Saturday, April 29, 2006

Johnson & Johnson JNJ raises dividend

"In recognition of our solid results in 2005, our very strong financial position, and our confidence in the future of the corporation, the Board has voted to increase our dividend for the 44th consecutive year," said William C. Weldon, Chairman and Chief Executive Officer of the Company.

Shares of JNJ at 58 are cheap relative to pharmaceutical sector and market as a whole. JNJ isn't flashy, but it is very profitable with an S&P earnings quality grade of A+, and consistently high 29% return on equity.

Normally when I recommend a stock, I make a detailed investment case for it. With Johnson & Johnson (JNJ) the stock almost sells itself. JNJ senior pharmaceutical company. It is largely immune from economic cycles and has deep competitive advantages over other owing to its large financial resources, scale of operations and worldwide sales force. Good stuff.

Friday, April 28, 2006

Collecting the VIG Vanguard Dividend Appreciation

Vanguard Dividend Appreciation Index Fund VIPERs are now trading on the AMEX. Mergent just put up on their website a section about the Dividend Achievers Select Index. The "select" index has somewhat fewer companies in it, 212 vs 317 and seems to have more a value tilt than the Broad Dividend Achievers Index of the Powershares Dividend Achievers Portfolio (PFM).

The select index excludes REITs, which means that all of its dividends will be "Qualified Dividends" taxed at 15%. If you compare the components for the indexes, there is a noticeable void. Many of the companies which pay out most of the total stock market's available dividends are not in the select index.

It seems that the Dividend Achievers Select Index includes a screen against high payout ratios. Many classic high dividend payers like Citigroup (C), Bank of America (BAC), Altria (MO), Verizon (VZ), and J.P. Morgan (JPM) are not in the select index. Most of the top players in First Trust Morningstar Dividend Leaders Index Fund (FDL) are not in (VIG) because they pay out too much of their income as dividends.

I look forward to seeing how the exclusion (VIG), inclusion (PFM), or severe overweighting (FDL) of major dividend payers will affect the performance of Dividend ETFs.

The wasting assets of GLD and SLV ETFs

Will all the hoopla about the introduction of the iShares Silver ETF (SLV): investors seem to have forgotten a big gaping flaw in the design all the metal ETFs.

None of the metal ETFs own any income producing assets. Metal itself is dead, and therefore fund expenses (0.40% for (GLD) or (IAU), 0.50% for SLV) are taken from the ETFs bullion holdings. Every day the amount of gold or silver backing an ETF share shrinks. As silver ETF's Prospectus helpfully explains:

The trust sells silver to raise the funds needed for the payment of the sponsor’s fee [...] and all trust expenses or liabilities not assumed by the sponsor. The purchase price received as consideration for such sales is the trust’s sole source of funds to cover its liabilities. Impact of Trust Expenses on the Trust’s Net Asset Value

For example on Jan 03 2006, each share of streetTRACKS Gold Trust (GLD) held 99.552% of 0.1 troy ounces of gold, today on April 27 2006 each share of GLD holds 99.433% of 0.1 troy ounces of gold. On GLD's inception date November 18th 2004 each share held 100.00% of its starting NAV. You can watch your GLD vanish on the official streetTRACKS website.

An commodities fund like DB Commodity Index Tracking Fund (DBC) or United States Oil Fund LP(USO) that uses futures does not have the problem because interest from the bonds deposited as margin for future contracts is used to pay fund expenses and offset losses due to contango.

A simple solution for NAV erosion is for the gold and silver ETFs to lend their bullion and collect "leasing" fee's. The fees would be used to offset fund expenses and increase fund assets/pay dividends over time. Alternately each share of an ETF would be a unit could consist of metal and a preferred share of a trust that invests in treasury bonds/mortgages/TIPS. I.e each share of GLD would consist of 0.1oz of Gold and a preferred share of par $10. Income earned by the trust in excess of fund expenses would be paid as dividends on the preferred shares. Whenever a creation transaction occurs, the preferred shares would be redeemed or issued as needed.

Many equity ETF's lend their securities to short sellers to generate fee's from short interest. These earnings are used to offset fund expenses. The current precious metal ETF's policy of holding only physical bullion and having no source of income requires erosion of NAV to pay fund expenses. This makes metal ETFs questionable as a long term investment or store of value.

Wednesday, April 26, 2006

Socially Responsible Investment in Defence of Usury

While doing a little backround research on my article about KLD Social Responsible ETF, I stumbled upon the vast world of the socially responsible investment comunity. As an anthropologist it’s very interesting to see how personal beleifs intereact with capital in a capitalist society.

The only time people directly invest capital in a corporation is during an initial public offering of stocks or bonds. After the underwriters are done selling securities to the market, the securities represent a participation. Bonds are a participation in a series of cash flows paid from business profits, and shares represent a participation in the underlying business itself. The $5 dividend of Reynolds American (RAI) is earned by the sale of several packs of cigarettes. If the cigarettes are not sold, the dividend is not paid.

Looking over my own portfolio and comparing them to Sierra Club Mutual Fund investment guidlines. My portfolio comes up short. My investments in operators of Pawnshops and Pay day loan operators fail the club's guidlines against investing in "preditory lending." However ethical philosopher Jeremy Betham (father of Utilitarianism) wrote a tract in Defence of Usury adressed to Adam Smith. So I can feel some vindication in my investment.

The Christian Science Monitor has a very nice section on their website devoted to ethical investing. Each month journalist Laurent Belsie sits down with guests to discuss the outlook for ethical investing in a videotaped round table discussion. It's interesting to watch and gives you something to think about.

There is even a mutual fund The American Trust Allegiance Fund which invests according to Christian Science values. The Allegiance Fund avoids the classical alcohol, gambling and tobacco industries. As Christian Science inspired fund, it also declines investment in the health care, biotech, and medical diagnostics industires. The fund as large growth orientation, and has earned four stars from morningstar for having below average risk.

RJ Reynold buys Conwood LP. Are Altria and UST next?

RJ Reynolds (RAI) has made it's big move into smokeless tobacco by purchasing Conwood LP for $3.5 made $300 million in cash and $3.2 billion in new debt. The deal valued Conwood at 7.8 times sales. That would imply a private value of UST is worth $12 billion to $14 billion, compared with its market capitalization current market capitalization of around $7.24 billion.

