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Such strategies - Buying the companies whose current earnings estimates are rising the most - worked very well. But in 2000 that strategy began to fail spectacularly. Part of the problem was that analysts' enthusiasm for high-tech darlings lingered on long past the Nasdaq's March 2000 peak: Many of the companies they thought would do better and better ended up doing worse and worse. An even bigger factor may have been that, because the strategy had been so effective in the past, too many investors crowded into it, whittling away at potential returns. "Everyone was leaping on the bandwagon," says Michelle Clayman, chief investment officer at New York money manager New Amsterdam Partners. Also hurting the strategy, ING Investment Management quantitative analyst Krista Kennedy points out, are new securities rules that banned companies from passing nonpublic information to analysts which meant that their estimates no longer gave an inside scoop. And as the accounting scandals at the likes of Enron and WorldCom unfolded, many investors began to question the validity of the earnings the analysts were trying to estimate. Lately, however, estimate-revision strategies are working again, according to Ms. Kennedy. Investors appear to have regained faith not just in the earnings numbers companies put out, but in the analysts. When Smith Barney analyst Stephen Kim became more cautious last month on home-building shares, after rightly predicting years of outperformance, the stocks dropped. Kmart rallied after UBS analyst Gary Balter upped his already-optimistic view on the company two weeks ago. The biggest danger to using estimate revisions to pick stocks is that others may be adopting the strategy, too. Anything that works gets pounced on. And then it stops working so well.
Mr. Bernstein reaches this depressing conclusion by analyzing the difference between the earnings that S&P500 companies have reported under generally accepted accounting principles and operating earnings, the figures companies typically trumpet because they do not include write-offs and other unusual items. The difference between the two figures, Mr. Bernstein says, is the GAAP gap. And it is widening. In the most recent period the gap was 13.7%. In other words, operating earnings were on average 13.7% higher than reported earnings. While that figure is well down from the 40% gap reached in 2002, it is much higher than the long-term, pre-bubble average of 6.7%. The result: while stock valuations may not be so high as they were before the bubble burst, the quality of earnings appears to be worse. Of course, none of this might matter if investors bought stocks based on GAAP earnings. But "the fact is, stocks trade on press releases, on what the headline number is," Mr. Bernstein said. "And on the conference calls, companies talk about whatever numbers they want to talk about. Investors should still be very skeptical of the quality of earnings." Mr. Bernstein said that he thought the recent downturn in earnings quality began, not surprisingly, a couple of quarters ago, when the profit surge started to subside. "If times are good, companies are not under pressure to keep their growth profile up," he said. "In tough times, when you get a cyclical company that has been coined by the Street as a growth company, it feels pressure to keep up that profile." That's when the earnings games usually begin. By focusing on operating earnings, rather than on more stringent reported figures, companies try to steer investors away from mistakes such as asset write-downs or restructuring charges. But these factors reflect bad choices by managers - such as overpriced acquisitions - and should definitely not be excluded from investors' analyses. "The difference between operating and reported earnings is an indication of how well executives are managing the balance sheet of their company," Mr. Bernstein said. This is often lost on investors who pay little heed to the balance sheet. The five companies with the widest gap between reported earnings and operating income currently, according to the Merrill Lynch analysis, are: Eastman Kodak; Georgia Pacific; Rowan Companies (an oil drilling concern); Ford; and Clorox. Mr. Bernstein said the vast majority of companies with the biggest gaps between reported earnings and operating income are of lesser-quality, those whose common stocks are ranked B or below by S&P; among the five with the widest gap, all are rated B or below except Clorox, which is rated A. So investors can often limit their exposure to earnings shenanigans by sticking with high-quality issues. But such a strategy won't offer full protection. As Mr. Bernstein noted, 22% of the companies with the largest gaps between reported and operating earnings were rated B+ or better by S&P. Mr. Bernstein said he thought the earnings games would be curtailed sharply if the SEC required that all company communications with investors reflected figures computed in accordance with generally accepted accounting principles. Then there would be no confusion among investors about what a particular company really earned in a quarter. "The reason you have GAAP is so investors have consistent clear information," Mr. Bernstein said. "The U.S. has always prided itself on having the most transparent financial markets. "But over the past 5 to 10 years, the U.S. market has become more opaque, and foreign markets have become more transparent. That has huge implications for the economy as a whole and for the cost of capital."
Q: What's the allure of alternative investments? A: The choices investors face today aren't especially attractive. Stocks rallied sharply in 2003 and 2004, after a three-year slump, and now trade at prices that no longer are cheap. Stocks in the S&P500 trade a tad above their historic average in relation to earnings. That suggests stocks are reasonably priced, but not screaming bargains. The market can surely rise as earnings expand, but investors need to rein in their expectations. Double-digit gains will be harder to come by in the years ahead since stocks are starting off at full prices. Bonds aren't much more exciting. Interest rates on all kinds of fixed-income securities -- from super-safe Treasurys to risky junk bonds -- have come down a lot in recent years, as the Federal Reserve slashed rates. And even though the Fed is in the process of boosting rates back up, the interest income on many bonds barely tops inflation. For instance, 10-year Treasury securities yield about 4.6%, compared with an inflation rate of almost 3%. Bond prices probably will be under pressure as the Fed raises rates. Given this discouraging environment, many investors are turning to alternative investments -- which refer to hedge funds, venture-capital firms, real estate, gold, art and timber. Some of these investments have turned in great performances in the past few years. And it has become easier for smaller investors to move into them. Unorthodox investment tools like exchange-traded funds also qualify as alternative investments. Q: Are there other reasons to shift into alternative investments? A: Yes, to diversify a portfolio. So many investors felt deep pain during the brutal bear market of 2000 to 2002 partly because they had too much money in stocks and suffered as prices tumbled. So some investors are looking for investments that zig when the stock market zags. Bonds help diversify a portfolio, but often bond prices also move in step with stocks. So far this year stocks have fallen even as bonds have lost ground. Alternative investments can move to their own drummer. Gold tends to rise in periods of global tensions, even as stocks tumble, in part because it is seen as a safe haven. Art can go up in value when the economy roars, but it also can rise in price in more troubled times if inflation is on the rise. Q: How much of a portfolio should be in alternative investments? A: That's a toughie. At one time, most experts recommended a basic investment mix of 60% stocks and 40% bonds, with some adjustments based on an investor's age. But in recent years, more have begun to appreciate the advantages of having 5% to 15% of a portfolio in alternative investments. In part that's because some of these investments have done so well -- especially real estate, where home prices as well as stocks of real-estate investment trusts have climbed. In general, wealthier investors should put a bigger slice of their portfolios in alternative investments. That's because some can be volatile. And many of these investments, such as art and timber, can be very illiquid, meaning it's hard to get in and out of them quickly without incurring a heavy loss. Other such investments, like hedge funds, prohibit withdrawals except for set times during the year. So if an investor might need to pull money out in a short period of time, such investments aren't ideal. Also, there tends to be less transparency with alternative investments. A stock price is just a mouse click away, but it's harder to get an accurate price for that rare stamp or piece of furniture, making some alternative investments a bit riskier. Q: So what's the hottest alternative investment right now? A: Hedge funds. Almost $1 trillion is invested in hedge funds, up from less than $800 million a year ago. The growth in demand is due, in part, to the fact that many of these funds managed to churn out small gains even amid the bear market. Hedge funds are private investment partnerships that aim to do well in both rising and falling markets. In hedge-fund parlance, they strive for "absolute returns." In contrast, mutual funds often are happy just to beat the market averages. Hedge funds generally buy investments they think have upside, such as stocks and bonds, while betting against other investments they think will go down. In that way, they seek to "hedge" themselves and achieve positive returns in all kinds of markets. Because they can bet against overpriced stocks, or move to the sidelines when opportunities are scarce, hedge funds tend to be less volatile than mutual funds. Traditionally, hedge funds were the domain of the super-rich or large institutions such as college endowments. That's largely because many hedge funds require minimum investments of as much as $1 million, and securities rules demand that investors have an annual salary of $200,000 or net worth of $1 million to be eligible for many hedge funds. But lately many brokerage firms have created innovative products, such as funds of hedge funds, that have minimum investments as low as $20,000. But there are big downsides. For one thing, hedge funds charge higher fees than mutual funds and other investments, usually around 1% or more annually of all assets as well as 20% of any gains. They're also lightly regulated, and some funds have exaggerated returns or taken on more risk than they promised, though more scrutiny from the SEC is coming. At the same time, hedge-fund returns have been in line with the market in the past year or so, even as more money has come into the business, a troubling trend.
