Fixed-income strategy: two interesting closed-end funds

With the discount rate reduction announced late last week, we are slowly changing our fixed-income or balanced accounts to take more interest rate and credit risk, after keeping all of our fixed-income money in a higher-yielding Schwab money market the last year. Thanks to the inverted yield curve, there was little incentive to take either interest rate or credit risk, a strategy that has paid off handsomely the last eight weeks.

However, with the discount rate announcement, the unlocking of the credit spreads and the expected new liquidity from coming fed funds rate reductions should have a beneficial effect on credit instruments, so here are two closed-end funds we have been buying for client accounts:

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The DUC or the Duff & Phelp's Utility and Corporate Bond Trust is a closed-end utility and corporate bond fund that is currently trading at a 7% discount to NAV (as of this posting) and is yielding north of 7%. The chart is WAY interesting (to paraphrase a West Coast Valley girl): on a monthly chart (attached and compliments of http://www.wordencom/) DUC has historically bottomed with the end of Fed tightenings: in November and December, 1994 DUC bottomed at $10.25 and $10.50 per share which marked the end of the 1994 round of tightenings by then-Chairman Alan Greenspan, and then again in March and June of 2000, DUC bottomed at $10.69 and $10.56, and on both occasions, DUC - over the next two years - traded from these fed-induced lows to a high of $15 per share as the Fed reversed course and provided for an easier monetary policy. (See attached monthly chart above, and note the low coincident with Fed tightening cycles.)

Fundamentally, DUC's holdings consist of a 10 3/8th's Treasury maturing on 11/15/12 (essentially a 5-year Treasury) which is 8% of the closed-end fund, with 33% of the corporate's being utility credits and 28% financial credits. From a rating perspective, 18% of the funds credits are AAA/AA, and 48% are BBB+ or below. (Statistics compliments of etfconnect.com).

The monthly distribution is $0.065 per share (six and a half cents).

Our target price is between $14 - $15 per share, which given historical technical patterns, DUC should make easily. The DUC fund is WAY (!) oversold on the daily, weekly and monthly charts, so the technicals and fundamentals are lining up nicely.

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The second interesting closed-end fund we have been buying is the JRO, or John Nuveen closed-end leveraged loan fund. The JRO is trading between a 3% - 4% discount to NAV, and its current distribution rate is close to 10% (again, the current stats courtesy of ETFconnect.com).

20% of JRO's credits are from the media sector, with the 2nd largest holding at 3% of the fund being a Chicago Tribune credit, which saw its acquisition by Sam Zell close yesterday.

Consider this closed-end ETF to be a spicier credit play on the CLO/CDO, leveraged-loan lock-up frenzy, thus be more careful with JRO and buy in over time as we are doing. ETFconnect.com did NOT provide a ratings distribution on JRO as of this posting so assume that all credits are below investment grade.

Last week, just prior to the Fed's discount rate announcement, JRO fell below the late 2005 lows of $12.15 - $12.17 per share and gapped down to as low as $10.74 on the illiquidity issues surrounding high yield paper. The fund has subsequently bounced and will benefit handsomely from the slow unlocking and re-pricing of credit spreads over the next 6 months.

Our price target is alos $14 - $15 per share. The JRO fund is now very oversold on a weekly chart and can bounce nicely with further fed rate cuts in our opinion.

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To conclude, I think these closed-end funds provide a diversified vehicle to add credit risk to client accounts and yet remain diversified and liquid. Right now, the two aforementioned funds are a couple of our favorites, but we're always looking for more.

We'll try and keep readers updated on our thoughts on these funds but we may sell out entirely or even add more to the positions without updating the blog. However, we'll do our level best to keep readers updated. I think these two funds are better longer-term plays on what we hope will be improving liquidity and credit spreads in the corporate bond markets.

position in DUC, JRO

Trinity Asset Management, Inc. by:

Brian Gilmartin, CFA

Portfolio manager

Trinity's fixed-income strategy

With Walmart's (WMT) earnings this morning, it is clear that the consumer is slowing. (We owe readers an apology: I thought WMT would report earnings last Thursday, August 8th, but instead WMT reported this morning.)