RJ Reynolds was forced to finance this acquisition with debt, as a result of the companies current policy of maintaining a 75% Payout ratio. Issuing new shares to finance the deal would have been impossible because it would jeopardize the current $5 a share dividend. RAI claims that the deal will be accretive to earnings. The heavy leverage means that if RAI succeeds at growing the conwood business, it will be very profitable.

This acquisition is very strategic for RJ Reynolds, given that cigarette's are a dying market. Conwood has been taking market share from UST for quite a while, and have several obvious growth opportunities. RJR's research and development department have historically been top notch, and Conwood has excellent R&D as well even though it hasn't been shown in their existing products in an obvious way. Logical brand extensions include introducing Camel and Winston branded snuffs. I would venture that Winston is the most likely brand for recasting, since it is the "manliest".

Conwood's core premium Kodiak brand currently only comes in wintergreen, straight, and ice flavors. Logical expansion would be to copy UST's recent introductions of kid friendly flavors of Skoal such as apple, vanilla, and peach, RJR has been very successful at introducing seasonal line extensions for Camel, and that could obviously be done with snuff as well.

Most importantly, this implies that Altria (MO) might consider buying UST (UST) or Swisher. Historically the major cigarette companies did not have any smokeless tobacco business (this dates back to the break up of the American Tobacco Trust in 1912, and American Snuff Company in 1907), because historically the snuff industry was so different and so much smaller than the cigarette industry. As cigarette sales have shrunk and snuff sales have grown, having a significant chunk of the smokeless market would be meaningful to the major tobacco companies.

Tuesday, April 25, 2006

First trust launches two ETFs with no publicity. QQEW and QTEC

QQQ Lovers can now get an even greater fix on the Nasdaq 100 with the launch of two new ETF from First Trust covering this index in different ways. Of these I think QQEW is most useful for investing, but both of these will probably be used by speculators. I have no explanation for why First trust isn't giving this any publicity.

TheFirst Trust NASDAQ-100 Equal Weight Index Fund (QQEW) is an exchange-traded fund designed to replicate the holdings and weightings of the NASDAQ-100 Equal Weighted Index. Given how the S&P 500 Equal Weight (RSP) has knocked the socks off the market cap weighted S&P 500 index (SPY), this might be interesting. A long/short combinations of QQQ and QQEW could be used to capture deflation/inflation of valuations in the NASDAQ.

The First Trust NASDAQ-100 Technology Index Fund (QTEC) is an exchange-traded fund designed to replicate the NASDAQ-100 Technology Sector Index: an equal weighted index based on only the technology stocks in the NASDAQ 100. This could in theory be combined with QQEW to create a synthetic NASDAQ 100 ex-Tech index.

Two New Exchange Traded Funds Based on NASDAQ Indexes Are Launched

Socially responsible investing with KLD:: What if they launched an ETF and no one came?

A recent article in Institutional investor discussed the seeming lack of interest in socially responsible ETFs. Specifically the iShares KLD Select Social Index (KLD). The KLD index is based on the Russell 1000 index, with tobacco companies excluded. The index methodology then uses an optimization scheme to favor socially responsible companies while not having more than 2% tracking error to the Russell 1000 index.
Looking at the funds performance over the past year KLD's quantitative strategy has been quite successful at matching the benchmark index. The very low trading volume relative to the number of KLD shares outstanding can easily be explained by most owners of KLD being buy-and-hold types rather than active traders. (SDY) also has ridiculously low volume relative to size for the same reason.

I think the main reason for lack of interest in socially responsible funds is that most investors agree with economist Milton Freedman that the social responsibility of business is to increase its profits. Indeed according to Prof Jeremy Siegel, Ben Bernanke's Favorite Stock is Altria (MO) (f/k/a Phillip Morris).

Socially responsible investing suffers from socially desirability bias, the tendency for people to claim things about themselves which are socially desirable. A classic example is flossing your teeth; most people when asked will claim that they do floss their teeth, even though in reality regular flossing is quite rare.

The article notes that "according to Calvert, more than half of all non-SRI investors are “interested” in putting money with socially responsible funds, and almost 40% of investors consider themselves socially responsible, the share of investors in socially responsible investments range from 2% to 11%, depending on who you ask." I could be snarky, by noting that 2% to 11% is probably the same proportion of the population that drives Volvo's, contributes to NPR, or thinks the BBC is Fair and Balanced, but that would be cheap and I won't do it.

The article also lumps together the Powershares WilderHill Clean Energy Portfolio (PBW) with KLD. I feel that most investors owning PBW are doing so because they believe that increased fossil fuel prices will drive growth in the clean energy sector. Interest in PBW is driven by greed, not moonbeams.

The other big picture item that article seems to miss is that now that the broad asset allocation (I.e Large Cap, Small cap, Bonds, REITs etf) area have been covered by ETFs, future ETFs are going to be narrower and focus on themes and gimmicks. Which is exactly what has happened in the strictly retail UIT sector which is a ministry of all the talents.

Sunday, April 23, 2006

JMP Securities 5th Annual Research Conference. Sell side for the rest of us.

San Francisco based Investment Bank JMP Securities has put archived webcasts of presentations from their 5th Annual Research Conference. JMP covers a diverse set of small and mid cap companies, with an emphasis on Technology, Healthcare, Consumer, Real Estate, Financial Services and Business Services. This conference has something for everyone.

One thing that smaller investment banks should do is publicize and promote their research and investor conferences with the general public. Investment banks do sell-side research in order to promote interest in their underwriting clients. It is not done as part of disinterested quest for pure knowledge. IMHO you are going to do sell side research, then investment banks need to realize that the public is a big and growing part of the buy side. Companies should ask that their underwriters make their research publicly available as part of the underwriting services package.

Restricting research full conferences to institutional clients is silly. More investment banks should adopt the model of ThinkEquity Partners or Flagstone Securities by having a blog and regularly releasing bits of their research to the public.

Saturday, April 22, 2006

Convertables or cash?