"It is completely obvious that this will end badly - for the firms, investors, everyone," said Seth Klarman, founder of the Baupost Group, which manages $5 billion. "No area of financial endeavor is immune from the effects of competition." The numbers are mind-boggling: 15 years ago, hedge funds managed less than $40 billion. Today, the figure is approaching $1 trillion. By contrast, assets in mutual funds grew to $8.1 trillion from $1 trillion, during the same period. The number of hedge fund firms has grown to 3,307 last year, up 74% from 1,903 in 1999. During the same period, the number of funds created has surged 209%, with 1,406 funds introduced in 2004, according to Hedge Fund Research, based in Chicago. Unlike mutual funds, which are restricted in the ways they can invest, hedge funds can use leverage, trade derivatives and bet that stocks will fall, a technique called shorting. And unlike mutual funds, which generally try to beat a market average, hedge funds seek positive returns, even in down markets. The meteoric rise of hedge funds has had a huge impact on the markets, investment banks and investors, who increasingly include institutions like pension funds or endowments. A recent report published by Credit Suisse First Boston said that hedge funds were responsible for up to half of all activity in major markets, including the NYSE and London Stock Exchange. Investment banks are tripping over one another to service them. According to the same report, Wall Street made $25 billion catering to hedge funds - lending them money, trading for them, helping to structure complex derivative transactions or lending them stock to bet against a company. That's one-eighth of the street's total revenue pool. Signs that hedge fund managers have become the financial industry's new elite abound. Young, ambitious talent is fleeing Wall Street in search of hedge funds' overnight riches. In hedge fund offices, employees have perks like swimming pools and basketball courts. Because few people outside the industry know exactly how they trade or what they trade, there is a certain mystique to the hedge fund set, which only adds to their allure. Predictably, most people in the hedge fund world scoff at the notion of a bubble. "Hedge funds are not an asset class, so there is no asset class to burst," said Jane Buchan, chief executive of Pacific Alternative Asset Management, a fund made up of hedge funds with $7.2 billion under management. "It's not like real estate. Even if you think about people doing silly things for silly reasons, it's not a bubble." Indeed, the so-called smart money - rich investors like Thomas H. Lee, the famed leverage buyout maven - could not seem less worried. "Every investment board I am in touch with is interested in hedge funds," said Mr. Lee, ticking off the names of such giants as Calpers and Harvard's endowment fund. Mr. Lee himself has invested a substantial portion of his estimated $1.2 billion net worth in a portfolio of dozens of hedge funds. Yet, as Mr. Klarman said: "How many venture capital investors in 1999 said, 'We are doomed because of all the money flowing in?' " The Fed is Concerned Whether the hedge fund boom is a bubble may still be open to debate. But it is certainly not alarmist to wonder about the consequences of such torrid growth, built as it is on the leverage that banks provide managers to double or triple their bets. The Federal Reserve seemed concerned enough last fall, when it set up a group to examine what systemic risks had been created by the explosion of entrants into the market and the aggressiveness with which Wall Street was welcoming them. The Fed also encouraged the revival of a high-profile watchdog group formed in the wake of the market-shaking 1998 collapse of the Long-Term Capital Management hedge fund. Called the Counterparty Risk Management Policy Group II, it will examine everything from narrow credit spreads - a result of low perceived risk - to the cavalier ways that Wall Street lends to hedge funds. "Hedge funds are significant market players," Stephen M. Cutler, director of enforcement at the SEC, said in an interview. "They use leverage that mutual funds cannot, so the power of that $1 trillion is magnified. Your concern is not just the investors in the hedge funds but the hedge fund's impact on the market." To impose a modicum of order on the industry, the SEC has required that most hedge fund management firms register as investment advisers by February 2006, a move that an industry trade group has protested. Concerns about hedge funds, however, extend beyond finding out where they are based and whether their managers are felons (two of the objectives of SEC registration). Among other things, it remains a mystery - even to investors - what kind of bizarre financial products are traded by the funds, and how they value them. Given the potential returns, the incentives for investors to bet the house are huge. And many seasoned money managers have closed their funds, opening the door to newcomers to satisfy demand for ever more funds. Perhaps topping the list of concerns is the proliferation of funds of funds, pools of hedge funds that are meant to lower risk but that also come with another layer of fees on top of what standard hedge funds charge. By the end of last year, assets in funds of funds had soared to $359 billion, from $84 billion just four years earlier. Traditionally, investors have needed a minimum of $1 million to get into a hedge fund; with the newest funds of funds, investors with as little as $25,000 to spend can gain entree. Even hedge fund experts who pooh-pooh the notion of an investment bubble acknowledge the possibility of a compensation bubble. Instead of just receiving a fixed percentage of the funds they manage, hedge fund managers generally make "1 and 20" - that is, 1% of assets under management and 20% of profits. To put that in context, a mutual fund company managing, say, $100 million and earning 1% of assets under management makes $1 million. By comparison, a hedge fund making the 1% management fee and a 20% "carry" takes in $1 million for opening the doors, and an additional $10 million if the fund returns 10%. That's $11 million in revenue. "Hedge funds are an innovation of compensation," said one fund-of-funds executive. "It's a compensation system, not an asset class." The comment is meant to be positive: in hedge funds, compensation is aligned with absolute performance. In the mutual fund industry, compensation is usually tied to performance against a benchmark, like a Standard & Poor's index, or assets under management. Will fees come down? Few people think so. "If you lower your fee, they think something's wrong with you," said one longtime manager who described the fees as "absurd." In fact, fees have been moving higher. When Carl Icahn, the famed takeover trader, raised a $2 billion fund last year, he demanded 2.5% of assets and 25% of the profit. In 2003, the 25 highest-paid hedge fund managers earned more than $200 million, on average, according to a survey by Institutional Investor magazine. The top-ranked manager, George Soros, took home $750 million that year. At No. 2 was David Tepper, manager of the $3 billion Appaloosa funds, who earned $510 million, according to the magazine. Hedge Fund Returns The lure of hedge funds, of course, is not supposed to be the high pay but the outsized returns. Lately, the results have been less than compelling. Over the 10-year period that ended last December, hedge funds had an average annualized return of 12.57%, according to an index maintained by Hedge Fund Research. That is just slightly ahead of the 12.07% return of the S&P500 during that period, though hedge funds earned their return with half the volatility. During the market downturn, however, hedge funds did hold up well. In both 2000 and 2001, for example, the average hedge fund rose nearly 5%, according to Hedge Fund Research. That compares with declines of 9% in the S&P500 in 2000 and nearly 12% the next year. In 2004, however, the average hedge fund rose around 9%, lagging behind the S&P by nearly two percentage points, Hedge Fund Research has reported. During the first two months this year, the latest data available, hedge funds were up nearly 2%, compared with a flat return for the S&P. Many in the industry say the sharp increase in both supply and demand won't destroy the fundamentals of the business. "It is so much the better way of managing money," said Julian Robertson, who got out of the business five years ago after forging a reputation at Tiger Management as one of the most successful hedge fund managers. Today, he keeps a hand in the industry by providing seed money to new hedge funds. "Hedge funds have had about a 10-year place in the sun," he said. "I don't see any reason for that to stop." Many industry veterans say the party will continue, partly because of the shift in who invests in hedge funds. As recently as 2000, hedge funds were almost exclusively for the very rich. Now institutions want a piece of the action. Pension funds and other institutions are expected to invest as much as $250 billion in hedge funds over the next five years, according to a recent study by the Bank of New York and Casey, Quirk & Associates, a consulting firm. That would ultimately account for half of all money flowing into hedge funds. But as the pension money comes in, hedge fund returns are likely to go down, as fund managers adapt their strategies to suit the new clientele. Pension funds prize predictability over outsized returns; the average pension fund is looking to make just 8%, net of fees, on its hedge fund investments, the Casey Quirk report concluded. That is a far cry from the 25-percent-plus returns generated by rock-star managers like Mr. Soros and Michael Steinhardt. A possible check on hedge funds is the simple fact that while anyone can start one, the industry has a high casualty rate - especially for the smallest funds, which struggle to attract and keep investors. Untested managers whose returns languish often see their capital flee and are forced to shut down. "There are very low barriers to entry but very high barriers to staying in business," said Philip Duff, chief executive of FrontPoint, a $4.3 billion hedge fund, citing the average annual life of a hedge fund of 3.5 years. "That's problematic for investors," he said - particularly institutional investors who do not relish moving money around. "There's a reasonable probability a hedge fund will have a significant problem," Mr. Duff added. The fund, he said, "will be high-profile, and the question is, if and when that happens, does it materially change the growth in demand? My answer is no." While new funds have flourished, seasoned managers are also absorbing the demand generated by institutions. "In 2004 we saw nine $1 billion-plus start-ups, and 2005 is on track to outpace that number," said Gerard Coughlin, a head of Morgan Stanley's prime brokerage services. "While the high-profile start-ups command great attention, many established managers are busy broadening their product offering and expanding their footprint. The capacity created by these proven managers and high-profile start-ups is effectively raising the bar on what it takes to be successful as a new manager." Longtime hedge fund investors have faith in the power of Darwinism. "It will be survival of the fittest," said Michael Price, former manager of the Mutual Series mutual funds, who now invests $1.6 billion - a good chunk of it in hedge funds - on behalf of family, friends and two college endowments. "The guys who are not creative or don't know what they are doing won't last." That is not to say that there is anything stopping them from starting up - and potentially losing investors' money. But there's zero shame involved in launching a fund and failing. It is not unusual for managers to get a second chance. William A. Ackman once ran Gotham Partners, one of the most successful hedge funds in the 1990's, boasting a list of blue-chip investors. By the end of 2002, Mr. Ackman and business partner David Berkowitz were forced to shut the fund after they became stuck in a private equity investment they couldn't sell, and some investors demanded their money back. Since then, Mr. Ackman has raised $410 million for a new firm, Pershing Square. He has promised investors in his new fund that he will not make private equity investments. In the same way that there is no quelling the bulls, there will be no quieting of the critics. The Horvitz family of Cleveland, which made its fortune in road construction, media and real estate, started investing in hedge funds in the 1990's. A decade or so later, it has virtually no money in such funds, said Jeffrey Horvitz, who oversees his family's investments. Too often, he said, the funds produced disappointing returns. "Hedge funds are no longer attractive," Mr. Horvitz said, noting the influx of start-ups. "I see no relief in sight, especially for taxable investors like us."
