After a Brief Break, Here’s A Merger Arb Trade For You

Regrettably I was out of town for several days and as a result it has been awhile since I’ve posted anything. So, I decided to give you all a conservative trade idea now that the market has had a huge run over the last four weeks. We are definitely getting overbought here, so tread carefully.

Anyway, I am a big fan of arbitrage opportunities and I think there is a merger arb play right now with the pending merger between Merck (MRK) and Schering Plough (SGP). The deal should close by year-end and the agreed upon cash and stock ratio (SGP shareholders get $10.50 cash and 0.5767 shares of Merck for each SGP share they own) implies a total deal value of $25.76 for each SGP share. That represents a premium of 9.4% based on Friday’s closing prices for both stocks.

Normally, someone wanting to make this trade would simply short ~58 shares of MRK for each 100 shares of SGP they were long, wait for the deal to close, use the new Merck stock they receive to cover the short position, and pocket the 9.4% financial spread as profit. In this case, the actual return would be slightly less because Merck’s dividend yield is above that of Schering.

However, there is another way to play this (and a more profitable one) because Schering Plough has a convertible preferred issue (SGP-PB). This security pays a higher dividend than the common (7.1% versus just 1.1%) and converts into SGP common in August of 2010. By that time, it will actually convert into Merck stock, since Schering will no longer be an independent company.

The attractive thing about the convertible preferred is that it too trades at a discount to implied value upon conversion. The convertible currently trades at $210 but would convert into $214 of SGP stock if converted today. Add in the $15 annual dividend and the spread is even higher.

How would an investor play this? Simply by buying the SGP preferred instead of the common when simultaneously shorting MRK common. Rather than using common stock from the merger to cover the short, you can simply wait until the preferred converts into common in August 2010 to cover the short. In the meantime you can collect the 9.4% deal spread, a 7.1% annual dividend as well as the 4% spread on the convertible security.

Full Disclosure: Peridot Capital has positions in both SGP and MRK at the time of writing. Positions may change at any time.

Historical Data Disproves “Trough P/E Multiple on Trough Earnings” Myth

Doug Kass, a hedge fund manager dedicated to short selling and frequent guest on CNBC, made a call on the air Monday that the S&P 500 could make its lows for the year this week. A bold call indeed, given that Doug is a short seller and has been correctly bearish on the economy’s prospects for a long time. His reasoning is mostly based on extreme pessimism (not unlike in November when we made a short-term low) and low valuations.

Other commentators debate the valuation point. CNBC’s own Bob Pisani made the case that assigning a 7 or 8 P/E ratio (a typical number at bear market bottoms) to this year’s depressed earnings level forecast (currently around $50 for the S&P 500) is reasonable. Pisani concluded that unless you think that earnings in 2009 will be substantially above $50 (which is very unlikely), the market is not cheap because 7 or 8 times $50 is 350-400 on the S&P 500 index, versus today’s sub-700 level.

When Kass was on the air on Monday he rightly suggested that putting a trough P/E on trough earnings is not appropriate, but market commentators continue to insist that is where the market needs to go before a cyclical bottom can be put in.

I have argued against this logic on this blog before (sorry to keep harping on it), but I decided to dig up some evidence on this topic so perhaps we hear less of it in the future. Below you will find the earnings of the S&P 500 relative to the level of the index from 1970 through 1985, a time period that encompasses both the early 1970’s recession and the early 1980’s recession, both if which are similar in depth to what most believe will be our fate this time around.

From this data you can clearly see why everyone is using a trough P/E ratio of between 7 and 8 times earnings (the bear markets bottomed at a 7 P/E in 1974 and at 8 in 1981). The year of both market bottoms is in boldface to show these levels.

The key here is to look at the level of S&P 500 earnings during both 1974 and 1981. Although the stock market traded at the trough P/E ratios during those years, earnings were at record highs both times! The 1974 level of earnings ($9.35) had never been reached before. The same goes for 1981 earnings ($15.18). Therefore, the idea that we take trough earnings and apply trough P/E multiples is simply unfounded if we look at the very data people have supposedly been using.

Not surprisingly, I am far from the first person to point this out. John Hussman, former professor of economics and international finance at the University of Michigan, actually has created a more relevant P/E ratio called “price to peak earnings” which suggests that trough P/E ratios on previous peak levels of earnings are far more reliable bear market valuation tools.