At this point, the full effects of $75 oil and higher real interest rates are very unclear. But we can predict with confidence that they will be negative to overpriced stocks. One sign of this has been a weakening of the spread between treasuries and junk/BBB bonds. It seems like the market in general is forgetting the importance of certainty in uncertain times. For people with investments in the broad US market, for example S&P 500 shares or similar broad market mutual funds, now is good time to shift to defensive assets to protect your capital and therefore have it around when new opportunities emerge. Seth Klarman also has also noted this, in his January 26, 2006 letter to investors:

The world could well be setting up for considerable upheaval and with it an avalanche of opportunity. As we have said, nearly every investment professional is fully invested, and many are leveraged. With massive trade imbalances and huge U.S. government budget deficits, tremendous leverage everywhere you look, massive and unanalyzable exposures to untested products like credit derivatives, still low interest rates, rising inflation, a housing bubble that is starting to burst, and record and unprecedentedly low quality junk bond issuance, there appears to be little, if any, margin of safety in the global financial system. The day of financial reckoning for these and other excesses has been repeatedly put off, creating the illusion that risks are low, when in fact they are enormous and rising. High energy prices, ongoing terrorist threats, and nuclear proliferation add to the vulnerabilities. While we won’t hesitate to take advantage of investment bargains we uncover at any time, we are preparing our team to be well-positioned for the emergence of an expanded opportunity set.

There are many possible defensive investments that you can chose from to reduce your exposure to the broad market. I think it's very reasonable to shift up to 50% of your investments in S&P 500 linked assets to uncorrelated assets with less US market risk. Two good choices in my opinion are risk-free high yield savings accounts, convertible securities funds. If someone had $20,000 in shares of SPY, I think it would be quite reasonable to switch about $10,000 of that into a combination of a money market account and convertable securities fund. Based on modern portfolio theory we can create any desired risk profile via a combination of a risk free asset and one or more risky assets. By combining a risk free asset (the savings account), with a less risky asset (the convertible bond fund), and a risky asset (the broad market fund), we can create portfolio with less total risk. And that is a good thing.

Right now FDIC insured high yeild savings accounts are offering up 4.60% on deposits. At moment VirtualBank eMoney Market is offering best deal @ 4.60% APR on their eMoney Market Account. Other banks like HSBCdirect, Capital One, and Emmigrant direct are offering 4.50% or 4.25% on online savings accounts.

Convertible bonds are the thing with feathers; to paraphrase Emily Dickinson. They participate in the upward price movements of the obligor's stock, and yet they cannot bury themselves below the ground of their intrinsic bond value. And while their value fluctuates above a floor value, the bonds are paying interest. This risk return profile, is caused by the call option value of the bond's conversion feature. Convertible bond funds are a good way to reduce portfolio risk while still participating in the market. The non linear nature of convertible bonds suggests that active management is useful so long as it is not too expensive. The Vanguard Convertible Securities Fund, (VCVSX) ($10,000 Min) or Fidelity Convertible Securities Fund (FCVSX) (2500 Min) are good choices.

Friday, April 21, 2006

Vanguard Dividend Appreciation Index Fund

Vanguard is planning to launch a new dividend ETF on April 21, 2006. At the moment there is very little information out there about this fund. Russell Bailyn, recently interviewed Noel Archard of the Vanguard’s VIPERs Institutional Sales Team. Noel mentioned that he thought that demographic trends and tax advantages are leading investors towards dividends. Speaking for myself, I like getting dividend checks.

Based on the latest 485A Post-effective amendment (a tentative prospectus) filed for the fund, the fund will be based on a "Dividend Achievers Select Index" provided by Mergent. According to Vanguard, "The Fund's investment in the index will be within the capitalization range of the companies included in the Dividend Achievers Select
Index ($198 million to $378 billion as of February 28, 2006)."

This implies that the index is similar to Mergent’s Broad Dividend Achievers Index which is a total market index of companies that have raised dividends for 10 or more years. The broad index is the basis for the PowerShares Dividend Achievers Portfolio (PFM).

PFM is the runt of the dividend ETF litter, with a mere $23 million in assets under management. It is unclear if this because investors explicitly do not want broad market dividend funds or if this is merely a symptom of investors being satisfied with the existing major dividend ETFs (DVY),(PEY),(SDY) which have almost $7 Billion in assets combined. The success of WisdomTree’s funds depends on investor interest in total market dividend funds.

The 0.28% expense ratio of the Vanguard Dividend Appreciation VIPERs will be much cheaper than other dividend ETFs. DVY charges 0.40%, the Powershares dividend funds all charge 0.50%, the SPDR Dividend ETF charges 0.30%, and Morningstar Dividend Leaders (FDL) charges 0.45%. I think that the vanguard fund will dominate the other the other dividend ETF, with the exception of PID and SDY. PID remains the only international dividend fund. SDY is as cheap as the Vanguard fund and has a unique universe of Dividend Aristocrats that have raised dividends for at least 25 years.

IMHO Powershares and other sponsors will cut expense ratios or switch to monthly dividends if investors start switching. IMHO there is no real reason for exchange traded dividend funds to charge more than 0.30%. Dividend stocks are liquid and cheap to trade on the US Exchanges. Lower expense ratio's will also lead to higher yields, which is ultimately what income investors want.

Thursday, April 20, 2006

Investing in global water stocks: US listed companies and ADRs

The most popular article on this website is PHO -- Water ETF as a liquid asset. The Powers hares Water Resource Portfolio is hot. It has gotten alot of attention in the investment media and even Jim Cramer has talked about it.

At this point many investors want to look a bit further out into investing into international stocks in the water industry. To satisfy that interest Claymore has launched a UIT the Global Water Equities Portfolio, Series 3. When combined with the ADR's listed in PHO, its possible to make a list of non-US companies which are involved in the water industry. These companies are easy to invest in because their shares are traded on the major US stock exchanges. It would be very logical for an ETF sponsor to make an global clean energy and water ETF that would include more international companies than just those traded as ADRs. (FD: As usual you should do your own due diligence, and I indirectly own some of these stocks by virtue of owning shares of PHO.)

International Water Stocks

  • United Utilities PLC (UU), a major British utility company, that provides water and sewage services to much of northern England. The company also has global operations in the United States, Canada, Australia, the Philippines, and Continental Europe.

  • Veolia Environnement SA (VE), a major French water services and construction firm. Veolia is similar to Halliburton (HAL), except that Veolia does water, not oil. For example, Veolia recently won a contract to build a seawater desalination plant in Bahrain. This plant will make 273,000 cubic meters drinking water each day (72,118,966 gallons/day) and cost $336 million to build.

