TMFDeej (99.46)

Weathering the flood of falling earnings by climbing higher up capital structure ladder

February 09, 2009 – Comments (8) | RELATED TICKERS: CHK , JPM , AA

As many of you may have been able to tell by reading my blog lately, I have been restricting my new investments to things that pay me to ride this economic storm out rather than crossing my fingers and hoping that I will eventually be repaid with a higher share price in today's world of rapidly falling earnings and contracting multiples. 

In addition to seeking dividends, I have been climbing increasingly higher up the capital structure with my investments lately.  I very rarely purchase common stock any more.  The yields on corporate bonds that mature over the next 5 years and preferred stock are too compelling to ignore when compared to the flat to negative returns of the major indices over the past two decades.  If I can lock in relatively safe yields in the 8% to 10% range for the next several years, why on Earth would I want to mess around with non-dividend paying stocks?

I strongly believe that the market will breach the lows that we saw at the end of 2008 before this messy recession is all said and done.  The earnings power for companies, particularly those that are exposed to the consumer just won't be there. 

I like to look at things graphically whenever possible.  Doing so makes it so easy to visualize what is happening now and what likely will happen in the future.  Take a look at the fantastic charts that John Mauldin provided in this week's issue of his outstanding Thoughts From the Frontline newsletter:

This first chart shows just how anemic U.S. GDP growth would have been over the past several years (before the stuff hit the fan) if consumers had not been pulling money out of their mortgages and spending it at an unsustainable pace.  And this is when the economy was going great and unemployment was low.  Imagine what the GDP is going to look like over the next year or two with unemployment approaching double digits and no one willing or able to spend the equity that they have in their home...if there's even any left. 

Unemployed people don't spend a lot of money.  The consumers who still have jobs are scared and don't want to spend.  Even if they wanted to, their net worth has fallen off of a cliff in conjunction with the destruction of the the value of their homes and their stock portfolios, so they don't have a lot of money left to spend.  That means that any wasteful consumers left out there who want to spend will have to borrow to do so and banks aren't lending like they used to.

The next chart shows how overly optimistic analysts have been with their earnings estimates for the S&P 500 over the past year:

The consensus estimate has been cut in half.  And the funny thing is that the estimate that's out there right now is probably still too high. 

There's nothing wrong with investing your money in stocks and bonds now.  Just keep your eyes open when doing so and don't expect immediate or significant capital gains.  Buy things that pay you to wait out this storm.  Better yet, buy things higher up the capital structure that will continue to pay you even when companies have to reduce or cut their common stock dividends.

Barron's had an excellent article on the ins and outs of preferred stock in this week's issue.  It is a must read for anyone who is interested in investing in the sector.  My only problem with this piece is that it really only talks about preferred stock in financials.  I have a number of small positions in financial institution preferred stock in my real world portfolio, but I would never ever go overweight any individual company in the sector with all of the uncertainty and possible government intervention out there right now.

Here's a sampling of a few of my recent purchases in these sectors that I am now allowed to talk about.  At the time I purchased them all of these items yielded 9% to 10%:

Alcoa 5.55% Bond Due 02/01/17

JPMorgan Chase 7.9% Variable Perpetual Notes due 4/30/2018

Montpelier Re 6.125% due 08/15/13

Chesapeke Energy Conv. Preferred 6.25%

Wells Fargo 7.5% Convertible Preferred Series L

Make sure to diversify into preferred stock outside of financials and into bonds and keep your bets spread out between a number of different companies.

It Only Looks Like a Wipeout 

Deej