With WMT lowering guidance thanks to a weakened consumer, and WMT accounting for 10% of all retail sales, and consumption 2/3rd's of GDP, it doesn't take a genius to figure out that GDP could suffer in coming months.

With a Fed that could start cutting rates before we see the end of August or September, here is how we are positioning our fixed-income accounts regarding interest rate risk, and credit risk:

If and when the Fed cuts rates, I think the yield curve will in fact steepen, and I would expect the 10-year to trade above 5% and begin returning to more normal slope. Ex fed funds, the 2 - 10 year spread is now back to a positive +35 bp's thus the steepening is beginning already.

We are positioning muni portfolios in the 5 - 7 year maturity range (non-callable), in high quality insured or AA notes, with no credit risk being taken. I think the 5-7 year maturities will outperform in an environment where the Fed is friendlier and where we are moving from an inverted to a normally-sloped curve. The 2-year Treasury is currently yielding 4.44%, thus it has discounted three Fed easings already, which is why we are positioning within 5 - 7 year maturity. We would buy 10-year paper if we get over 5.25%.

In terms of credit risk, I think it is is still too early as credit spreads could continue to widen through September - October, '07. Corporate high yield is getting more interesting, but we have not put any money back into high yield (after selling all of our exposure in early 2005).

All of our taxable bond accounts have been 100% money market the last two years, which didn't look so hot when high yield was trading at +150 Treasuries, but it looks much better now.

Given the currency risk, we have never been international fixed-income investors, preferring to take interest rate and credit risk, and leaving currency risk for others.

I think over the next year we will see some great opportunities to put money to work in high yield, corporate high grade,mortgage-backed (MBS) and asset-backed (ABS), but now is not yet the time.

position in WMT

Walmart reports earnings this week - critical read of consumer

WalMart (WMT) reports earnings later this week, and unlike Exxon-Mobil which some people think is the key stock for this market given that XOM is the largest market cap name in the best performing sector of the past three years, I think WalMart is the key "tell" for this market, given its importance in deciphering the behavior of the US consumer.

Most people failed to notice that on the day that the Dow closed above 14,000 and the S&P 500 closed at 1,555, was the same day that WalMart announced June comp's that were 2% - 3% versus the less than 1% expected, which was a pleasant upside surprise that Thursday morning, July 14th (I think that was the date of the most recent highs.)

The point is that consumption is 2/3rd's of GDP, and WalMart accounts for 10% of all retail sales in a year, thus if mortgage worries and higher gas prices and consumer confidence were to impair the consumer to any great degree than the equity market is currently discounting, it would likely show up in WalMart's revenues, earnings, comp's and guidance.

My own personal opinion is that WalMart is a cheap stock: trading at 9(x) earnings for a mid-single-digit earnings grower, and just .5(x) 4q trailing sales (yes, WMT is trading at a market cap that is close to half of its 4q trailing sales) and just 11(x) cash flow from operations, with a AA-credit rating indicative of a solid balance sheet , I consider the stock to be a safe haven not only within retail but within the large-cap sector in general.

WMT as an investment is now the antithesis of what it was in the late 1990's: it is unloved, with few advocates on Wall Street pushing the stock, and it gets bashed with unrelenting frequency (and rather unjustifiably in my opinion) when the press needs a capitalist fall-guy to pick on for a story.

After reaching a high of $70 per share in late 1999, early 2000, the stock has traded as low as $40, but it has essentially been trapped in a 7 - 8 year trading range. Although we are currently long the stock and consider WMT a core position in our client portfolios, I am waiting for the stock to take out $50 per share on heavy volume, before we add to the name.

Current analyst consensus for this coming week's earnings report is $0.77 per share and $92.7 bl in revenues for year-over-year growth of 7% and 8.5% respectively, thus coming into this week's results, expectations are tempered.