  • Suez (SZE), is the other major French water services and construction firm. Suez is similar to Veolia (VE) except that Suez also also owns and operates public water and electricity services which are its core business. Recently Suez has been involved in the takeover mania in Europe and has been gunning for italian electric company, Enel SpA (EN). This has made the stock very volatile over the past few months.

  • Companhia de Saneamento Basico do Estado de Sao Paulo (SBS), is water utility of the Brazillian state of Sao Paulo. SBS provides over 26.5 million people with water and sewage services. Companhia De Saneamento is in my opinion a very safe way to play on the strength of the Brazilian economy. According to SBS's own accounting, sales have grown by 12.7%, and EBIDTA by 18.6% in 2005.

  • Consolidated Water Company, Ltd (CWCO), is the water utility of the Cayman Islands, Belize, Barbados, British Virgin Islands, and the Commonwealth of the Bahamas. Increased carribean tourism has created demand for more fresh water to provide of things like golf courses and swimming pools. Shares of Consolidated Water Company has been trading at Google (GOOG) like valuations, which presents a certain level of risk untill new projects begin paying out earnings to justify the current share prices

An income investor with mean varience :: Part 1 of 2

Recently Geoff Considine has been analyzing various income portfolio's with his companies portfolio optimization software. Geoff's software (which costs $35/year) gives ordinary folks the ability to compose mean-variance optimized portfolios. In simple words, by allocating your portfolio assets along an "efficient frontier," it is possible to construct a portfolio with the greatest return for the least risk.

Before the development of Modern Portfolio theory by Harry Markowitz in 1958, investors who wanted more return and less risk got it by investing in income producing securities. The cash return of an income portfolio is immune to market forces; it is a bird in the hand. To some extent income investors exchanged the growth effect of compounding interest (by reinvesting dividends) for the more uncertain chances of growth in market price.

Traditionally income investment meant bonds, preferred stocks, and blue chip dividend paying companies. Since the days of Graham and Dodd, investors have a choice of many types of income security such as real estate investment trusts [REITs], business development companies [BDCs], income trusts, income deposit securities, publicly traded partnerships [PTPs, MLPs], and income oriented dividend and bond ETFs.

What Geoff Considine has shown in his recent articles about income investing and portfolio risk, is that blindly investing in high yield assets doesn't reduce risk as much as you might think. That is because many stocks/securities with high yields got that way because their prices are low relative their dividend payouts as a result of distress (real or perceived) or the inherent risk that flow through entities take on as result of paying out all their income as dividends. You have to be an intelligent investor to make safe money from income investing.

Geoff has shown the expected result that dividend ETFs like (DVY),(PID) or (SDY), tend to give more income than broad market indexes and have somewhat less volatility. This happens because of the stable companies/industries that are overweight in the dividend paying segment of the broad market. Dividend paying companies tend to be larger, more mature, and operate in regulated industries with fairly slow growth and risk (utilities, banking, and pharmaceuticals).

Most importantly dividend paying companies have stable cash flow that can be returned to shareholders as dividends. However dividend paying companies rarely have yields greater than 3% because of the need pay taxes and retain income to finance growth. To get more than a 3% income return on your investments you must have high yield equities in your portfolio. But all high yield income securities are not created equal, only by choosing carefully can you earn the greatest rewards for the least risk.

Part two of this series will cover what makes income securities tick, and how they offer real portfolio diversification which gives investors lower risk, higher risk adjusted returns, and cash return on capital.

Tuesday, April 18, 2006

The Anatomy of Value and Growth Stock Returns

We break average returns on value and growth portfolios into dividends and three sources of capital gain, (i) reinvestment of earnings, (ii) convergence in price-to-book ratios (P/B) due to mean reversion in profitability and expected returns, and (iii) upward drift in P/B during 1926-2003. The capital gains of value stocks trace mostly to convergence: P/B rises as some value firms become more profitable and move to lower expected return groups. In contrast, reinvestment, which is trivial to negative for value portfolios, dominates the capital gains of growth stocks. For growth stocks, convergence is negative: P/B falls because growth stocks do not always remain highly profitable with low expected returns.

Fama, Eugene F. and French, Kenneth R., "The Anatomy of Value and Growth Stock Returns" (September 2005). CRSP Working Paper Available at SSRN:

Monday, April 17, 2006

A Merrill Lynch index for all seasons :: Part 2 of 4

This is part two of a four part series. Part one discussed the Merrill Lynch Early Cyclical Index
The next index in the Merrill Lynch basic 4 series, a set of indices containing companies affected by different parts of the economic cycle, is the Merrill Lynch Interest Rate Sensitive Index

The index components are select financial companies from the S&P 500 whose performance is closely tied to the direction and movement of interest rates. The index is a blend of major banks, insurance companies, and mortgage bankers. The top five components are Citigroup (C), Bank of America (BAC), American International Group (AIG), JP Morgan Chase & Co (JPM), and Wells Fargo (WFC). The closest ETF to this index is the Financial Select Sector SPDR (XLF).

Sharing the fate of companies in this sector are Mortgage REITs such as MortgageIT Holdings (MHL) and Annaly Mortgage Management (NLY) as well as specialty finance companies like CIT Group (CIT) and KKR Financial (KFN).

This index has been quite done quite well since November of 2005, coinciding with interest rate increases. In recent months as Federal Reserve policy has become clearer (more inflation, higher interest rates) the index has settled down and now trades in a narrow channel. Many of the companies in index pay generous dividends.

International ETF's; whats on the menu?

Thanks to exchange traded funds investor's now have a quick, easy and cheap access to foreign stock markets. The biggest non-US ETFs are iShares MSCI EAFE Index Fund (EFA) [14.87B] and iShares MSCI Emerging Markets (EEM) [9.09B]. Unfortunately most foreign ETFs (except for Vanguard VIPERs) charge heavy management fee's, generally north of 0.60%. This is still much cheaper than normal mutual funds targeting a "specialty" area such as international stocks.

Somewhat more specialized than the broad market ETFs are a gaggle of single country funds from iShares, and more broad geographic funds (Europe, Asia ex-Japan, Latin America). The only differentiated international ETF's have been the iShares MSCI EAFE Value Index (EFV), iShares MSCI EAFE Growth Index (EFG), and Powershares International Dividend Achievers (PID). I love PID, and I think everyone must own it. Note that I said "must", not "should"; everyone must own PID.

