Moe Johnson First Vice President Investment Advisor (613) 531-5500 moe.johnson@cibc.ca 500 366 King St. E. Kingston, ON K7K 6Y3 Fixed Income and Equity Quarterly Commentary Moe Johnson Ryan Johnston Glen Johnson September 2013 Ryan Johnston Associate Investment Advisor (613) 531-5503 ryan.johnston@cibc.ca Linda Wilson Investment Advisor Assistant (613) 531-5520 linda.wilson2@cibc.ca Glen Johnson Investment Advisor Assistant (416) 594-7983 glen.johnson@cibc.com Michelle Flegal Investment Advisor Assistant (613) 531-5515 michelle.flegal@cibc.ca www.moejohnson.com Connect with: Steering Through the Financial Engineering Age Gov t of Canada Rates Aug 30, 2013 Sept 30, 2013 Change 5-Year 2.00% 1.86% -0.14% 10-Year 2.67% 2.53% -0.14% 30-Year 3.13% 3.07% -0.06% Indices % Change S&P/TSX 12,653 12,787 1.06% S&P500 1,633 1,682 3.00% DJIA 14,810 15,130 2.16%
The Fed Blew It the concern is that with inflation at only 1.2%, the possibility of slipping into another recession and a deflationary environment still looms The Dow Jones Industrial Average jumped 147 points on September 18 th to an all time high, powered by the Federal Reserve Board s (the US central bank) decision to keep moving ahead with its bond purchase stimulus program (Quantitative Easing, or QE). Bond prices posted the biggest one-day rally since November 2011 on the news, sending bond yields down to 2.70% as measured by the US Treasury ten-year issue (bond prices move inversely to interest rates). After reaching a low yield of 1.63%, the ten-year bond jumped in yield to 3.00% by August on the expectation that the Fed would peel back (read, taper, as it is being referred to on Wall Street) its bond buying from $85 billion a month to about $70 billion. Big demand for bonds (which is effectively what the Fed is creating) forces bond prices up and interest yields down. Ostensibly, the Fed has been using its bond buying program to keep economic stimulus alive in light of an economy that has been growing at lackluster levels. In June, the Fed thought that some tapering might be warranted, given their forecast of 2.3% to 2.6% economic growth in the US by the fourth quarter. That number has shrunk to 2.0% to 2.3% and is still much more optimistic than many forecasters on Wall Street are projecting. And, importantly, the concern is that with inflation at only 1.2%, the possibility of slipping into another recession and a deflationary environment still looms, in the minds of the Fed board members. The President of the Federal Reserve Bank of New York said as much on September 24 th, when he suggested that he is not confident enough in the strength of the US economy to begin winding down bond purchases. Which brings us to a moral question, and one of economics. QE1 was a highly creative maneuver designed to rescue the economy from the depths of the 2008-09 recession. We watched CNBC on September 19 th as the former chairman of Duquesne Capital Management, Stanley Druckenmiller, denounced the Fed s inaction and the whole concept of QE (Quantitative Easing, as in the buying by the Fed of $85 billion of bonds per month) as a negative for the wealth effect on Americans, not a positive. Saying that the Fed blew it because they had a chance to get us off the dope of QE stimulus, we now have financial market behaviour that is taking its lead from the Fed. What was QE intended to do? QE1 was a highly creative maneuver designed to rescue the economy from the depths of the 2008-09 recession. Arguably, it was both necessary and successful. But we are now five years into recovery, and QE is still with us in an economic environment that is arguably much more sanguine.
Who benefits from low interest rates? Certainly not the average individual The Federal Reserve Board had rightfully prepared the markets in June for a tapering scenario. with the recent rise in rates from May to the present, some extension of term, and the higher interest rates that come with that strategy, is well warranted. With the Fed bent on sustaining an environment of low interest rates, it forces investors to sell bonds and take on more risk in order to generate a respectable return. Moreover, the Fed is arguably contributing to the biggest redistribution of wealth in history with its low interest rate policy. Who benefits from low interest rates? Certainly not the average individual, the middle class and the poor, who generally cannot access and therefore do not benefit from stronger asset markets. Low interest rates, while good for securing a mortgage, have forced house prices up, both there and in Canada. Large institutional investors and ultra wealthy billionaires like the Warren Buffetts do benefit from QE2 with higher stock prices, commodities and big real estate. With stocks rising on the news of a non-taper, Druckenmiller admitted that he, personally, had a good day. Meanwhile, the small investor who hopes to mitigate risk by buying bonds is facing record low interest rates and has been forced into taking on more risk, thanks in large part to the Fed. And the person on the street looking for work, is, well, still looking for work. Druckenmiller was right. The Fed blew it. The Federal Reserve Board had rightfully prepared the markets in June for a tapering scenario. Stocks had sold off somewhat and bond prices had sagged. I suggested to our bond trader in Toronto that no matter what the Fed did on that Wednesday, interest rates as measured by the ten-year Treasury would be lower by day s end. The bad news, in other words, had already been priced in to the markets. The Wall Street Journal on September 20 th phrased it well The risk now is that investors again wrap themselves in the comfort blanket of the Fed liquidity and ignore what is happening on the ground. We would much prefer that the real economy begin to have a chance to stand up without the complication of Fed stimulus, making our job of buying stocks just a little easier, and based more on true fundamental values as opposed to Fed stimulus. As for bonds, with the recent rise in rates from May to the present, some extension of term, and the higher interest rates that come with that strategy, is well warranted. We are advising you accordingly. CEOs Bow to Financial Engineering For years, many legacy high technology companies, and others, have been supporting earnings per share growth through the use of common share buybacks. With huge cash balances on the books and limited growth opportunities, many corporate CEOs and their respective boards of directors