One interesting aspect of WMT's fundamental story is the growing importance of the international operations to the core business: once just a single-digit percentage of revenues and operating income, WMT International is now higher than 20% of total revenues while international operating income as a percentage of WMT's total operating income gravitates above and below the 20% figure. (Frankly given that investors and strategists are falling all over themselves to have international in their portfolios, I thought WMT would have been afforded a higher multiple for its international growth, which has averaged between 10% and 30% the last five years (i.e. WMT's international operating income has varied between those two figures since the early 2000's.)

To conclude, WMT is a company that generates $350 bl in annual revenues, which is a truly remarkable figure when you come to think of it, and they have achieved this success by having one single mantra: be the low-price retailer to their customers, and they have managed to accomplish this by assembling a coordinating a logistics and distribution network that would put the US Army and National Guard to shame. (Rumor has it that just after Hurricane Katrina devastated New Orleans, WMT's trucks were the first to penetrate the devastation and get to their stores. Joe Nocera, who writes the main column for the New York Times business section Saturday edition once wrote that WMT could be the single biggest reason inflation remained contained during the 1990's.)

I don't know, nor want to speculate that this week's earnings report will push the stock higher, and above key technical levels, but WalMart will give us some good clues to the state of the US consumer, and how this mortgage crisis is impacting mainstream America.

position in WMT, XOM

Subprime mess: what the financial press might have missed

What has struck me about the recent decline in the financials relative to the subprime mess, and the comparisons to both the 1990 commercial real estate crunch and the October, 1998 Long-Term Capital mess is that credit cycle is different, and could very well be worse.

In the late 1980's and early 1990's our banking system was choked with bad commercial real estate loans sitting on bank and insurance company balance sheets as a result of the passive income tax loss deduction that was eliminated by then President Reagan in the 1986 Omnibus Budget Reconciliation Bill. Banks, insurance companies, brokerage houses and other financial intermediaries bought these illiquid commercial real estate mortgages and then watched as they went belly up, and put banks in particular in a bad capital position. (10% of all banks and S&L's were declared insolvent in 1988.)

However in the early 1990's, the RTC bailed out the banking system as did the new financial engineering tool known as securitization. Securitization was in its infancy in the late 1980's and the subsequent explosion of credit-cards, auto loans, home mortgages and any other asset that could be wrapped into a pool and dropped into a trust allowed financial institutions to rebuild capital. The positively sloped yield curve, the easing of monetary policy by then Chairman Greenspan from 1990 - 1993 and the rebuilding of consumer balance sheets all contributed to the regeneration of the banking and financial system, all of which helped as we moved therough the 1990's...

Now fast-forward to 1998: LongTerm Capital blows sky highs thanks to leverage and bad risk arb bets, and our capital markets seize up, as evidenced by Chairman Greenspan noting the difference in spread between on the run and off-the-run Treasuries that occurred in August and September, 1998. Chairman Greenspan reduced the fed funds rate in October, 1998 to take pressure off of the capital markets as he arranged a bailout by the then very healthy and well capitalized banking system. What exacerbated this seizing of the capital markets was that many brokerage firms had emulated or replicated the LongTerm Capital positions on their own balance sheets, thus you had many major Wall Street players leaning the same way as a global run on credit started.

The point being that in the early 1990's, the capital markets were the relief valve to rebuild and recapitalize the banking system, and the banking system was the relief valve or safety net for the capital markets during the 1998 LongTerm Capital crisis.

Today, with high yield spreads so tight and the private equity market choking, and now the banks hindered by rising single-family mortgage delinquencies both the capital markets and the banking system are hindered.

Even the consumer is feeling the pinch as mortgage refi's from the earlier part of this decade have flowed through spending already.

Still, our Thomson Financial market timing model (see earlier posts to this blog) rose to over 9% this past weekend thanks to the lower 10-year bond yield and the fact that forward 4-quarter earnings continue to rise. At just over 9%, the equity market timing model, particularly the S&P 500 looks very attractive relative to bond yields and earnings. The Thomson market timing model hit a high of 9.8% in October, 2005, and a low of 4% in the spring of 2000.