Right now PowerShares is the only player for investors seeking international dividends for income and as a hedge against the decline of the dollar. That is going to change "real soon now" as WisdomTree has filed with the SEC for 20 dividend ETFs. Wisdomtree has proposed to create universes of dividend paying stocks from United States and the rest of the world. This indices will be weighted based on dividends paid in proportion to the total dividends available in the universe, a similar methodology to the Morningstar Dividend Leaders Index Fund (FDL) from First Trust. Morningstar has published a white paper on their available dividends index method.

What is most interesting about the proposed International Dividend funds from WisdomTree is that they plan to slice the non-US universe into regions (Europe, EFA, Japan, Pacific ex-JP) and market cap tranches. When the WisdomTree ETFs get listed, investors who want exposure to small cap Japanese companies that pay dividends can do so. These dividend funds will be the first funds to offer explicit small-cap and mid-cap international exposure. The requirement that companies pay dividends will act a screen against immature companies with weak cash flow and will give the indexes a value bias. I predict that these WisdomTree ETFs will become very popular with investors and be an essential part of a balanced portfolio

Sunday, April 16, 2006

Market Participant Book Review Index

From time to time I review books that may be of interest to readers. I recomend shopping at for the best prices and fast shipping.

Book reviews

Mentioned Books

Perhaps GM isn't dead yet.

The Investor Relations Blog has a very good summery and discussion about GM's recent "Tahoe Apprentice" website promoting the Chevy Tahoe SUV. The website allowed surfers to create their own ads for the SUV. Not surprisingly many trolls created negative ads, that decried the thought of purchasing an SUV.

As GM noted on its corporate Fastlane blog

Early on we made the decision that if we were to hold this contest, in which we invite anyone to create an ad, in an open forum, that we would be summarily destroyed in the blogosphere if we censored the ads based on
their viewpoint. So, we adopted a position of openness and transparency, and decided that we would welcome the debate. (citation)

The GM blog, which includes postings from GM Vice Chairman Bob Lutz, is a model for corporate investor relations and public relations. The fact that the companies top brass understands the need for openness and the appearance of honesty and fair dealing harks back to the days of Lee Iacocca at Chrysler. If top management gets it then perhaps there is hope for GM.

As is the stock price is quite low (It's trading at %78 of book value), as are GM bonds. People who are interested in a speculative investment in General Motors would be better off buying GM bonds that GM stock. GM has many $25 par bonds listed on the NYSE, including convertible debentures. Any event that is good for GM stock will be equally good for GM bonds, which are all trading well below par. In the event of bankruptcy, the bondholders (senior capital) will be far better off than the junior capital (share holders).

Right now a GM 7.5% $25 bond (Due 07/01/44, callable 06/30/09) (GMS) trades for $15.08 giving it an effective yield of 12.5%. It's possible to assemble quite an impressive income portfolio out of the publicly traded GM Bonds. The convertible bonds are less interesting because their conversion prices are so high (typically in the mid 60s or higher) as to not come into play.

Team of Rivals : The Political Genius of Abraham Lincoln :: Book Review

Although the Market Participant is mostly interested stock market investing, sometimes a good book is the best investment
French philosopher Jean-Francois Revel noted in his book "Anti-Americanism" that American's, more than citizens of any other country, enjoy learning about the history of their country and its founding fathers. No other American president is as interesting and inspiring as Abraham Lincoln. A search for "Abraham Lincoln" on returns 4,037 results. Doris Kearns Goodwin's "Team of Rivals : The Political Genius of Abraham Lincoln" is new biography of Lincoln and his cabinet has quickly risen to the best seller lists and with good reason. It is an excellent and enjoyable book.

Mrs. Goodwin has written great literature that gives new insights into Lincoln's leadership and his deep understanding of human motivation. Lincoln was able to create an effective cabinet by recognizing the talents of his political enemies, and including them in his administration. The book is really a multiple biography of the entire team of personal and political competitors that Lincoln put together in his cabinet to lead the country through the Civil War. I highly recommend this book to all people who enjoy reading popular history

Thursday, April 13, 2006

First Trust IPOX 100 Index Fund, What is it good for?

Greg Newton has has written a good article "ETF du Jour: IPOX-100 sets sail" about the new First Trust IPOX 100 Index Fund. I basicly agree with him that the investment case for investing in initial public offerings as a class has not been made. Not by First Trust, and neither by index provider IPOX Schuster LLC

IPOX Schuster is almost as bad as powershares in not documenting index methodology.One of the many advantages of ETF's over classic mutual funds is that the portfolio is open and deterministic. IPOX Schuster makes only vague comments about the exclusion criteria for the IPOX index.Without any filtering for the quality of the IPO companies, FPX could become cluttered with various dot-bombs and overleveraged zombies tossed out by private equity companies. IPOX Schuster does claim that Sabarnes-Oxley has improved the quality of IPO companies, but I disagree. You still see a fair amount of immature uninvestable companies (now with good accounting) being offered for sale. The reference to “pre-IPO accruals management and long-run stock price performance” refers to IPO’s of companies with low quality earnings and precious little internally financed growth tend to tank. And recent IPO’s like (CROX) are a perfect example of the problem.

One of the big problems with the current IPOX fund is that it has %10 weight cap and (GOOG) is 10% of the index. I wouldn’t want to have a single penny invested in that bubble. Since Russell has a policy of including IPO’s in their indexes on a quarterly basis, the Russell indexes will capture any IPO outperformance effect. I believe that Wilshire 5000 and other total market indexes also includes IPO’s quarterly.

After GOOG leaves the index I could see FPX as being part of a very long term passive portfolio, where FPX is intended to capture new growth during growth phases of the economy. Another use of FPX could be to balance a pure large-cap blue chip portfolio with younger fresher companies A similar solution would be to invest in the Russell Microcap and Russell 2000 Indexes which would give you full exposure to the small/micro company sector (Companies -1000 to 2000 in the Russell market universe) where most IPO’s start.

Wednesday, April 12, 2006

The missing funds of the future

Matthew Hougan posted an article on compiling reader suggestions for exchange traded funds. The main idea is that investors want international exposure, especially to small cap, as well as one-shot balanced allocation ETF's.