Three years ago, Mr. Arnott was arguing there was a risk stocks might underperform bonds over the next 10 or 20 years. Three years later, he's still dishing out predictions that most investors don't want to hear. He reckons the S&P 500-stock index might clock just 5% or 5½% a year over the next decade, only slightly ahead of the 4½% return he's predicting for long-term high-quality bonds. Part of Mr. Arnott's pessimism stems from an analysis of historical returns. He points out that, over the past eight decades, a big part of the S&P 500's return has come from both rising p/e multiples and fat dividend yields. Today, with the S&P 500 yielding less than 2%, dividends won't contribute much to returns. And, if anything, P/E multiples are more likely to fall than rise. In fact, Mr. Arnott believes stocks are more richly valued than many investors realize. It appears the S&P 500 is trading at around 20 times 2004's reported earnings, somewhat above the historical average of 16 times trailing 12-month earnings. That makes the market appear expensive, but not outrageously so. But Mr. Arnott contends the true earnings of the S&P 500 are far lower. Figure in the cost of employee stock options, the under-funding of corporate pension plans and other aggressive accounting moves, and he says the S&P 500's real earnings might be 25% below published numbers. If Mr. Arnott is right, that puts stocks at an alarming 27 times trailing earnings. While Mr. Arnott remains downbeat about the prospects for the S&P 500, one thing has changed from three years ago: He no longer sees a lot of other attractive opportunities. "Markets are broadly priced for inadequate returns," he says. "We're currently in a world of no low-hanging fruit. In that world, it makes sense to diversify more broadly than ever before." Mr. Arnott does just that as manager of the Pimco All Asset Fund, a $5.5 billion mutual fund that makes its money by investing in other funds offered by Pimco Funds. Through its investment in these other funds, the Pimco All Asset Fund owns a smattering of all markets. Nonetheless, Mr. Arnott has emphasized certain sectors in recent years, notably commodities, inflation-indexed bonds and emerging-market debt. "Are there ways to make money in a world of low returns?" Mr. Arnott asks. "Yes, but you're getting more and more out of the mainstream." Mr. Arnott figures higher inflation lies ahead, which is one reason he likes commodities. He also sees hefty demand for commodities from fast-growing emerging markets, especially China. There are only a couple of mutual funds devoted to commodities. Pimco offers one of them, in the form of Pimco Commodity RealReturn Strategy Fund. If you are a no-load fund investor and you want to buy this or any other Pimco fund, your best bet is the D shares, which are sold through the mutual-fund supermarkets offered by discount brokers and large no-load fund companies. Mr. Arnott has been a longtime fan of inflation-indexed bonds, and he remains enthusiastic despite the drop in yields over the past five years. He notes that conventional long-term Treasurys have delivered a long-run total return that is some two percentage points a year above inflation. As he sees it, inflation bonds [TIPS] should be priced to deliver even less. Why? Inflation bonds remove one of the major risks associated with conventional Treasurys, which is the risk of unexpected inflation. If inflation spikes higher, conventional Treasurys will get hammered. But in that scenario, inflation bonds should fare just fine, because their value steps up along with inflation. Today, 20-year inflation bonds yield some two percentage points above inflation. "I would not be entirely shocked if, 10 or 15 years from now, long TIPS yields were below 1%," Mr. Arnott says. Like inflation bonds, emerging-market debt has performed well in recent years. Mr. Arnott notes that emerging-market debt used to be considered below "investment grade," meaning there was a serious risk of default. Since then, bond prices have risen and yields have fallen, as the risk of default lessens. "The quality is ramping up," he says. "Fifteen years ago, 100% of emerging-market debt was below investment grade. Today, 60% is above. I like emerging-market debt, even at today's relatively modest yields." Unfortunately, when it comes to emerging-market bond funds, there aren't a whole lot of attractive options. But you might check out Pimco Emerging Markets Bond Fund and TCW Galileo Emerging Markets Income Fund.
As the number of hedge funds has increased, it has given big investors, especially pension funds, more power dictating terms of investment. Investors negotiating what are known as "side letters" also include insurance companies and funds of hedge funds, or funds that invest in a number of different hedge funds much as a mutual fund invests in stocks. Some 7,500 hedge funds manage nearly $1 trillion in investments from wealthy individuals and institutions, up sharply from 1990, when about 2,000 hedge funds managed approximately $40 billion, according to Credit Suisse First Boston. Typically, hedge funds require investors to keep their investments in a fund for a set period of time, such as one year, and only allow redemptions every quarter or six months. Side letters "are a common way of doing business, albeit not the appropriate way," says James Hedges IV, president of hedge-fund adviser LJH Global Investments. "Certain investors have benefited at the expense of other investors." In general, investor-protection laws demand that all investors be treated equally, regardless of size. It is illegal in most instances, for mutual funds regulated by either the U.S. SEC or the United Kingdom Financial Services Authority to offer favorable terms to only some investors. But regulators in the U.S. and the U.K., where the bulk of the world's hedge fund managers are based, maintain minimal oversight of the actual funds, which typically are located in offshore centers such as Bermuda, the British Virgin Islands or the Cayman Islands. As a result, the regulators have limited say over the use of side letters, which are contractual matters between funds and investors. Mark Lewis, a lawyer at the Cayman Islands law firm Walkers, says about 60% to 70% of the funds set up by his firm now have side letters. He says that investors who put in a lot of money and thus take on additional risk may be entitled to special arrangements, although he adds that it is important for the side letters to be properly recorded. An FSA spokesman says the British regulatory agency generally doesn't look at investment terms set by a hedge fund because the funds themselves are typically domiciled outside its jurisdiction. The SEC, in new registration rules for hedge-fund managers, highlighted the use of side letters by funds in a footnote, but hasn't taken any action regarding them. A spokesman for the SEC says the agency would be concerned about situations involving inadequate disclosure of side-letter arrangements. In an SEC filing in July 2004, AIG Strategic Hedge Fund of Funds, said: "In some cases, the manager actively negotiates the terms of an investment with a [hedge-fund] portfolio manager.... The primary items that may be negotiated are management and incentive fees, liquidity and reporting transparency. These revised terms will be reflected in a 'side letter' that modifies the generic offering terms." Some funds of hedge funds tout their ability to secure better terms. "Size really works in this industry," says John Godden, managing director in Europe for Hedge Fund Research, which manages about $7 billion in fund-of-hedge-fund assets. "The big investors, people like us, we can make demands." In some cases, big investors seek side letters simply because others have already secured more favorable terms. If a fund "offers the same terms to all, that's fine, so long as they put this in the letter and agree to offer us better terms if they do decide to offer someone improved terms," says James Walsh, head of strategy at U.K. pension-fund manager Hermes Pensions Management Ltd., which recently set up its own fund-of-funds operation. "We want to ensure we are protected in the future." But not every fund of funds agrees with the practice. Permal Asset Management, one of the world's biggest fund-of-funds operations with about $16.3 billion in assets, doesn't generally ask for side letters, says Omar Kodmani, senior executive officer in Europe for the manager. "We believe in the concept that investors in the fund should have equal rights," he says. "If someone is bigger and has separate requirements, the manager shouldn't make a special provision for that investor." And, of course, smaller investors won't have the financial clout to demand side letters of their own. "If you're just a mom or pop investing a few hundred thousand or a million dollars, you'd find it very difficult to ask for or get a side letter," says Jacob Schmidt, director of Allenbridge Hedgeinfo, a hedge-fund ratings and research firm in London. The growth in side letters is sufficiently new -- and hedge funds overall have been performing sufficiently well -- that the legality of side letters hasn't been much tested, lawyers say. A case now being heard in the Cayman Islands, however, could call into question how much big investors can rely on their side letters. According to people familiar with the case, which isn't publicly available, Deutsche Bank AG and a J.P. Morgan Chase unit, which acted as intermediaries for investors, filed suit against Macro Fund Ltd. for its refusal to honor a provision in a side letter. Side letters can allow investors to exit from a fund without being assessed a penalty if there are significant changes such as a change in management or a drop in value by a certain percentage during a certain time period. But when the investors in Macro Fund sold out after a manager was fired in 2002, the fund refused to exempt them from the penalty. IIU Capital Ltd. of Dublin and London, the investment manager for Macro Fund, contends that the fund's articles of association didn't give directors the right to craft side agreements waiving an early redemption penalty, according to a person familiar with the matter. Deutsche and the fund settled the case out of court in a confidential agreement, according to a person familiar with the matter, but J.P. Morgan's action is proceeding. Deutsche Bank and J.P. Morgan decline to comment.