have taken the seemingly easier road to EPS growth through the purchase and cancellation of their own common shares. Microsoft (MSFT Nasdaq) recently bowed to pressure from activist investor, ValueAct Capital Management LP Cisco s stock price has increased at a 2.9% annual compound rate, MSFT by 2.2% and IBM, more impressively, by 9.5%. It works this way. Corporate profits in the most recent year might total $100. Ten shares are outstanding. Therefore, earnings per share equal $10. The Board declares a 2-share buyback and cancellation, leaving 8 shares outstanding. If you are still a lucky shareholder, the earnings per share number just got a boost to $12.50. All good news, or so it seems. Microsoft (MSFT Nasdaq) recently bowed to pressure from activist investor, ValueAct Capital Management LP, by offering a seat on the board. The company also increased its dividend payout by 22%, and resurrected a $40 billion stock buyback. ValueAct holds only $2 billion in MSFT stock out of a total market capitalization of $277 billion. Cash on MSFT s balance sheet totals $77 billion. S&P Capital IQ tells us that MSFT has repurchased and cancelled $110 billion of stock over the past nine years, reducing its share count by 22%, resulting in a sizable increase in earnings per share, reports The Wall Street Journal. Thanks to such buybacks, the company s [Microsoft s] average annual earnings per share growth of 11% was 46% higher than it would have been holding the share count constant. According to the WSJ, IBM (IBM NYSE) over that same period has bought back $100 billion of stock, thereby boosting its earnings per share growth by 53% to 16% per year. Cisco Systems (CSCO-Nasdaq) has bought back $63 billion over nine years and in so doing has increased annual earnings per share growth by 40% to 10% per year. Based on the impressive buybacks and healthy balance sheets alone, it is surprising that stock price growth over nine years has impressed for only one of those names. Cisco s stock price has increased at a 2.9% annual compound rate, MSFT by 2.2% and IBM, more impressively, by 9.5%. Buyback Guidelines We are wary of buybacks, but some can work. A few considerations 1. Did the company borrow heavily to affect the buyback, and at high interest rates? Our work in the late 1990s suggested that IBM was notorious in this regard. 2. Did the buybacks simply offset the stock that was issued to top management in any one year, thereby not really reducing overall share count.
3. Was the stock buyback done at historically high stock prices based on price to earnings ratios and price to book value? 4. Is the company running out of growth options in its own business, prompting a buyback as the only earnings per share growth avenue? The stock now trades at $84.30 (September 27 close) not cheap at 23.9 times expected January 2014 earnings. Dollarama (DOL-S&P/TSX) is a case in point of a company exercising some balance in its use of cash for both buybacks and store expansions. DOL has been a reasonably aggressive buyer of its own stock, at successively higher prices. From June 17 th of this year, to September 10 th, the company bought back a total of just over 2.2 million shares, or 3.3% of the shares outstanding, out of 3.3 million authorized. The average price has been $74.35. The stock now trades at $84.30 (September 27 close) not cheap at 23.9 times expected January 2014 earnings. However, the company continues to grow store count responsibly, earnings per share in the most recent quarter increased by 24% over the prior year (20% if you take out the share count reduction) and sales growth continues to be in the 6%+ range. Net debt stands at only $272 million on a company generating $2 billion in annual sales. Store openings totaled 93 over the last twelve months to bring the number to 828. The company instituted a dividend in mid- 2011 and now pays $0.56 per share. Share buybacks represent but one ingredient in a prudent approach to cash management. What s our point? We are cautious, incremental buyers at this point compared to the last 2 years, based on valuation. However, strong growth in sales and earnings, combined with new store growth of about 70 to 80 in the coming year, suggest that DOL is not about to run out of growth opportunities soon. Debt has remained very much under control. Share buybacks represent but one ingredient in a prudent approach to cash management. Moe Johnson Ryan Johnston Glen Johnson September 2013 Connect with:
This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change. CIBC and CIBC World Markets Inc., their affiliates, directors, officers and employees may buy, sell, or hold a position in securities of a company mentioned herein, its affiliates or subsidiaries, and may also perform financial advisory services, investment banking or other services for, or have lending or other credit relationships with the same. CIBC World Markets Inc. and its representatives will receive sales commissions and/or a spread between bid and ask prices if you purchase, sell or hold the securities referred to above. CIBC World Markets Inc. 2013. CIBC Wood Gundy is a division of CIBC World Markets Inc., a subsidiary of CIBC and a Member of the Canadian Investor Protection Fund and Investment Industry Regulatory Organization of Canada. Clients are advised to seek advice regarding their particular circumstances from their personal tax and legal advisors. Yields/rates are as of September 30, 2013 and are subject to availability and change without notification. Minimum investment amounts may apply. Ryan Johnston is an Associate Investment Advisor working with Moe Johnson, Investment Advisor. CIBC World Markets Inc. expects to receive or intends to seek compensation for investment banking services from Dollarama Inc. in the next 3 months