The WisdomTree international small cap dividend ETF will be the first international small cap fund traded. I think it's a telling sign of the innovation in the dividend ETF world that more than three years after international iShares began trading there are still no international small cap ETFs from any of the traditional sponsors. As I've mentioned before, I think getting foreign currency dividends are defensive investment against the impending decline of the US Dollar. Powershares (PID) fund has become very popular for investors seeking diversification with quality assurance.

I think that next generation of ETF's will mostly consist of quality screened indexes. The proposed First Trust Recently Deutsche Bank Strategic Value ETF is the kind of index fund that will be more common in the future. There is a precedent in the Powershares Zacks Small Cap/Microcap funds and dynamic market portfolios for screened indexes. Dividend funds could also be thought of as having a built in quality screen.

Although there are currently three REIT ETFs (IYR) (ICF) (VNQ), all of them focus on equity real estate investment trusts that own real property. A combined Mortgage REIT/Business Development Company ETF would make a nice complement to equity REITs, as well paying out generous dividends to income investors. It is unclear if the proposed streetTRACKS KBW Mortgage Finance ETF will include REITs or be limited to mortgage banks and related industries.

Balanced ETFs will probably the death the mutual fund industry. My conservative income portfolio would make a fine one-stop ETF for people seeking a single investment for retirement. Portfolio ETFs would save on brokerage fee's because investors would only have to trade a single stock, and not pay for rebalancing. I am surprised that Barclay's has not cobbled together pools of iShares into to "Portfolio ETFs".

Monday, April 10, 2006

A Merrill Lynch index for all seasons :: Part 1 of 4

Merrill Lynch created a series of four benchmark indexes designed to cover companies affected by different parts of the economic cycle. These indices are good source of investment ideas for large cap stocks. Over the next few days I’ll discuss each index and my thoughts on the investment outlook for that index.

Merrill Lynch Early Cyclical Index consists of stocks that Merrill Lynch believes would benefit during the early part of the economic cycle in which there is increased consumer spending. The index components include automobile, building materials, household equipment, retail and homebuilding stocks in the S&P 500.

Sharing the fate of companies in this sector are retail REIT's, such as Simon Property Group (SPG) or Pan Pacific Retail Properties (PNP), that operate shopping malls. Of the index companies, I think that Target Corp (TGT) and Costco wholesale corp (COST) are the most interesting. TGT and COST have best consumer perception in their respective sectors of big box discount retail and warehouse stores. Both companies compete with Wal*Mart and both Costco and Target have been taking share from the market leader.

This index has been quite stagnant since November of 2005, which is in harmony with reduced spending on consumer "capital goods" such as cars and houses. Rising interest rates and the loss of high paying jobs from the US suggest this trend of reduced spending on cars, homes and gadgets will continue. The debt capacity of many consumers has been drawn down. Many consumers can no longer tap home equity and personal credit lines to pay for spending. As the Fed Funds rate (as well as the prime interest rate) rises, many consumers are forced to devote increasing amounts of personal income to debt service.

Part two of this series covers the Merrill Lynch Interest Rate Sensitive Index

First Trust files prospectus for ETF based on Cost of Capital

First Trust has filed a tentative prospectus for the "First Trust DB Strategic Value Index Fund" ETF. This fund will track the Deutsche Bank CROCI US+ Index. The CROCI Index is an equal weight index containing forty stocks selected from the 251 largest stocks in the S&P 500, based on economic value added.

The forty stocks are selected on their ability to earn cash profits above and beyond the weighted average cost of capital. The fund uses Deutsche Bank's Cash Return on Invested Capital methodology to calculate a companies real profits and cash cost of its capital assets (including costs to create capital intangibles such as brands and accumulated R&D). For companies with positive economic earnings, an economic price to economic earnings ratio is calculated, and the 40 stocks with the lowest economic P/E ratios are included in the index.

This is the first exchange traded fund to publicly use an economic value added [EVA] methodology to select companies. The "First Trust DB Strategic Value Index Fund" will be a large/mega cap value index fund focused on highly profitable companies with strong operating margins. The current Deutsche Bank CROCI US+ Index constituents are listed on the AMEX website.

I applaud First Trust for starting an ETF based on the best thinking in corporate finance and fundamental indexing. Joel Greenblatt's best selling Little Book That Beats the Market is based on picking stocks that can earn more than the cost of capital used by the company. Assuming that the management fees are not excessive, this ETF based on companies with real cash profits has real potential to outperform other index funds based on market cap weighted indices.

Sunday, April 09, 2006

Ameritrade's new izone: all trades only $5, all of them.

Recently Ameritrade has launched a new brokerage service for clients seeking the lowest commissions. Ameritrade izone can do this because they have removed all the bells and whistles from the regular Ameritrade service. All support is by email only and all account funding done via electronic transfers. The result is $5 trades for all stocks and options. This is a better deal for active traders than even the most generous active trader programs at other stockbrokers.

One of the best aspects of $5 trades is that you rebalance your holdings quarterly without incurring massive trading costs. Rebalancing enhances performance and lowers portfolio volatility. Anyone with over $5000 on account should to consider using Ameritrade izone, if you don't need handholding or a lot of support. Ameritrade requires that you fill out a quick screening questionnaire, and all izone accounts are margin accounts.

(FD: I use Ameritrade as my broker)

Friday, April 07, 2006

Joining the syndicate.

Market Participant is now being syndicated via RSS, so you can keep up with up with all the latest posts with your favorite online blog reader.
  • Add to Google
  • Subscribe in Bloglines
  • Universal RSS format

Intel as featured on Barron's

The story of Intel's (INTC) amazing cheapness, caused by market neglect, has been picked up by the main stream media. On Thursday April 6, 2006 Tiernan Ray wrote an article Intel Turning Into a True Value (Sub req) in Barron's that reported chit chat from sell-side analysts on Intel.

The common element is that Intel's product road map, of energy efficient microprocessors based on new designs, looks better than (AMD) roadmap of trying to copy whatever Intel is doing. As well Apple is using only Intel chips in their new Macintoshes. If Apple can gain market share from other PC makers, that will put more of Intel's output into the hands of a "hard" customer that won't use AMD chips, unlike Dell or HP.

I've made the case for investing in Intel in a previous article back in March,".Intel for value investors", and as information about Intel's value potential gets out, the stock should experience a nice lift. This is rare chance for value investors to purchase a semiconductor stock cheaply.