''The future is bright," Siegel declares in his first chapter. ''Our world today stands at the brink of the greatest burst of invention, discovery and economic growth ever known. The pessimists, who proclaim that the retiring baby boomers will bankrupt Social Security, upend our private pension systems and crash the financial markets, are wrong." Siegel found that the top performers among big stocks around since 1950 were not the cutting-edge tech firms such as IBM but the ordinary companies: National Dairy Products (now Kraft), R.J. Reynolds Tobacco, Standard Oil of New Jersey (now Exxon Mobil), and Coca-Cola. With dividends reinvested, $4,000 put into these four would now be worth $6.3 million, vs. $1.1 million for the average stock. IBM trailed all those stocks. It returned 13.8% a year, while Standard Oil returned 14.4%. That small-looking difference would have caused the Standard Oil investment to grow 25% larger over 53 years. Siegel also examines stocks that, at one time or another, have been on the Standard & Poor's 500 index, created in 1957 with the 500 largest stocks. Since then, more than 900 additional companies have spent time in the index as original members were removed. But as a group, the 900 newer stocks did worse than the original 500 -- the older companies with less sexy products. How come? Because investors eager to own stocks in firms with hot new products consistently paid too much for the shares. Remember the tech-stock bubble that burst five years ago? From 1950 through 2003, IBM shares traded at prices averaging nearly 27 times the company's annual earnings. Standard Oil was a bargain next to that, with an average price-to-earnings ratio of about 13. Because of its high share price, IBM's dividend yield was a mere 2.2 percent, compared to 5.2 percent for Standard Oil. The oil company's shareholders, thus, accumulated many more shares from reinvested dividends, causing their holdings to snowball. Investors can be excused for getting excited by IBM, since it beat Standard Oil in per-share growth of revenue, dividends, and earnings. But this led them into what Siegel calls ''the growth trap." They paid too much for the shares because they expected more growth than the company would deliver. The key to a stock's success is not how fast earnings grow but whether they grow faster than investors expected, Siegel found. This holds true for entire sectors as well. Railroads, a shrinking sector, have beaten the S&P 500 over the past half-century because their earnings did better than expected. Siegel's conclusion: Invest in stocks with high dividend yields and low price to earnings ratios, which reflect investors' low expectations. Spurn anything 'hot,' like a stock in its initial public offering.
But could we increase the return – or reduce the risk – by adding more funds? One portfolio that does that is the well-known Coffeehouse Portfolio. An all-index fund portfolio, it consists of 40% Vanguard Total Bond Market and 10% in each of six index funds [one fund each in large cap, large cap value, small cap, small cap value, international and REIT]. Another is William Bernstein's Coward's Portfolio [20% S&P 500, 20% US small stocks, 15% EAFE-Europe, 5% EAFE Pac. Ex Japan, 5% Japan Large Cap, 10% Continental Small Cap, 5% UK Small Cap, 5% Japan Small Cap, 5% Pac. EX Japan Small Cap, 10% Latin American]. Either way, the idea of owning seven to 10 funds, in different proportions, is enough to cause most people to leave the room. Enter the Couch Potato Building Blocks. The basic idea is that we start with the Couch Potato portfolio of two funds, invested in equal amounts. Then we do the same thing with three funds, invested in equal amounts. Then we graduate to a portfolio of four funds, invested in equal amounts. We can keep doing this until we have a portfolio of six funds, invested in equal amounts. Each added fund changes the proportions in the portfolio, but we are always investing equal amounts. That's pretty simple, and it means we are always investing 50% to 67% of our money in equities – the usual range of "balanced" funds. But we should boost our returns. Here, block by block, are the five portfolios. The Updated Couch Potato is 50% Vanguard Total Market Index and 50% Vanguard Inflation Protected Securities. In the five years ending Dec. 31, 2004, this portfolio had one losing year (2001), two just-above-zero years and a total return of 30%. At its worst, it lost 12% of original value. (Note: Vanguard Total Bond fund was used in 2000 because Vanguard Inflation Protected Securities wasn't available.) My Margarita Portfolio is equal amounts of three funds, the two in the Updated Couch Potato plus the Vanguard Total International Stock Index. This portfolio returned 19.6% over the period. It trailed the Updated Couch Potato because it was two-thirds equities during three years of bear market, while the Updated Couch Potato was only 50% equities. It also lost money in three years. Had the Updated Couch Potato portfolio been two-thirds Total Stock Market and only one-third Vanguard Inflation Protected Bonds, the returns would have been virtually identical. At its worst, the Margarita Portfolio lost 16.5% of original value. Its return over the last three years has been better than the standard Couch Potato. This portfolio should provide more diversification, less risk. My Four Square Portfolio is equal amounts of four funds, the three in the Margarita Portfolio plus the American Century International Bond fund [a managed fund]. This returns us to the basic 50/50 equities/fixed-income mix, but it commits half our money to international investments, half to domestic. This portfolio provided a total return of 30% over the period and lost money in two years. At its worst, it lost 11% of original value. Again, the benefit of diversification isn't apparent. So we have to trust the academics – or just distrust the value of the dollar. The Five Fold Portfolio is equal amounts of five funds, the four in the Four Square Portfolio plus the Vanguard REIT Index fund. This gives us domestic and international stocks and bonds plus real estate. This portfolio had only one losing year and provided a total return of 51.3%. At its worst, it lost only 0.5% of original value. Research shows that REITs add true diversification, improving returns while reducing risk – and it shows in the results. The Six Ways From Sunday Portfolio is equal amounts of six funds, the five in the Five Fold Portfolio plus the Vanguard Energy fund. This gives us domestic and international stocks and bonds, real estate and energy. This portfolio had one losing year (2001) and provided a total return of 64.6%. At its worst, it never went below its original value. Vanguard Energy fund is a managed fund with a very low expense ratio. Unfortunately, it was recently closed to new investors. An alternative is its exchange-traded fund, Vanguard Vipers Energy. While no market scholar will argue that energy stocks are a separate asset class, I offer this rationale: Energy is the ultimate currency and the ultimate commodity. Whether we are talking about grain, chicken, beef, iron, copper or gold, every commodity in our daily lives is directly affected by the cost and availability of energy. The best way for most people to invest in energy is through the stocks of major energy companies.
Money market mutual funds virtually assure protection of principal, and their yields have been rising along with short-term interest rates. And they will keep rising if the Federal Reserve raises interest rates further, as most market watchers expect. The average taxable money fund was yielding 1.93% last week, according to iMoneyNet, which tracks money market funds, up from 0.51% a year ago. Still, money funds are returning less than the inflation rate, about 3% for the last 12 months. Traditionally, investors turn to bonds to earn slightly higher yields than money markets can offer. But "I would hesitate to use the bond market with the Fed in tightening mode," said James Stack, editor of InvesTech Market Analyst. But fixed-income investors have a couple of options. For starters, the broad category of bond funds includes so-called bank loan funds. These portfolios, also known as loan participation funds, invest in floating-rate debt taken out by companies that are not rated or are not of investment grade. These companies pay a premium on these loans that is above a benchmark rate like the London interbank offered rate, or Libor. Investors in bank loan funds can typically expect to earn around two and a half or three percentage points above the Libor, which is now above 3 percent on 90-day loans. Moreover, unlike traditional bond funds, bank loan portfolios invest in variable-rate debt. So in a rising rate environment, there's an opportunity to pick up greater returns. Floating-rate loans are often compared to high-yield bonds, because both are non-investment grade. But there are big differences. Floating-rate loans are a form of senior debt while high-yield bonds are subordinated. That means investors in bank loan funds get priority when making claims against the borrower's assets in case of default. Moreover, junk bonds are an unsecured form of debt, meaning they're not backed by collateral. Floating-rate bank loans are secured by the borrowing company's assets. Bank loan funds tend to do best when rates are rising and the economy is improving, reducing the likelihood of defaults, said Andrew Clark, senior research analyst at Lipper. Since retail versions of bank loan funds started in the late 1980's, interest rates have generally fallen. Yet the average bank loan portfolio has managed to return 4.1% a year since the start of the bear market, according to Morningstar. That is well above money market levels. There is also a relatively safe way to invest in traditional bonds amid rising rates: by laddering, or building a portfolio of bonds that mature at various intervals. All eight bond funds run by the Thornburg family of funds ladder their securities. By doing so, the Thornburg Limited Term U.S. Government bond fund, for instance, has had virtually the same returns as the average intermediate-term government bond fund, but with only about "two-thirds of the volatility of five-year Treasuries," said Steven J. Bohlin, managing director of Thornburg Investment Management. If equity investors don't think the stock market will go straight up, they can hedge bets by, among other things, putting a small portion - say, 10 percent - of their equity stake into market-neutral funds. Some of these funds aim to be perfectly "market neutral," meaning that for every $1 they bet on stocks, they bet another $1 against a market climb, by shorting. Others aren't so strict. Market-neutral funds some can dampen the volatility of a total portfolio better than money market funds. For instance, according to Morningstar, a portfolio with 60 percent in stocks, 30 percent in bonds and 10 percent in money funds returned 5.7%, annualized, in the three years through February; the portfolio's standard deviation, a gauge of volatility, was 9.14%. By comparison, the same portfolio with 10 percent of its assets invested not in money funds but rather in the Laudus Rosenberg Value Long-Short fund would have returned 6.2%, annualized. And that's with a standard deviation of only 8.45%. Market-neutral money management is hard to execute, and many of these funds lag behind traditional long-only stock funds for extended periods. But the point of this exercise is not to find the hot investment of the month, but to reduce risk in your overall portfolio, said Mr. Ablin at Harris Private Bank. "And here's a way to do it," he said, "while avoiding just idling in cash." Related Articles: Investing When Rates Go Up [June 2004] - [1] Large Caps May Fare Best As Rates Rise - Meg Richards, Associated Press; [2] Three Problems with Small Caps - Paul Lim, NY Times; [3] Investors Can Gird Against Inflation - Jeff Opdyke, WSJ; [4] Money-Market Funds - Damato & McDonald, WSJ; [5] TIPS Lack One Protection - Lucchetti & McDonald, WSJ Profiting When Rates Go Up [May 2004] - [1] How to Bet Bonds Will Fall - Stan Hinden, The Washington Post; [2] Using Alternative Investments When Rates Increase - V Kahn, NY Times; [3] Two Options for Bond Investors - MacKay Shields LLC & Columbia Funds; [4] The Classic Strategy Used When Rates Go Up - Jesse Eisinger, WSJ