This credit cycle might not end until we get a bankruptcy or financial failure of enough size for the market and the Fed to take notice.

position in spy, S&P 500 index funds

Market timing: when do we get out

One of my favorite B-school professors (this prof taught Money & Banking and Bond Management, and did a great job at both) once said that "if it's good in theory and not in practice, well then it's not really good in theory, either", and after 12 years of managing money, and 20 years in the investment business, I have to agree with him.

In academic theory, at least in most textbooks, a student is taught not to "market-time" i.e. to move in and out of cash and stocks in order to maximize gains and minimize losses. In fact many studies have been done that have shown that if an investor misses, or is out of the market and in cash, just two of the best days of a rally off a major market bottom, then they may see their holding-period return cut almost in half.

A case can be made for both market-timing and not market-timing: however if there is one lesson we learned in the 2000 - 2003 bear market, it is that client's like "absolute return" in a down market, meaning they don't want declines in the stock or equity portions of their portfolios (which makes sense) but client's like relative returns in up markets, meaning that clients not only want to see gains, but better than benchmark gains, in good markets (and again, that makes sense.)

In other words, in order to be an effective money manager, you have to time the market in some form or fashion. You have to take gains for clients at some point, and cut losses at some point.

Since we are entering the 4th year of this bull market in equities since the March, 2003, market bottom, I needed to update clients on our thinking about market-timing and let clients know that we are using market-timing tools so as to not repeat the mistakes of the early 2000's:

1.) The first "market-timing" barometer we are using is the Thomson Financial Market Risk Premium (TMRP) calculation, updated every week, which is a combination or derivation of the Fed model, and quantifies in one number, whether stocks are "rich" or "cheap" relative to historical norms.

On Friday, May 25th, 2007, the TMRP showed that the S&P 500 has a risk premium of 8.6% (this is not technically an equity risk premium, but it is close, and I'd show clients the calculation, but I think you'd get lost in some of the math and the logic, and you'd lose the essence of the calculation ). The TMRP hit a high of 9.8% in October, 2005, and a low of 4% in March of 2000, thus as you can tell from Friday's reading, the TMRP "range" is much closer to the historical high showing that the S&P 500 is still relatively, attractively valued, versus the low in March of 2000 when the TMRP showed the S&P 500 historically overvalued. The TMRP is not a "precision" timing model, it gives a signal over time based on a number of factors, and it is more like an hourglass than an alarm bell.

2.) The second marketting tool we are using is Bob Brinker's monthly Markettimer newsletter. Bob Brinker is rated one of the top marketimers in the last 5 and 10 year time periods per the Hulbert Financial newsletter tracking service. When Bob says get out, we'll get out (with a caveat to be discussed below) and we'll do it quickly, particularly if the Markettimer market call coincides with the TMRP signal, and without regard for capital gains (unless a client specifically asks us not to sell). Bob Brinker is currently bullish on the state of this cyclical bull market, primarily due to the high pessimism seen in the 60-day put-call ratio, and the relatively low P/E ratio for the S&P 500 relative to previous market tops. The put-call ratio is currently skewed to a high number of puts versus calls as investors look for downside protection.

Finally, just because the market gives a sell-signal doesn't mean that we need to get out of equity or sectors, or individual stocks entirely. In 2000, housing and homebuilding sectors, and gold and precious metals started to break out of long-term technical consolidations, thus it could warrant some equity exposure in long-out-of-favor groups, should the market start to roll over.

My guess is that if and when this bull market peters out, we will likely first sell the current leadership groups like energy, like commodities and utilities and telecom (since these sectors will have the most downside risk) and we will likely see the old growth babies of the 1990's, like GE, like AIG, and large-cap tech and financials, possibly become the "safe-havens" of the next bear market.