Where would this type of P/E ratio peg the bottom of the current bear market? Well, S&P 500 earnings peaked at $87.72 back in 2006. Multiply that figure by 7.3 and 8.1 and you get a range for the bear market trough of between 640 and 710 on the S&P 500 index. Interestingly, especially given comments from Doug Kass predicting a possible yearly low this week, the index is in the 680’s currently, which is right in the middle of that projected range.

Hopefully actual data is enough to debunk seemingly popular myths about bear market low valuations for the stock market. While this evidence does not make it impossible for the S&P 500 to dip to 400-500, it would make such a move unprecedented in terms of the last four decades of market history, during which we have seen two recessions that are proving to be very similar to this one.

Why Not Just Sell And Wait For Rosier Days?

I was emailing with a client yesterday and during the course of the conversation he asked the following:

“Are you overloaded these days? It seems to me that right now all we can do and should do is wait….there’s still more downhill. I understand your investment philosophy does not concern itself with short term events, but still…shouldn’t there be an exception if you have reasonable expectations that the market will sink more before it bounces?”

Since it is a good question, and one others may be wondering about, I thought I would elaborate here rather than just respond privately.

This client is right, I am not a market timer and do not base investment decisions on what the stock market may, or may not, do over the short term. If the market’s short-term direction merely correlated with economic activity this would not be a wise philosophy. We would all simply sell our stocks when the recession began and wait until it ended before getting back into the market.

The reason why market timing is so difficult (and why I choose not to partake in it) is because the stock market is not a proxy for the economy over the short-term. The Dow didn’t drop 300 points on Monday because the economy got worse, and the next time it goes up 300 points it will not be because the economy got better. There are so many crosscurrents that affect day-to-day stock market movements that it makes it very hard to guess which way things will go, even during a severe recession.

As an example, consider the last three months. If you asked economists and market watchers how the economy did over the last three months, there would be a consensus view that it has been bad and is getting worse. As a result, one might conclude that stocks would simply drift lower day after day, week after week, month after month, because there is no evidence that the economy is improving.

If we look at market data, however, we see that the S&P 500 rose by 27% between the lows made on November 21st (741) to the highs made on January 6th (943). Did the economy improve during that time? No, it got worse.

Since January 6th the S&P 500 has dropped from 943 to 700, a loss of 26%. What explains this move down? A bad economy? Probably not entirely, given that it has been bad the entire time despite two dramatic (and equally substantial) market moves in opposite directions.

We could make a list of at least a dozen reasons why the market rose 27% over a six week period, only to fall 26% over the next eight. All of those factors combined determine the short-term movements in the market and personally, I find them oftentimes irrational and highly difficult to predict.

To further illustrate the point that markets and economies don’t always move in tandem, consider the last recessionary period of this magnitude that our country faced, 1980-1982. Look at how the stock market fared during this three-year period compared with key economic figures such as GDP growth and unemployment:

Does the above data make any sense on its own? Not really. After all, the market rose significantly in the years the economy declined and fell during the year it rebounded temporarily. Joblessness rose consistently over the entire period. Simply assuming that the market will stay bad if the economy stays bad is too simpleminded for such a complex marketplace. There are so many variables that play into it, it could give you a headache trying to make sense of it all.

As a result, I choose to simply focus my time on researching individual companies, their long term prospects, and their share price valuations. There are plenty of people who prefer to focus on other things, and that’s fine, that is what makes the market. We are all looking at the exact same data and still come to many different conclusions or choose to focus on different data points entirely.

As a long term investor, I am investing in a world where the stock market rises in any given year about 75% of the time. Not only that, but sometimes it goes up dramatically even when the economy sucks (as the data above shows). Over the long term, historical data has shown that there is a direct, inverse correlation between current share price valuation and future share price returns. Over the short term, stock prices are dictated by any number of factors and the near-term movements are anyone’s guess quite frankly.

I prefer to stick to one aspect of stock market analysis. That is just my preference, it doesn’t make it right or wrong, it’s just what I am good at and have confidence in. Other market participants prefer to ignore the things I look at and focus on those that I ignore. Thank goodness for that, because without that discord, there would be no market for us to participate in, and it certainly would not be inefficient enough to present compelling investment opportunities for all of us to try and profit from.

Capital One: Book Value Down 3% in 2008, Stock Down 60%

When I construct an equity portfolio, I focus on individual companies rather than sector allocations. My thought process is that if I can pick the winners and avoid the losers in any given sector, I don’t have to predict which sector will do well and which won’t.