He pointed out that the least expensive, safest and most secure energy we could acquire wouldn't come from more drilling and more nuclear power plants. It would come from using energy more efficiently. Rather than the hard work of raising the bridge, he suggested the easier work of lowering the water. All we had to do was to make cars, trucks, houses and buildings more energy efficient. That, he wrote, would eliminate the need to build more nuclear power plants and to search for new sources of hydrocarbons. Amory Lovins – ridiculed as a dreamer at the time – was right. The conventional wisdom was wrong. Energy efficiency in the next decade reduced our oil consumption so fast it broke the pricing power of OPEC and crushed oil prices. Now working with a team from his Rocky Mountain Institute and with the support of the Department of Defense, he has a bolder idea – apply energy efficiency to end our dependence on oil. Not just foreign oil. All oil. In the process, we can revolutionize (and save) our auto industry, create a million jobs, strengthen our economy, end the flow of oil money that funds terrorism and win enduring national security. In Winning the Oil Endgame: Innovation for Profits, Jobs and Security " (Rocky Mountain Institute, Snowmass, Colo., $35), Mr. Lovins shows us the path to reduce our oil consumption. How much? How fast? Think about this timetable: [1] Cut consumption by the amount we import from the Persian Gulf by 2015. [2] Use less oil by 2025 than we used in 1970. [3] Import no oil at all by 2040. [4] Use no oil at all by 2050. More impressive, much of this can be done simply by getting back on the efficiency improvement path we were on when we responded to the first and second OPEC oil price shocks in 1973 and 1979. An idle dream, you say? Not hardly. The book is supported with a "Technical Annex," a collection of studies and spreadsheets that totals a massive 15 megabytes, much of it in compressed Zip format, and all available as a free download. This is no pipe dream. The centerpiece of Mr. Lovins' plan is a transformation of the largest oil consumer – transportation. As you might expect, he starts with the American automobile. The plan calls for a transition to lightweight but safer carbon fiber-based vehicles that start as near-80 mpg hybrids (like the Toyota Prius) but evolve into fuel-cell vehicles. If you are thinking to yourself, "Oh great, we'll all be riding around in three-wheeled Dinky Toys," relax. A pragmatist, Mr. Lovins' designs for future automobiles call for reduced weight but not reduced acceleration or safety. More important, this is a market-oriented plan. Both political parties can back it, if they can sheathe their knives and ideology for a few moments. While that is happening, we can replace 20 percent of current oil use with a domestic biofuels industry that would triple farm income and end the need for agricultural subsidies. (Brazil, he points out, has already done this.) Similarly, we can save about half of our natural gas consumption by becoming more efficient consumers of electricity. A Cheap Tranformation The stunner is how little this transformation would cost – a $180 billion investment over 10 years that would also create a million jobs. That $180 billion is less than investors lost in the collapse of WorldCom Inc. It is less than we will have spent on the war in Iraq in 2004-2005. Measured another way, it's what the U.S. government pays in interest on its $7.776 trillion debt in about seven months. It's what an interest rate increase of 100 basis points (1 percentage point) would cost in only 28 months. Why do I mention interest rates? The longer we import oil and borrow billions from other nations, the greater the odds we'll be paying through the nose for both imported oil and borrowed money. It's time to change the game plan.
The market could grow to $102.4 billion annually by 2014, according to Clean Edge, whose forecasts on renewable energy have been exceeded by the market for the past three years.With oil well above $50 and natural gas futures double what they cost in the late 1990s, renewables should remain the fastest-growing energy market, the study said. In the United States, incentives for renewables have been growing. Some 18 states have issued rules known as renewable portfolio standards that will require up to 25 percent of all power to come from clean energy sources. In gusty parts of the country, such as West Texas, wind power at 4.5 cents per kilowatt has even become cheaper than power from natural gas at 5 to 6 cents per kilowatt.
Indeed, Q1 may well represent the peak in earnings for the energy sector, says Merrill Lynch energy analyst John Herrlin, who tracks the U.S. integrated majors and independent producers. The market may swirl with talk of oil reaching $60 or even $80 a barrel, but a recovery in the U.S. dollar, large U.S. trade imbalances or some other outside factor could easily kick in to send prices down, he said. "I don't view the current prices as being sustainable," Herrlin said. "You could have peak earnings in the first quarter unless we see refining margins stay above mid-cycle levels and oil prices stay substantially high." Earlier last week, Smith Barney also recommended that clients trim back from a full overweight position to a more moderate overweight position on the energy sector, suggesting some risks to the rosy story surrounding the stocks. "Earnings estimates have been ramping up in the energy sector, and we are a bit worried that expectations are ramping up too quickly in the near term, suggesting that some risk is developing," Smith Barney said in a note. There are already some early signs that a correction is taking place. Energy stocks tumbled Wednesday alongside a more than $2 slide in oil prices, after data showed a build in U.S. crude stocks and after a Federal Reserve rate increase last week and gains in the dollar. Oil rose more than $1 Thursday in the aftermath of the BP blast in Texas City, but analysts said the explosion won't have a significant effect on gasoline production at the plant. Of course, Wednesday's fall in energy stock prices came after a dramatic run-up this year. Some of the recent enthusiasm is reminiscent of the tech bubble in the late 1990s, with a flurry of speculators and energy novices pouring money into the markets, Herrlin said. "We're getting more of these calls that make us feel like tech analysts of the last cycle — 'What's the company with most reserve exposure? Who has the most takeover potential?' " he said. "Those types of things are symptomatic of a sector that's near peaking on a short-term basis." Also, while investors have eagerly lapped up oil and gas stocks, energy sector insiders have sold $1.2 billion in stock across Merrill's energy universe since the start of the year, Herrlin said. Concurrent with a surge in oil prices to a record high over $57 a barrel earlier this month, the Standard & Poor's integrated oil and gas sector has already shot up more than 18 percent this year, led by a more than 21 percent spurt in shares of Exxon Mobil this year.
Oil prices, which traded for about $40 per barrel in December, flirted this past week with the record of $55.17. During that same run-up, however, oil and gasoline inventories also were hitting records, running well above the five-year average. There is usually an inverse relationship between inventories and prices — growing stockpiles mean supply is outpacing demand, so prices should fall. So why the increase? Market observers say this isn't a case of irrational market behavior but rather one where buyers are choosing to focus on long-term factors — namely the constraints of the worldwide supply and growing demand. From AP 3-11: The Paris-based International Energy Agency said Friday that it expected world oil demand growth of 1.81 million barrels a day, bringing its forecast for average daily demand to 84.3 million barrels. In raising its demand forecast by 330,000 barrels a day from earlier estimates, the energy watchdog cited a cold snap in February and March in the U.S. and Europe, a better outlook for the U.S. economy and higher demand from China. Buyers are choosing to ignore others short-term factors they believe will change. From AP 3-11: The latest U.S. government petroleum supply report showed growth in crude oil inventories to about 9% above year-earlier levels and only modest declines in supplies of gasoline and distillate fuel. "Inventories are a short-term issue when it comes to price," said Mark Baxter, director of the Maguire Energy Institute at Southern Methodist University's Cox School of Business. "Economic growth is more effective at driving prices up than high inventories are at driving them down." That thinking was in evidence Friday when the International Energy Agency raised its estimate for worldwide demand, which pushed up the price of crude by 89 cents, to $54.43 in trading on the New York Mercantile Exchange. Supply and demand are the primary movers of price, but prices also react to changes in currency exchange rates, weather and political unrest. A Constant Flow Added to the mix is the constant flow of information, and misinformation, from throughout the world and more speculators who look to make money off changes in price, which many believe adds volatility. "Traditional metrics, like oil rig counts and inventory levels, don't explain recent high prices," said Clay Seigle, a Houston-based oil strategist. "Anyone who lacks a macroeconomics and geopolitical background will lose a lot of money in energy." There are significant differences between the pricing environment today and that of four or five years ago, when the U.S. had similar inventory levels, said David Pursell, an analyst with Houston-based Pickering Energy Partners. Demand was somewhat lower in the past, Pursell says, but more importantly the market assumed the Organization of the Petroleum Exporting Countries had 5 million to 6 million barrels per day in excess capacity to cover a rise in demand. Today, the margin between excess supply and demand is far thinner. "The oil markets are concerned that the petroleum supply chain will not be able to meet the record demands without disruptions," Seigle said. As far as demand, it's only been a story of growth. China's growth caught many off guard last year when its demand for oil imports grew 15.6%. Pricing theories Whether these high prices are going to stay with us is a tough call. There's a growing school of thought, led by such analysts as Houston's Matt Simmons, that says world oil production is peaking and companies have few enticing places to drill for more. Stock investors seem to have bought into this argument by continuing to drive up the stock prices for oil companies this year. And oil futures markets show that traders believe the price will still be above $50 well into next year. But there's no shortage of skeptics who question the justification for high prices. Many in the oil industry believe this cycle will be the same. "I don't necessarily think that there is a new paradigm," said Exxon Mobil CEO Lee Raymond to reporters after an investor meeting in New York this week. "The last time I heard a speech about the new paradigm was in 1996 ... And 18 months later the price of oil was $10 a barrel." Many claim the growing number of speculators in the energy markets are falsely pumping up prices. The New York Mercantile Exchange released a study this week responding that hedge fund speculators actually dampen volatility, but the question is far from settled. Even if high prices aren't caused by the recent flood of investors, even fundamental drivers, like demand, are subject to change. "The day the Chinese economy hiccups, we will all be having very different conversations from today," Pursell said.