A more agressive conservative income portfolio

Four ETFs to create an income portfolio for conservative investors described how to use four ETF's to make a portfolio that would combine current income with capital gowth.

Original Market Participant Conservative Income Portfolio

  • 25% (SDY) --SPDR Dividend Aristocrats
  • 25% (PID) -- Powershares International Dividend Achievers
  • 25% (VNQ) -- MCSI US Equity REIT index
  • 25% (AGG) -- Lehman Aggregate Bond Fund.
With a few tweaks we can increase the yield without taking on excess risk. The first step is replacing (SDY) with (DVY). SDY is the most blue chip of the dividend funds, made up of companies which have raised dividends for over 25 years. DVY is little more lenient, looking only for a five year history of non negative dividend growth and a payout ratio of less than 60%. DVY's Dividend weighting scheme results in a index with greater emphasis on absolute dividends paid. The yield difference between SDY and DVY is about 0.6%.

The second step is to replace 10% of the (VNQ) allocation with 5% each of (KFN) and (ALD). KFN is KKR Financial Corp., a real estate investment trust launched by buyout firm Kohlberg Kravis Roberts, to engage in equity investment and investments in residential, corporate, commercial loans as well as mortgage and asset-backed securities. Like most things associated with KKR, KFR uses leverage and a finely tuned capital structure to enable the REIT to punch far above its weight. KFN is currently yielding 7.1%.

ALD is Allied Capital, the oldest and largest Business Development Company [BDC] in America. Established in 1958, Allied makes loans and takes equity positions in small and midsized private companies. ALD is currently yielding 7.6%. Adding these higher paying non-equity REIT assets to the portfolio will both increase income and provide diversification from the property REITs in VNQ.

Aggressive Conservative Income Portfolio

  • 25% (DVY) --Dow Jones Select Dividend Index
  • 25% (PID) -- Powershares International Dividend Achievers
  • 15% (VNQ) -- MCSI US Equity REIT index
  • 5% (KFN) -- KKR Financial Corp
  • 5% (ALD) -- Allied Capital
  • 25% (AGG) -- Lehman Aggregate Bond Fund.

Thursday, April 06, 2006

Flagstone Securities Blog, a must read for REITster's

Flagstone Securities is a specialty investment bank with expertise in specialty finance sector focusing on Mortgage REITs and Mortgage Finance Companies. According to my hypothesis of "Inflation or Insolvency", corporations involved with debt will be very profitable.

Flagstone has public blog which publishes much of their research with a slight time delay. I recommend reading it if you are interested in investing in financial REITs for income and capital appreciation. I think this trend of smaller boutique investment banks, like Flagstone and ThinkEquity, publishing blog’s is a good thing. It’s a great way to demonstrate their expertise, as well as the value and quality of their research.

Gold @ $600 is an excellent time to move out of gold and into PID

The recent run up for gold to $600 and silver to $12 is a sign of the declining value of federal reserve notes. However the best response to this decline is not to buy gold, even though gold will continue to rise as the dollar weakens.

The problem with gold is that it is a dead asset. It doesn't produce income; it never grows even as it increases in price. Income producing assets give you the benefits of compound interest growth. Gold just sits there, looking shiny.The best investments in the context of weakening dollar are income producing assets that are not dollar denominated.

The easiest way to buy non-dollar income producing securities is to buy shares of (PID), the Powershares International Dividend Achievers portfolio.I've outlined the case for investing in PID in an earlier article The growing income stream of non US-dollar dividends from companies that are raising dividends is the best defense against the weakening of the dollar and the general inflation inherent in fiat currencies.

Wednesday, April 05, 2006

Investing with David Gladstone

Gladstone Management, an investment advisor run by David Gladstone operates two Business Development Companies and a REIT. These companies allow individual investors the chance to participate in the lucrative world of private equity finance.

An article in the Washington post "Gladstone Stays in the Middle Of Commercial Finance" describeses Mr Gladstone's long experience with Business Development Companies, a type of flow through entity that pays out its pre-tax income as dividends similar to a real estate investment trust.

Private equity financing is refers to venture capital investment in companies as well as helping to finance buy-outs and recapitalizations. Mezzanine debt is debt that stands between the balcony (senior debt) and the orchestra (equity holders). Mezzanine debt usually consists of secondary blanket mortgages, unsecured subordinated debt, or preferred stock. Often mezzanine loans include a "sweetener" for the lender in the form of warrants to buy stock or conversion privileges. These sweeteners can provide a lot of upside if the obligor company uses the capital effectively. In Mr Gladstone's own words "We try not to do crazy things and go for home runs, just doubles and singles."

The key benefit of investing in Business Development Companies is that their investments in private equity and mezzanine debt have a low correlation with publicly traded equity and are somewhat less affected by interest rates. As Business Development Companies's they must distribute their pretax income to shareholders like a REIT. This results in very high yields of taxable dividends. All of Gladstone's companies pay monthly dividends.

  1. Gladstone Capital (NASDAQ: GLAD) supplies debt financing to small and mid-sized businesses. Compared to Gladstone Investment, Gladstone Capital makes senior loans which are more secure than direct equity investments and junior loans. This is the oldest of Gladstone's BDCs, The company is currently paying a $0.135 monthly dividend ($1.62 a year).
  2. Gladstone Commercial (NASDAQ: GOOD) is a REIT that supplies real estate financing for industrial and commercial real estate to small and mid-sized companies. GOOD specializes in sale-and-lease back transactions where they purchase property and lease it back to the original owners.An article "Gladstone Commercial Takes On Hard-To-Finance Tenants" in NAREIT's magazine gives some persepective into the thinking behind GOOD. The company is currently paying a $0.12 monthly dividend ($1.44 a year).
  3. Gladstone Investment (NASDAQ: GAIN) (IPO June 28, 2005) seeks to make equity-type investments in small and mid-sized private businesses. Compared to Gladstone Capital, the Gladstone investment makes riskier loans and may take direct equity positions via preferred stock into its portfolio companies. Eventually the company will ownership interests in a portfolio of operating companies At the current time most of GAIN's capital is in cash, as it still filling out its portfolio of investments. The company is currently paying a $0.07 monthly dividend ($0.84 a year).

Energy Trends and Their Implications for U.S. Army Installations

Energy Trends and Their Implications for U.S. Army Installations is name of a report prepared by the Construction Engineering Research Laboratory at University of Illinois at Urbana/Champaign for the U.S. Army Corps of Engineers.

