bank of Scotland has written down some assets it clearly has a long ways to go and I would not be surprised to see it be forced to raise new capital in effort to keep its Tier 1 capital level above 6%.  In the days and weeks ahead, I would not be surprise to see other European banks follow the Royal Bank of Scotland’s example and begin the process of raising significant amounts of capital to help strengthen their balance sheets.

For Further Review:

Royal Bank Scotland Article on Bloomberg

Finding Value in Altas America (ATLS)

Atlas America, Inc is a fascinating energy company that can be found over on the NASDAQ with the ticker ATLS.  Atlas America is a rather complex company that holds a variety of assets through large ownership stakes in publicly traded subsidiary companies.  Despite its complexities it is will forth the time required to gain an understanding of it as it has considerable value to it as it trades at a sharp discount to its future value.  The two direct subsidiaries in which Atlas America has stakes are Atlas Energy Resources (NYSE:ATN) and Atlas Pipeline Holdings (AHD).  Atlas Energy is engaged in the exploration and production of natural gas in the Antrim Shale of Michigan and the Marcellus Shale of Pennsylvania.  Atlas Energy uses investment partnerships to fund a good deal of its drilling, giving it a significant cost advantage over its peers.  While Atlas Pipeline Holdings is a holding company of sorts that holds a significant number of share of Atlas Pipeline Partners (NYSE:APL) as well as the general partnership interest of Atlas Pipeline Partners and various incentive distribution rights associated with it that give Atlas Pipeline Holdings a share in the earnings of Atlas Pipeline Partners. 

Although you would never know it from Atlas America’s balance sheet, which is consolidated with its partially owned subsidiary companies, Atlas America sole assets are the following:

• 135 million in cash and short-term investments
• 29,352,996 common units of Atlas Energy
• 1,238,986 Class A units of Atlas Energy
• Incentive distribution rights related to the future growth of the distributions to shareholders from Atlas Energy
• 17,500,000 common units of Atlas Pipeline Holdings 
• 18% interest in Lightfoot Capital Partners

In addition to these assets, Atlas America has no significant debt.  The liabilities that appear on its balance sheet are a result of the requirement that it consolidate its subsidiaries (Atlas Energy & Atlas Pipeline Holdings) onto its own balance sheet.  Using today’s closing price (4/21/08) for ATLS of 71.58, ATN’s closing price of 39.66 and AHD’s closing price of 30.43 we can attempt to figure out a proper valuation for Atlas America.  Here are the assets we have so far:

o    Cash and short-term investments on hand of 135 million

o    A stake in Atlas Energy worth $1,164,139,821

o    A stake in Atlas Pipeline Holdings worth $532,525,000

This gives a total value of 1.83 Billion to Atlas America, slightly below its current market capitalization.  Assigning values to the remainder of Atlas America’s assets is difficult but I will now make some guesses as to what I think can be done.  The Class A units of ATN held by ATLS receive 2% of all the distributions made by ATN.  Over the last four quarters these distributions amounted to 119 million bring in 2.4 million for Atlas America.  Another way to look at this is that each preferred share held by Atlas America brought in nearly 2 dollars in dividends.  If you give them a 5% yield these shares are worth somewhere around 50 million dollars.

This brings total assets of Atlas America to slightly above 1.88 billion dollars, nearly even with the current market capitalization.  Trying to value the incentive distribution rights held by ATLS for ATN are difficult as they are not yet throwing off significant amounts of cash but as ATN expands its top and bottom lines ATLS will eventually collect 25% of all distributions by ATN with these rights.   In the next 2 to 3 years, this will occur as the partnership agreement calls for sustained earnings, at the rate currently achieved by ATN, for 3 years before the 25% distribution rate kicks into high gear, covering all earnings above the current amount.  

If ATN were to add 100 million to free cashflow available for distribution within the next 3 years ATLS would stand to receive an additional 25 million dollars on top of the corresponding increase in the normal dividend payment.  If you give a 5% yield to this 25 million dollars you can come to a market value of 500 million for these incentive distribution rights should they come to pass as I believe they will. The final asset left to examine is Atlas America’s holdings in Lightfoot Capital Partners.  This private equity firm which invests in MLPs is extremely hard to value but I would place its equity at about 200 million and its assets under management at less then a billion dollars, giving Atlas America’s stake a value of around 50 million dollars. 

Even without taking into account any increases in the value of ATN and AHD it is clear to me that Atlas America is worth in excess of 2.5 billion dollars.  Please feel free to plug in your own share price projections for ATN and AHD to come up with your own value for Atlas America.  I personally believe that within the next 3 to 5 years you will find that Atlas America, once you include the future appreciation of price in ATN and AHD will be worth somewhere between 3.5 and 4 billion dollars.  This would give you a share price that is nearly double what it is today.

Please take a look at this incredibly interesting but complex company.  Atlas America might just be a prudent speculation.   

For Further Review:

Atlas America 10-K

Opening Day for Prudent Speculations

Investing in the financial markets is always an exhilarating experience regardless of how long you have been apart of them.  The risks and returns of investing are all dependent on not only the results and actions of the specific companies in which you invest but on all the variables that affect the market as a whole.  That is why you, as an individual investor, need to be especially prudent when picking a stock to invest in as you can only manage to control the variables by which you select a company and not those that affect the market.  If you can select strong companies, I strongly believe that you can beat the market.  In this blog, I will try to talk about the companies that I believe are well positioned to outperform the market in the weeks, months and years ahead.  In the end though, we must all realize that we are merely speculating in the markets with the hope to make a little money.  If we can prudently speculate, we will hopefully make our money sooner rather then later.   Please feel free to comment on this blog or to send me an email with you thoughts, ideas and suggestions on how to make a little money in the market.