No one doubts what has led to such ominous predictions. China and India have increased their consumption of oil about 7% a year for most of the last decade. That's almost eight times more than the United States and other industrial nations have upped their usage. The Asian growth — which few predicted — has quickly absorbed an oil surplus that had kept the globe well fueled through the mid-1990s. Indeed, the world now uses 84 million barrels of oil a day, leaving only a 1-million-barrel-a-day surplus at best. The Energy Department sees no relief in sight. In their short-term forecast released last week, department analysts said that Asian usage would boost world oil demand 5% in the next two years. In contrast with the petroleum supply shocks that roiled the economy during the 1970s, this time "we have had a demand shock," says oil historian Daniel Yergin, head of Cambridge Energy Research Associates. But for all that, here's a bet that few seem willing to make right now: Oil prices will not — repeat, will not — climb inexorably in coming years, for one simple reason. It's called human nature. Rather than sit idly by and let oil prices erode their standard of living, people will react and make changes in the way they do things. Industrial practices, technology, even our lifestyle — all of these will inevitably evolve, tempering the surge in petroleum prices. It has happened before. In the early 1970s, as war-torn economies in Europe and Japan began to recover, they gobbled up more energy. Lots more energy. "Few realized that supply- demand ratios had changed," recalls oil economist Philip K. Verleger Jr., until they were awakened by a 20% increase in the price of oil in 1971. Then, two years later, the embargo by the OPEC went into effect. Prices quadrupled. The immediate reaction was confusion. Back then, everybody blamed oil companies and Arab countries. Economies fell prey to inflation. Today, everybody blames oil companies and Arab countries (along with Russia and Venezuela). Interest rates are again rising, and so are fears of inflation. Yet the lesson from the past that's so often missed is this: Adversity breeds benefits. Thirty years ago, industry invested heavily in energy efficiency and thereby altered a basic equation: Before 1971, a 1% expansion of the economy demanded a comparable increase in energy use. But that ratio soon was cut in half, and today only a one-third-of-1% increase in energy is needed for a full 1% — or $100 billion — expansion of U.S. output. Attitudes changed back then too. People put insulation in their homes, donned sweaters and turned down their thermostats. Small cars came into fashion. Granted, not all trends last. But fuel efficiency is making a comeback now. Sales of full-size SUVs are down 26% so far this year, according to J.D. Power. And hybrid gasoline-electric cars, which can get more than 50 miles to the gallon, are "flying out the door," says Fritz Hitchcock, who runs a big car dealership in City of Industry. And that's just the beginning. GM last week demonstrated that it could store hydrogen in solid form, theoretically allowing for a future fuel-cell car with a range of 300 miles or more. GM's chairman, Rick Wagoner, says such a vehicle could become a technological reality by 2010 and be produced in commercial quantities in the decade after that. The supply side of the equation isn't static, either. In the '70s, countries and companies focused their investments and found new deposits of oil in Mexico, the North Sea, Indonesia, Africa and Alaska's North Slope. Today, oil companies are fattening budgets for exploration and development in Russia, Africa, Central Asia and the deep waters of the Gulf of Mexico. Meanwhile, Congress is moving closer toward allowing oil drilling in Alaska's Arctic National Wildlife Refuge. "There's 6 [billion] to 15 billion barrels in there," notes Lawrence Goldstein, president of the Petroleum Industry Research Foundation, a New York energy economics firm. Nor should one overlook more unconventional sources of energy. The 1970s brought early experiments in wind power and ethanol, an alcohol-based fuel derived from corn. Today, oil is being tapped from Canadian tar sands. Wind power has become a favored investment from Denmark to Australia. And ethanol, a hamburger-helper kind of product that stretches supplies of gasoline, is coming into its own. What will the world do while waiting for these breakthroughs? It will change. Today's forecasts that China will consume more and more oil — simply because it has done so in recent years — are undoubtedly wide of the mark. "China needs electrical energy but not necessarily more oil," explains Joseph Tovey of Tovey & Co., a New York investment bank. As it happens, China has announced plans to develop 30 nuclear power plants in the next decade. And if history is any guide, China and India and other emerging nations will themselves become more efficient and innovative. Lee Raymond, chairman of ExxonMobil, points out that developing countries use more than three times the oil that industrial nations do to generate the same amount of energy. Before long, though, ExxonMobil and other companies will apply the same efficiencies in those countries that we have in ours, Raymond says. The real outlook? High oil prices will undoubtedly cause some pain for a while. However, history is clear: Nothing lasts forever — or, for that matter, even close to forever. Oil Keeps Rising Malcolm Morrison, Canadian Press 3-20 "I don't want to say the sky's the limit but there really is no cap on oil prices," said Doug Porter, deputy chief economist at BMO Nesbitt Burns. "And perhaps the biggest concern is this happened in a week where OPEC announced a production hike and the possibility of another one. (Normally) the second quarter is a period when they're trying to rein in production a bit." Futures contracts on the New York Mercantile Exchange show investors are buying oil priced at more than $57 US a barrel from now to September. Porter said this confirms what other data had showed. "The six month moving average, looking beyond some of the daily wiggles and so on (shows) the underlying trend in oil has been straight ahead for three years now," he said. It's just risen without fail since that point. He also discounts the theory that the rapid rise in oil has been driven mainly by speculators. "Some of that is true but there is no way the hedge fund or speculative investors could keep prices going up this far this fast," he pointed out. "There has to be some kind of fundamental story behind it or the speculative funds wouldn't be in there week after week, year after year if they didn't believe there was a fundamental story behind it."
But as the world's oil thirst swells to more than 84 million barrels a day and producers struggle to keep up, the extra supply being brought onto the market, primarily by Saudi Arabia, is the heavy, sour variety. Trouble is, not all refiners have the equipment needed to process it. As a result, the already high price of light, sweet crude has been magnified, with each barrel selling for more than $50 on futures markets. By contrast, there is a relative abundance of medium to heavy crudes that sell for much less and that puts refiners who can process it in a very good position. Depending on the precise chemical composition, lower-quality oil is selling at discounts ranging from $7 to $17 per barrel, when compared to light, sweet crude. A year ago, heavy, sour crudes, whether from Mexico, Venezuela or Canada, were discounted by about half that much. "The sweet-sour spreads have never been this good," said Gene Edwards, senior vice president of supply and trading at Valero Energy, the nation's largest independent refiner and the leading processor of sour crude. The gap has narrowed somewhat after the Saudis reined in production earlier this year to comply with reduced output targets set by the Organization of Petroleum Exporting Countries. And analysts say today's sharp price disparity is likely to narrow further over time, as more sour-crude-refining capacity is added and as Saudi Arabia or some other producer taps new fields that produce lighter crude to meet rising global demand. However, assuming the global demand for oil remains strong, the discounts are not likely to return to historical norms anytime soon. "The same trends are likely to be in place for the next three to five years," Edwards said. Despite the extra costs associated with processing lower-quality crude, the profit margins of independent refiners able to handle it are up sharply. For example, Valero reported net income in 2004 of $1.8 billion, nearly three times its results the year before, while Premcor's profits tripled to $478 million. Valero's shares have more than doubled in the past year, while Premcor's are up slightly less than that. Shares of Frontier Oil have also soared. Valero attributed its stellar fourth-quarter results to its "superior leverage to sour-crude discounts," which were $10 per barrel cheaper, on average, than the price of West Texas Intermediate, the light, sweet oil that futures prices are pegged to on the New York Mercantile Exchange. More than half the oil used by Valero [1.3 million barrels a day] was sour during Q4, including Mexican Maya, which accounted for nearly 1 out of every five barrels and averaged $16.75 per barrel cheaper than WTI, according to the company. The company also processes heavy, sour crude from the Gulf of Mexico known as Mars, which has become the U.S. benchmark. In the past two years, Valero has significantly expanded it ability to process heavy, sour crude, by acquiring a 315,000 barrel a day refinery in Aruba and a 185,000 barrel a day refinery in Louisiana. The company also completed in late 2003 the expansion of its heavy, sour-processing capacity at a refinery in Texas by 45,000 barrels per day. Fadel Gheit, senior oil analyst at Oppenheimer in New York, said the decision in recent years by Valero and others to expand their heavy, sour refining capacity has proven to be "brilliant." Premcor, a small independent refiner is also betting its future on the profit potential inherent in lower-quality crudes. In a similar move, Canada's Suncor Energy is spending $300 million to upgrade a refinery it owns in Denver, where it intends to process increasing volumes of heavy crude produced from its oil sands operations. Refining analyst Aaron Brady at Cambridge Energy Research Associates said these types of deals could become more common as Canada and other nations ramp up production of heavy, sour crudes. "That stuff is all looking for a home," he said. But as more "homes," or refineries, are built to handle sour crude, the profit margins will dwindle, said Cal Hodge, a former Valero executive who runs a Houston-based consultancy specializing in clean fuel issues. "Just watch for history to repeat itself," Hodge said.