This report lays out what the top minds are thinking about the future energy demands of the US Army. The Army and its related industrial complex is so large and diverse that they can be thought of as a microcosm of the US economy.

The key takehome for investors is that energy supplies remain tight and that major capital spending on energy infrastructure (power plants, pipelines, electric cables) will be needed. A "Utility Infrastructure" ETF would be very nice but in the meantime this four element ETF portfolio should be well positioned to benefit from future developments.

  • 25% (IGE) -- iShares Goldman Sachs Natural Resources Index
  • 25% (XLU) -- Utilities Select Sector SPDR
  • 25% (PBW) -- Powershares Wilderhill Clean Energy ETF
  • 25% (PHO) -- PowerShares Water Resource Portfolio

This portfolio has nice blend of large cap (IGE, XLU) and small cap stocks(PBW, PHO) as well a dividend income from (XLU) and (IGE). Many of the companies in the PowerShares Water Resource Portfolio are also involved in utility infrastructure for liquid and gaseous fuels. I've laid out the case for investing water industries in previous post.

PHO -- Water ETF as a liquid asset.

Tuesday, April 04, 2006

Four ETFs to create an income portfolio for conservative investors

Recently there has been quite a bit of discussion on ETFinvestor about investing for income. My position is that dividend payouts are a concrete sign of corporate maturity and strength as well as proof that management has its eye on shareholder value.

Dividends are a cushion against declines in stock prices: If stock's price fell by 10% but it paid out 3% in dividends, your net loss would only be 7%, conversely if the stocks price were to rise by 10% your net gain would be 13%. When combined with dividend reinvestment, income portfolios provide impressive amounts of capital appreciation

An income portfolio made up only of stocks will not yield very much, even the highest yielding dividend ETF's don't pay much more than 3.3%.To get higher returns you need to own "income producing securities" such as REIT's, bonds, income trusts, MLPs, and preferred stocks.

At the moment there are ETF's that cover the main sources of investment income: dividend paying stocks, REITs, and Bonds. When combined these will provide most of the diversification that could be created in a

I propose that the "Market Participant Income Portfolio" will provide conservative investors with good income as well as the potential for capital growth.

Market Participant Conservative Income Portfolio

  • 25% SDY --SPDR Dividend Aristocrats
  • 25% PID -- Powershares International Dividend Achievers
  • 25% VNQ -- MCSI US Equity REIT index
  • 25% AGG -- Lehman Aggregate Bond Fund.
It's possible to get much higher yields by replacing the REIT ETF with with a few well chosen REITs and Business Development Companies (BDCs). The bond portion could be improved by adding exposure to high-yield bonds and/or mortgages possbily via a Mortgage REITor a no load mutual fund that invests in high yeild bonds. For the US dividend portion, (SDY) could be replaced with (DVY) to get more yield, I chose SDY as it is the most conservative of the dividend ETFs. These idea's are explored in a later post on a more agressive conservative income portfolio

(FD: I own shares of PID and SDY)

Sunday, April 02, 2006

ThinkEquity's March 2006 Investment Research on Consumer Products

Michael T. Moe is CEO of ThinkEquity Partners, an Investment Bank specializing in "companies in the growth sectors of the economy". He has generously posted ThinkEquity's March 2006 Research on stocks in the consumer products and retail sector at TEP's ThinkBLOG.

ThinkConsumer March 2006

It's very useful research report with some good raw data on enterprise values to chew on. While I don't have the same investment interest in growth stocks that TEP does; they do put out good research, have a nice news letter, and a useful blog.

Unit investment trusts and the farsighted merits of ophthalmology companies

Roger Nusbaum has been writing about recent development of tightly focused ETF's. ETF developers such as State Street, Barclay's and Powershares have been coming out with exchange traded funds that target very narrow market segments. While some people, such as John Bogle feel that these narrow index funds are strictly for speculators, I feel that they can be part of a well balanced portfolio.

The precursor to these narrow ETF's are Unit Investment Trusts offered by companies such as First Trust Portfolios. Indeed FT has recently branched out from offering UIT by launching three ETF's: the Dow Jones Microcap Select ETF (FDM), Morningstar Dividend Leaders 100 (FDL) and the First Trust IPOX-100 Index Fund (FPX). I've written my thoughts on the IPO ETF: First Trust IPOX 100 Index Fund, What is it good for?

UIT's are defined baskets of investments that sold as individual units to investors. UIT's normally charge an exorbitant sales load of 4.95% much of which is kicked back to stockbroker's in the form of incentive fee's. In order to attract investor interests UIT's often target very narrow market segments or have gimmicky investment strategies. In the ETF world Powershare's gimmick's funds: Valueline Timeliness (PIV), and Zacks smallcap (PZJ) and microcap (PZI) funds have all been quite popular with investors.

Sometimes these UIT's do cover interesting investment themes an example being the: Access Pacific Coast 101 Growth Portfolio which focuses on Californian companies. With a Gross State Product of $1.4 trillion, California is currently the largest state economy in the United States. It would be ranked the 5th largest economy in the world if it were an independent nation. California is far more impressive than Sweden (EWD) if you think about it.

Roger gave the example of ETF's proposed by Ferghana-Wellspring such as the "FW Ophthalmology Index" ETF, as being too narrow. According to Ferghana-Wellspring: "Companies in this Index are involved in the research, clinical development and/or commercialization of therapeutic agents for the treatment of various diseases of the eye including, but not limited to, age-related macular degeneration, dry-eye, diabetic macular edema, glaucoma, presbyopia and myopia, by means of pharmaceuticals, medical devices or biomaterials."

Since people dislike going blind, I assume that there will be plenty of demand for ophthalmologic lasers, intraoccular lenses (for cataracts), and drugs to treat eye diseases. Demographic trends implicit in an aging and fattening US population imply an increasing need for treatment of diabetic macular edema (from obesity) and age-related macular degeneration.

Another use of very tight ETF's is to produce portfolio's full of uncorrelated assets, and thereby gain strong diversification. For example you could combine the "FW Ophthalmology Index" with other non related ETF's such as (IGE), (PHO) and (ICF). One would assume that that the Ophthalmology sector is not correlated with Water industries, Natural Resources stocks, or Real Estate.

(FD: I own shares of PHO, and PIV)