Now, I could go out on a limb and avoid all energy stocks, for instance, if I thought demand for oil (and therefore prices) would decline. But what if I was wrong? Energy stocks could soar and I would have no exposure whatsoever. Personally, I find it far easier to identify strong energy companies than to predict where energy prices will go.

If the energy stocks I choose to invest in are better than average, then the energy portion of the portfolio will outperform the S&P 500. If I can replicate that in more sectors than not over the long term, then I can outperform the benchmark index. In a nutshell, that is how I try to beat the market over the long term.

It sounds simple enough, but in unique times (such as today) rationality completely goes out the window, and that makes my job as a long term investment manager very difficult. I will use Capital One (COF) as an example. If you believe in efficient markets, this will serve as some evidence against that hypothesis.

I have followed Capital One for a long time and have written about it extensively on this blog over the years. In my view, it is one of the best managed and financially strong banking companies around. As a result, when faced with a choice of paying 10 times earnings for Citigroup (C) or the same price for COF, I chose COF.

My analysis has been mostly correct. Capital One has avoided huge losses on packaged securities of sub-prime loans and purchased various deposit banks before the credit crisis hit, which allowed it to maintain appropriate capital levels without begging the government for cash. As a result, the company’s tangible book value per share in 2008 dropped from $29.00 to $28.24, a loss of 2.6% in a year when many banks went out of business or were bailed out by the government and larger competitors.

As you can see from the chart below, however, Capital One’s stock price has fared far worse than their book value deterioration would suggest. It has dropped 60%, from over $50 to under $20 as of this morning. Fundamental analysis has gone completely out the window lately.

Sellers of Capital One will tell you that as the unemployment rate rises, Capital One’s loan losses will increase throughout 2009 and their earnings will decline, if not turn negative. I completely agree! Everybody knows this, including the company (management is forecasting $8.6 billion of loan losses in 2009, a dramatic increase from 2008).

Still, that does not justify a 60% drop in share price coinciding with a 2.6% drop in tangible book value. Let’s say book value falls 10% in 2009 (nearly four times the 2008 rate), reflecting an even worse year. At the same rate (20% decline in stock price for each 1% loss in book value), COF shares would drop 200% in 2009. Fortunately, a stock can’t go down more than 100%!

The market is behaving as if larger loan losses and a temporary disappearance of earnings threatens the survival of Capital One, although the company has a very strong balance sheet and can withstand these recession-related shocks, unlike many of their weaker competitors. Because such an assumption is off base, it makes very little sense for a long term investor to shun strong bank stocks in the current market environment.

Capital One may trade at two-thirds of book value today (how that figure is justified, I don’t know), but when the recession ends and the unemployment rate begins to drop, the odds are very good that the stock trades at two times tangible book value or more, which means the stock could triple in value, even ignoring any increases in book value which would certainly result as time went on.

Until then, the market will continue to only focus on the short term and conclude that a bad 2009 means companies like Capital One somehow have bad business models or are broken in some way. In actuality, they are simply riding the economic cycle. Finance companies make good money when times are good and do poorly when they aren’t. Fortunately, the good times far outlast the bad times.

Full Disclosure: Peridot Capital was long shares of Capital One at the time of writing, but positions may change at any time

Lesson from the Bernie Madoff Ponzi Scheme

As more and more news comes out about Bernie Madoff and how he managed to defraud many very smart people out of billions of dollars, it is useful to ask a simple question; what should we learn from what happened? From my perch the answer is very basic.

The few people who avoided Madoff’s funds did so due to doubts over the highly suspicious consistent returns he claimed (many concluded he could not produce such steady profits from the strategies he claimed to be using). They avoided disaster because they lacked information and without knowledge of what their money was invested in, they were not comfortable investing with Madoff.

The others were not as fortunate, but it begs the question, does it make sense for anyone to invest money with a money manager if they are forbidden from knowing where the money is invested? I don’t think so. I know I certainly could never look one of my clients in the eye and ask them to stop receiving account statements so their holdings could be secret. Trusting someone, as Madoff’s investors have learned the hard way, is not a good enough reason to put a blindfold on and hand someone millions of dollars.

Now, many hedge funds will argue that disclosing their holdings strips them of their “edge” since many people will simply mimic top managers’ trades and thereby reduce returns for the people coming up with the ideas. To curb this concern it is certainly reasonable to allow a slight delay in the reporting of actual holdings to ensure that a hedge fund manager can establish a full position before disclosing it to the public. You could also have investors sign a contract saying they will not act on or alert anyone to the nature of the fund’s investments.