On the debit side of the ledger, boomers now in their 50s have amassed roughly the same debt as their predecessors born between 1933 and 1945, says Missouri economist Michael Finke, who is scheduled to present his findings next month. ``The biggest surprise was that boomers are not suffering from a particularly heavy debt burden compared to the previous generation,'' said Finke, who teaches personal finance at Missouri. Adjusting for inflation, Finke calculated the average net worth for boomers at about $494,000, compared with $375,000 for pre-boomers. Finke reports average boomer consumer debt is roughly $9,600, compared with $9,400 for their immediate predecessors. Finke's research also gives the lie to the image of boomers as house-rich and cash-poor. ``Boomers have chosen to put a greater proportion of their wealth in financial assets, particularly stocks,'' he said. By Finke's calculations, the average boomer is holding about $234,000 in stocks, bonds and savings -more than double the $113,000 held by pre-boomers. For boomers, the average equity value for their houses is $110,000, compared with $113,000 for their immediate elders, according to Finke's data. ``Boomers are relying on their financial assets to fund their retirement, whereas pre-boomers hold a greater proportion of their wealth in housing and other real estate,'' said Finke. Indeed, with so much of their wealth tied up in the market, Finke spies possible trouble if Social Security reform encourages even more investment in equities via individual accounts. ``If we think of Social Security as a hedge against the market, then these private accounts pose additional risk for boomers,'' Finke said. Apples to Apples Comparison Edmund Andrews, NY Times 3-13 Comparing savings between age groups is not an apples to apples comparison due to the shrinking role of defined-benefit retiement plans. Boomers must have more financial wealth due to shrinking benefits. Consider: Only about half of all workers participate in a pension plan with their current employer, according to the Center for Retirement Research at Boston College. Less than one-quarter of workers are covered by a traditional defined-benefit retirement plan. And savings through individual retirement accounts and 401(k) plans have been meager: in 2001, the average worker in the 55-to-64 age group had a balance of only $42,000.
In 2004, total household debt hit $10.3 trillion, a record of enormous proportions. For a little perspective, total debt in 1994 was $4.6 trillion. Back then the debt was made up mostly of $3.2 trillion in mortgage debt and about $1 trillion in other consumer debt. Ten years later, mortgage and consumer debt have more than doubled, to $7.5 trillion and $2.2 trillion. Note that the ratio of mortgage debt relative to other consumer debt has been rising. This little detail illustrates the increased use of the American home as a source of income. Speaking of which, at $18.7 trillion, real estate now sits at its highest level ever on household balance sheets. A good indicator of how much home prices have risen in the last year would be the 12.9% rise in value from 2003, or $16.5 trillion. You'd think skyrocketing values would lead to higher levels of owner equity from last year's 56.1 percent, near the record low. But home equity levels didn't budge, reflecting the much faster growth in mortgage debt of 13.6%. In all, debt as a percentage of household net worth stands at 21.1%, up from 2003's 20.7%. Compare that to disposable personal income. At $8.8 trillion, income makes up 18.3 percent of total net worth, compared with 18.7 percent the year before. In 2002, it was 19.8%. This measure is also going in the wrong direction. As for the Fed's measure of personal savings, it barely hit $100 billion last year, down $10 billion from 2003 and nearly $60 billion from 2002. It's bad enough that we go up to our eyeballs in debt to enjoy the good life. Do we have to sacrifice our savings to the gods of consumption as well?
Few economists would deny that fools and gamblers participate in the stock market. But the participation of such irrational traders does not necessarily imply that stock prices themselves should be irrational. In principle, irrational exuberance should be self-correcting. If overly optimistic investors bid up the price of a stock, rational investors should step in and sell shares, moving the price back down to a realistic level. This adjustment process does not even require that sellers own shares of the overpriced stock. Someone who thinks that the price of a stock will fall but does not own any shares can borrow shares to sell, a practice known as selling short. If an investor sells short and the stock price does indeed fall, he can buy shares to pay back the loan and pocket the difference as profit. As with other sorts of borrowing, the borrower typically has to pay interest on the loan. But, in the case of the Internet boom, short selling was apparently not strong enough to damp the stock price increases during the Internet bubble. The question is, Why not? Owen A. Lamont, a professor of finance at the Yale School of Management, reviews some recent work in the economics of short selling in the latest issue of the NBER Reporter (available at www.nber.org). The 3Com - Palm Example As he points out, there were striking examples of apparent overpricing of stocks in 2000. For example, in March of that year, 3Com sold a fraction of its holding of Palm; it announced that by the end of the year it would disburse the rest of its holdings by giving 3Com shareholders 1.5 shares of Palm for each share of 3Com they owned. One would expect that 3Com shares would be worth at least 1.5 times the value of Palm shares. But on the first day of trading after the announcement, Palm shares were worth $95.06 a share while 3Com shares fell to $81.81. The market was valuing the non-Palm part of 3Com's business at minus $63. This pricing anomaly was widely reported in the financial press. The most likely explanation was that day traders and other overly optimistic investors bid up the price of Palm stock to excessive levels. These traders were presumably unaware that they could acquire Palm indirectly by buying 3Com stock. The apparent mispricing created a low-risk arbitrage opportunity. A savvy investor could buy some 3Com shares outright, borrow some Palm shares, sell them, and repay the borrowed Palm stock in a few months when 3Com issued the Palm shares. Indeed, many investors did exactly that. At one point, the number of Palm shares borrowed to sell short was 147 percent of the shares outstanding. (The number could exceed 100 percent since shares could be borrowed only to be lent out again.) Even this additional supply of shares was not enough to quell the Palm enthusiasts. According to Professor Lamont and his co-author on one paper, Richard H. Thaler, a big part of the problem is that the market for borrowing shares is not a centralized market with quoted prices, but rather a highly disaggregated market. In many cases, it was quite difficult to find shares of Palm that could be sold - and when they could be found, the interest rate charged to borrow them was quite high. Short selling was not the only way to bet against Palm. One could also buy put options, which allowed the stock to be sold for a fixed price. But the options were also mispriced during this period, making such investments unattractive. So the anomaly persisted for many months. Eventually, of course, it disappeared: a few weeks before 3Com issued its remaining Palm shares, the prices reflected the appropriate ratio. But the short selling constraints seemingly allowed the mispricing to persist for an awfully long time. Many intelligent investors believe that short selling is a strong signal of subsequent price declines. Professor Lamont's work and that of several other academics find that this is so: stocks that are subject to large short selling tend to have lower subsequent returns. One might ask why short selling is not immediately reflected in the price of a stock. The reason appears to be related to the basic problem with short selling: there is no centralized market for borrowing stock, so it can take time to find shares to sell short. Typically, there is no problem in finding shares of large companies that are traded frequently. But shares of small companies, whose stock is lightly traded, may be hard to find. This finding suggests that the total amount of short selling might be a good predictor of stock market movements in general. Somewhat surprisingly, this turns out not to be true. In fact, during the bubble years, the aggregate amount of short selling declined as stock prices were bid up. As Professor Lamont and his co-author on another paper, Jeremy Stein, remark, "Short selling does not play a particularly helpful role in stabilizing the overall stock market." But again one must ask why not. One suggested answer is that short selling arbitrage has more risk than appears at first glance. For example, the owner of the shares can force the borrower to return them under certain conditions. Hence, the short seller might find his position unwound at an inconvenient time. This risk factor means that short sellers may want to take smaller positions than they would otherwise prefer. It appears that at least on some occasions, short selling constraints can disrupt the normal operation of supply and demand: when supply is constrained, stock prices end up being determined by those who are overly optimistic.
That is the conclusion drawn by researchers at GovernanceMetrics International, a two-year-old independent research firm in New York that scrutinizes corporate governance practices for institutional shareholders. "For too long governance screening hasn't been part of the investment process," said Gavin Anderson, chief executive of GovernanceMetrics. "But investors are realizing that this is another area they need to monitor." The firm has just finished examining practices at 3,220 companies around the world. Of those companies, only 34 received GovernanceMetrics's highest rating of 10. Happily for American investors, most of these - 27 - were United States companies. These companies, Mr. Anderson noted, have outperformed the Standard & Poor's 500-stock index by an average of 11.13% for the 12 months ended Feb. 28. The average American company earned a rating of 7 from GovernanceMetrics. Other good news: the number of independent directors at the companies has climbed to 55% from 52% in 2003. And fewer companies have chairmen who are also chief executives: 39%, versus 47% in 2003. But GovernanceMetrics found questionable practices at many companies. Executive pay was the No. 1 culprit, at least in the United States. Pay issues accounted for 31% of the red flags it issued on domestic companies, versus 6% of those issued on European companies. Only 5% of Asian companies exhibited pay problems. Of course, lapses in governance do not necessarily lead to poor performance at a company. But enough investors have lost big money in companies where conduct was questionable that governance should be a constant consideration. Just look at Krispy Kreme, the formerly faddish doughnut maker. A hot stock for many years, Krispy Kreme has lost 81% of its value in the past year as its accounting has come under scrutiny. In June 2003, GovernanceMetrics gave Krispy Kreme relatively low marks for its policies, ranking it 4 out of 10 over all. Then, in January 2004, the firm dropped its rating to 2.5. In July, Krispy Kreme disclosed that securities regulators were investigating its accounting. The firm's recent study has turned up red flags at a number of companies. For example, it assigned demerits to UnitedHealth Group, a manager of organized health systems, because of the employment agreement it has struck with its chief executive, Dr. William W. McGuire. The agreement requires the company's shareholders to make generous annual payments to Dr. McGuire if he is terminated, no matter the reason. And if he dies after his departure, his surviving spouse is entitled to half the benefit. Dr. McGuire would have received $5.1 million a year under this plan if he had retired at the end of 2003. Mark F. Lindsay, a spokesman for UnitedHealth, objected to GovernanceMetrics's criticism, saying that the payout represented Dr. McGuire's pension and was modest when compared with the lofty returns shareholders in the company have received as a result of his leadership. "His compensation reflects our corporate performance and that has been, without equivocation, superlative," Mr. Lindsay said. Indeed, UnitedHealth's stock is up almost 50% over the last 12 months.