Right now though, it is too early too tell what the next bear market might look like, and we are staying invested in a combination of sector ETF's and individual stocks. Higher interest rates, particularly the 10-year Treasury yield, will push that TMRP lower, thus I do believe that higher rates and slower earnings are the biggest threat to this current bull market.

If clients want to see the actual TMRP calculation, let me know.

To conclude, we are using the "belt and suspenders" methodology in terms of market-timing.
One sell signal will be a yellow light, and we'll alert clients accordingly and two sell signals - one from each service - will result in a major shift in our holdings for clients.


position in S&P 500 index funds, SPY, ETF's, GE, AIG

Avoiding China, Russell 2000, and REIT's

Michael Santoli's editorial column this weekend (within Barron's) was right on target in my opinion, as China has now become to the decade of the 2000's, what Japan was to the 1980's, i.e. the hot market, the economic model to be worshipped and the "it" economy, kind of the Paris Hilton of global economies, and you really can understand why when the latest "reported" GDP growth for q1 '07 for China was north of 10%.

Michael Santoli talked about the P/E multiple of the Shanghai Stock Exchange being "50(x) earnings" which one could deem as an expensive valuation, but my thought when I read that was "what constitutes earnings" ? Throughout my career when I've heard analysts or portfolio managers or whoever talk about the valuation of a foreign stock or foreign market, you don't often hear them talk about the quality of those earnings.

Because of the global economy, the world seems to be moving towards a uniform set of accounting standards, which would leave companies from different countries with a more uniform set of financial statements for analysis. In fact if we dissected China's corporate earnings, we could find the Shanghai trading at 100(x) earnings or 20(x). (I'll let you guess which valuation is more likely.) Most people, if you listen solely to the news, probbaly have forgotten that China is still a Communist country, and although unlikely, could still wake up one day and see that the government has "appropriated or nationalized" the country's asset base. (The risk is small, but it is there, or maybe some derivation thereof...)

For present clients, we are staying away from international in general, and China in particular for the time being, given the enormous popularity of investing "internationally" and given that if China should crack, there is a high likelihood of a contagion effect throughout Southeast Asia. According to one source, over 90% of all mutual fund inflows in 2006 (can't remember if it was an Investor's Business Daily article, or an IBD article referencing a Citigroup research piece where we read the statistic) went into "international" funds, and we'd love to own this asset class, just not now.

Regarding the Russell 2000, small-caps have outperformed large-caps, particularly the S&P 500 for 6 - 7 years running, and the valuation of the Russell 2000 is almost twice that of the S&P 500, interms of the P/E ratio.

Tony Dwyer, the equity strategist at FTN Midwest and a frequent CNBC contributor, e-mailed me some data on Friday showing that the Russell 2000's P/E is 28(x) trailing earnings for 15% y/y growth, or almost 2(x) PEG. In and of themseleves these statistics aren't bad, but when compared to the S&P 500's 16(x) forward eps for what has been quarterly growth of 10% - 15% year-over-year year earnings since the March, 2003 bottom, you can quickly see that the S&P 500 is more attractively valued than the R2K, and the S&P 100 (or the top 100 stocks in the S&P 500) is even cheaper than the entire index. (In April, '07, the S&P 500 rose 4.43% while the Russell 2000 increased just +1.80%; I don't know or want to say that that is a trend, just the amount of underpeformance was surprising. You would think - at some point - that large-caps would "mean-revert" and start to outperform small-caps.)

Finally, although we have recently bought the XHB (homebuilder's ETF) for some client accounts, we are staying away from REIT's in their entirety, although commercial property REIT's still seem to have a decent valuation given the strength of corporate cash flow.

We'd love to own all these groups once again, particularly international via Oak Mark's David Herro's International Fund, David being one of the best portfolio managers in the international asset class today, but I would prefer to wait until we get an inevitable currency disruption or exogenous event to take hot money out of these groups.