Regardless, if you are investing in any fund that does not adequately disclose where your money is allocated, I would strongly consider ceasing such an investment. It sounds obvious to many, but given what has transpired recently, it warrants mention.

Chad’s Stock Idea for the Annual Business Week Investment Outlook Issue

The annual Business Week Investment Outlook issue (dated 12/29-1/5) is out and I was asked to contribute a bargain investment idea from the currently depressed market. My pick (on page 58) was Anheuser-Busch InBev. I am on vacation through 12/27 but I will write about this newly created beer giant in more detail when I return. For those of you who do not have access to the magazine, I made a PDF file:

Business Week Investment Outlook – 12-29-08 (Page 58)

Financial, Retail Weakness Mask Underlying Core Profitability

Simply judging from the stock market’s performance over the last couple of months, you might think the entire U.S. economy is teetering on the brink of disaster. In reality though, the sheer ugliness of the financial services and retail sectors is masking the other eight sectors of the market that, while certainly weaker than they once were, are actually holding up okay given the economic backdrop. The easiest way to illustrate this is to show earnings by sector for the last three years; 2006, 2007, and 2008. Keep in mind the 2008 are estimates based on nine months of actual reported profits and estimates of fourth quarter numbers.

As you can see from this graph, earnings in areas like telecom, healthcare, staples, or utilities are doing just fine and can withstand further weakness in 2009 and still more than justify some of the share price declines we have seen in recent months.

The selling has been indiscriminate but the business fundamentals are quite differentiated, depending on sector, which is one of the reasons that the U.S. equity market has not been this cheap relative to earnings, interest rates, and inflation since the early 1980’s. It is a gift for long term investors.

Remember, Markets Rebound Before Economic Data Improves

As we head into 2009, the economic backdrop looks gloomy. Two important measures in particular, employment and corporate earnings, are set to deteriorate further throughout next year. The unemployment rate has risen from 4.4% to 6.5%, but many are now predicting a peak of 8%-9% sometime in 2009. Corporate earnings will fall for the second straight year in 2008, but many top-down forecasters expect a third year of declines. Does that mean stock prices have a lot further to fall still? Not necessarily.

Remember, the stock market is a discounting mechanism. It reflects future events ahead of time, as the 50% decline over the last year or so reflects. At some point, stock prices reach levels where they already are reflecting the assumptions of continued weakness in unemployment and corporate earnings. Bill Hester, of Hussman Funds, helps to shed light on this concept. He writes:

“The four-week moving average of the jobless claims data breached 500,000, which has happened only 4 other times. It occurred in December of 1974, in April of 1980, in November of 1981, and in March of 1991. During the 12-month period following these periods, the S&P rose 32 percent, 30 percent, 20 percent, and 9 percent, respectively. These periods also shared attractive valuation. Over the four periods the price-to-peak earnings ratio averaged 8.75, which is about right where the market’s current valuation is. Although it’s a small sample, low valuation, coupled with economic data confirming a substantial contraction in the labor market, has offered longer-term investors very strong average returns.

Those returns aren’t restricted to bull markets that follow the worst recessions. Returns following all of the recession-induced bear markets have been quite strong. First-year returns following a recession have averaged 37 percent with surprisingly little variation. Not including the out-sized gains following the 1982 bottom, all of these first-year bull markets gained between 29 and 44 percent.”

Even if we assume, as the market has already begun to grasp, that both employment and earnings don’t trough until mid or late 2009, we should not assume that the market will not hit bottom until those numbers stabilize or improve. Examining market history shows that the market rebounds before the economic data signal the recession has ended. As always, the market is a discounting mechanism.

Now, I don’t know if the economy will bottom in early 2009, mid 2009, late 2009, or during 2009 at all. As a long term investor, I don’t find it very helpful to try and guess between outcomes that are only a quarter or two away from each other. Even Nouriel Roubini, the biggest proponent around of a doomsday economic scenario, thinks the recession will end by the end of 2009. Even if you believe in his forecast, the market would start a new bull market in Q3 or Q4 of 2009 (3-6 months before the recession ends, as history suggests). If he is proved a bit pessimistic, it could be even sooner than that. As a result, long term investors should be buying, not selling at this point. Equity market valuations are too low to make the case that the market has not yet discounted most of the bad news we are likely to get in coming quarters.