We made the trek to Boston last week to visit Bain Capital, the $24 billion in assets powerhouse that was founded by now Massachusetts Governor Mitt Romney in 1984. Bain’s roots go back to the consulting firm Bill Bain started in the early 1970s that took the novel approach that its value would be driven by results for its clients – not the voluminous theoretical reports which main value was often to serve as a doorstop. In fact, Bain Consulting’s track record shows its clients have outperformed the S&P 500 by a whopping 3 to 1 margin since 1980. Bain Capital’s results have been nothing short of spectacular and now have funds across the capital market spectrum from buy out, venture capital, fixed income, international, to its $4.5 billion hedge fund – Brookside. We have said that great businesses are systematic and strategic in how they operate. Being systematic creates a discipline of execution and leads to consistency. Being strategic is where the “big ideas” get generated. Bain has been systematic and strategic on its approach to investing and building its business. The recipe for identifying great growth companies - the “stars of tomorrow” - that have high and sustainable earnings growth, have the ingredients of the 4Ps: (1) great PEOPLE, (2) leading PRODUCT, (3) huge POTENTIAL and (4) PREDICTABILITY. Bain has their own 4P’s. What they described they were looking for was a company in an industry where there was: (1) PAIN. Due to competitive, structural or regulatory PROBLEMS; there was significant pain being experienced by participants within an industry. (2) PRODUCT. Identifying companies that have a compelling product to eliminate or reduce the pain. The classic solution for a problem – the bigger the problem or pain, the bigger the opportunity. (3) PRICE. How much does it cost to have the pain go away? Many “pain” solutions are so expensive, they are prohibitive to implement on a scale basis. (4) PAYBACK. What’s the ROI on the product and how fast will we see it? Obviously the clearer, more tangible and faster the payback, the more likely the solution will be implemented. Using the Think 4P’s framework and our liberal interpretation of what I call Bain’s 4P’s, and you have a pretty systematic way to hunt for the most important future winners. Finding companies with characteristics like these is like finding rare and swift moving elephants; extremely difficult to do, but when we find one, we should know it! Monthly Employment Stats
The unemployment rate jumped to 5.4% in February from 5.2% in January. The household survey used to measure unemployment, different from the survey of employers commonly used to measure job growth, indicated an unexpected loss of 97,000 jobs. The Labor Department's report indicated that hourly wages of production and nonsupervisory workers remained stagnant in February at $15.90 an hour, which translates into a decline after accounting for inflation. The length of the average workweek was unchanged at 33 hours and 42 minutes. Though manufacturers added 20,000 jobs, the first increase in six months, the average manufacturing workweek declined by 12 minutes, to 40 hours and a half. 7.7 million workers - nearly half a million more than in February of 2004 - held more than one job. Professional and business services [from janitors to temporary workers] added 80,000 positions. Retail jobs grew by 30,000, the biggest gain since April. Construction added 30,000 jobs. Investors welcomed the absence of wage growth, which reassured them that inflation remained tame and reinforcing expectations that the Federal Reserve would stay on its present course of raising short-term interest rates at just a gradual and moderate pace. David Resler, chief economist at Nomura Securities, noted that monthly ups and downs aside, the labor market had set a solid trend of about 180,000 new jobs each month, which would equate to employment growth of somewhat over 2 million jobs in 2005. He said this was consistent with economic growth close to 4% coupled with a slowdown of productivity growth to about 2.5%"
If you want to know what probably happened, the February release shows that payroll employment rose by a "not-seasonally adjusted" 856,000, after taking the usual wallop in January of a not seasonally adjusted decline of 2,713,000. The real world isn't accommodating enough to seasonally adjust us. So the key question that hangs over the job market after the turn of the year gets adjusted away: How soon will employment recover from the January Massacre? Not that we don't share the seasonal adjusters' passion for the underlying trend. A more focused look reveals a job market that isn't quite as hot as the February report implies. But it ain't cold, either. The 12-month trend in payroll employment is far more reliable, and doesn't require seasonal adjustment: Gains have been averaging 196,000 per month. We talk that way because we have a sense of humor; grown-ups would make that 200,000. For purposes of historical comparison, payroll employment in February '05 ran 1.8% higher than in February '04; for private-sector employment, the comparable figure was 2.0%. As for the unemployment rate, its one brief shining moment at 5.2% in January never happened. The jobless rate was actually 5.7%, not seasonally adjusted. In February, it was about unchanged, at a not seasonally adjusted 5.8%. But since here, too, we seek the underlying trend, the seasonally adjusted February reading of 5.4% is about in line with the more accurate 12-month average of 5.5%. Here's what we really know, then, about the broad tends in the job market: employment gains running at an annual rate of 1.8 % to 2.0%; the unemployment rate, around 5.5%, down from its peak of 6.0% (based on 12-month moving averages) in 2003. Now put all that in perspective. There is a 'Nineties-nostalgia crowd that still see a few things faintly rotten in today's job market. Through the late-'Nineties -- or as some prefer to put it, "the years when Bill Clinton was in the White House" -- annual employment gains ran a good half-percentage point higher. The jobless rate broke below the 5.0% barrier by early 1997, reaching a 30-year low by late 2000 of 3.9%. So, in comparison, a 5.5% rate of joblessness looks bad. The critics will add that the rate would be a lot higher, but for the fact that so many discouraged people exited the labor force. Perhaps most damning of all, however, the critics charge that the employment gains of the past year were only a make-up. According to the official figures, it was not until January '05 that the seasonally adjusted job count exceeded the peak of February '01. By February '05, it was a mere 297,000 higher. You don't even want to divide 48 months into that puny figure. Four years go by, and that's all we have to show for it? Even Alan Greenspan concedes that last point. I don't. The payroll employment figures come from the Establishment Survey, which asks employers how many people they have on the payroll. The Bureau of Labor Statistics provides an alternative series derived from the Household Survey. It's available at www.bls.gov/cps/ces_cps_trends.pdf. These "payroll-compatible" figures show a more plausible trend. In fact, nonfarm payroll employment probably gained 2.2 million from February 2001 to February 2005, which ain't great, but it ain't bad, either. For the details on why I believe these figures are more accurate, see my column of Oct. 11, 2004. What really matters, of course, is where the job market is now, and where it's likely to go. The boom of the late 'Nineties, however glorious, also led to a bust. By the standards of the mid-'Nineties, a 5.5% unemployment rate is enviable. Even if employment growth slows down a bit, the rate of joblessness should continue to tick down.
David Greenlaw, an economist at Morgan Stanley, recently increased his estimate for first-quarter real gross domestic product to 4.4%, significantly higher than the 3.3% he was predicting last month. Economists at Citigroup told clients in its closely watched "Comments on Credit" report that "tracking inputs to first quarter GDP suggests that our above-consensus estimate of 4% growth is too low, perhaps by as much as a half point." The employment report showed payroll gains occurred across a wide array of industries. Neil Lebovits, president and chief operating officer of Ajilon Professional Staffing in Saddle Brook, N.J., said hiring by his clients seemed directly related to expansion plans. Joy Global Inc., a mining-equipment company in Milwaukee, plans to spend $30 million this year, roughly a 50% increase from last year, and is hiring welders and machinists at its six U.S. plants. Joy Global also is adding workers in places such as Australia, Chile and even Botswana. The company is benefiting from soaring global demand for commodities such as copper and coal. Although economists say such anecdotal evidence is encouraging, they caution that it is too early to conclude that February's job gains will continue at such a strong pace. In fact, the strong gains in business investment could mean that companies are seeking new ways to lift productivity in an attempt to limit their staffing needs. Spending on equipment and software rose 13.5% last year, including an 18% surge in the fourth quarter, according to the Commerce Department, marking the strongest annual performance since the technology boom. Sheryl King, senior economist at Merrill Lynch, expected spending to rise just 3% in Q1. She now has revised that to 14%. Ms. King believes that spending will slump later this year, and she hasn't altered that view. "Our general view is that rising interest rates are going to impact the U.S. economy in a negative way," she says, "it's just that the timing of it has been shifted out." J.P. Morgan economist Bruce Kasman revised his Q1 GDP forecast to 4%, from 3.5% last Thursday. The catalyst was the upward revision of government figures for durable-goods orders, he said, which suggest that there won't be a material falloff in capital spending with the end to tax incentives. Like Ms. King, he also drastically raised his forecast for growth in spending on equipment and software, to 15% from 5%. "The strong durable-goods report is only the latest of a string of stronger-than-expected demand indicators at the start of the year," wrote Mr. Kasman in a report. Other factors fueling capital spending include the recent surge in merger-and-acquisition activity. "When firms undergo a merger or acquisition, capital spending is often necessary to make the firms fully compatible or to have cohesive business plans," wrote Avinash Kaza, an economist at Goldman Sachs, in a report last week. Mr. Kaza found a close correlation between capital spending and the volume of large-scale mergers. Many companies also are flush with cash, allowing them to spend more without loading up on debt. And thanks to a recent tax break, even more money could be available. Dell Inc., for instance, has said it plans to repatriate $4.1 billion under the American Jobs Creation Act, a law passed last year by Congress that allows companies to repatriate foreign earnings at sharply lower tax rates. Dell says it plans to use about $100 million of that to build a manufacturing plant in North Carolina (the company hasn't specified plans for the rest of the repatriated money |