To conclude, we sold our Russell 2000 too early in 2004, 2005, and we sold our REIT's too early as well, and we continue to think that the S&P 500 remains relatively cheap, and unloved relative to the rest of the world.

long S&P 500 index funds, SPY

McDonald's: within a $1 of all-time high

Technically, you could say that MCD's is ready to break-out to an all-time high, or is putting in an 8-year double-top (a technical term meaning that a long-term topping formation is being put in place) for the king of Big Mac's, but if we had to fall into one bucker or the other, we'd say that MCD's still has some room to run.

Since its previous peak at $49.56 in December, 1999, MCD's fell all the way to $12 per share in mid-March, 2003, and then finding a bottom with the rest of the stock market at that point, MCD's has climbed steadily higher to its current price of $48 and change, however the stock price appreciation isn't all market related.

MCD's grew earnings between 4% and 12% in the last half of the 1990's which paled in comparison to the technology sector's 40% growth year-in-and-year-out at that point in time, so if I had to guess, I'd say that most of the MCD's stock price performance was attributable to its "large-cap growth" moniker of that period since operationally MCD's didn't do all that well. (We owned the stock at one point between 1997 - 1999 until we heard that MCD's had a "Bun Committee" of 12 people which was responsible for all facets of hamburger bun operations, and right away GM and IBM came to mind in terms of corporate sloth. The stock was sold the next day.)

Now the fact that we avoided the name in the 1990's and the early 2000's and then started buying MCD's right around March, April, 2003 had to be one of our better decisions as a firm to date, but what got us interested in MCD's was the fact that in early 2003, with the stock trading near $15, the stock was approaching the real estate liquidation value, and thus represented a low risk entry point.

However, the key to the MCD's story since eraly 2003 has been cash flow: pure, unadulterated, unmitigated cash and free-cash-flow generation along with improved operations.

In the last 4 years, MCD's annual dividend has increased from $0.40 to $0.55 to $0.67 to 2006's $1 per share and the 4q trailing cash flow from operations has increased from $3 to $5 bl in the last three years. The dividend yield has remained fairly constant at between 1% - 2% since 2003, as the stock price appreciation has kept pace with the dividend growth.

Free-cash-flow, or the FCF "yield" ( 4q trailing free-cash-flow as a percentage of 4q trailing revenues) has ranged from between 6% - 10% in the last 16 quarters or 4 years, much of which has been returned to shareholders in the form of stock repurchases and the aforementioned higher dividends.

ROIC or return-on-invested capital has increased from a low of 7% in mid 2003, to the current ROIC of 14%.

So what does the future hold ? With 30,000 stores currently a lot of MCD's store expansion is behind it, but this also is one of the reasons MCD's is generating so much cash flow: it is now a mature grower, and a cash cow of sorts, but through the "designated licensee" (DL) program, MCD's is trying to reconfigure ownership and the balance of franchisee's to company owned stores, and thus continues to unlock more value, and generate more excess cash.

More importantly, MCD's is improving operations: per our internal spreadsheet, the March '07 comp of 9.7% was the best systemwide sales comp for MCD's since December of 2004, and Europe's March '07 comp of 11.2% was one of the best ever for that region. (In MCD's 2006 annual report, on page 25, management states that a 1% increase in European comp's "would increase annual net income per share by about $0.02 (two cents).)

Bottom line: MCD's stock options are subsiding, thus the share repurchase program will be more accretive to shareholders, the turnaround in operations is a huge positive, and the very strong cash-flow and free-cash-flow generation will keep a floor under the stock. Since 2003, MCD's has grown earnings per share, 35%, 6%, and 20% respectively with the lumpiness due to the amount of cash being distributed and thus used for share repurchases. Current First Call eps estimates have MCD's growing earnings in the high single digits in the next three years, which, given the operational turnaround, could be conservative.

MCD's is trading at 13(x) Enterprise value to 4q trailing cash flow (hardly expensive), and is a perfect candidate for P/E expansion in a market totally vacant of such phenomena.

A move above $50 (and thus through formidable resisitance) for MCD's on good volume, and the hamburger king could run for a while.

position in MCD