Staying Out of Trouble

CALL IT GREATNESS. CALL IT GIFTED. Call the consistently outstanding stock-picking performance all in a day's work for Schneider and his team at Schneider Capital Management of Wayne, Pa., who manage $6.3 billion. Dedicated to finding deeply undervalued stocks on the verge of cyclical change, Schneider's funds have outshone their benchmarks and most competitors year after year after year. As of May 31, the Schneider Small Cap had average, since its start in September 1998, compared with 15% for the Russell 2000 Value index. The Schneider Value Fund (SCMLX) was up 29.2% annually, on average, since its start in October 2002, versus 20.1% for the Russell 1000 Value index. That's what greatness looks like. This is what it sounds like.

Barron's: Last year, you likened the market to Lake Wobegon, where all stocks were priced above average. What do you make of this year's market?

Schneider: I don't have any cute lines for it, but it seems late in the bull-market cycle. The market is priced for perfection. It seems to me that the market is assuming that credit spreads stay low and therefore the private-equity boom continues. It also seems to assume that the U.S. economy avoids a recession and that the very rapid international economic growth continues. Collectively, the risks are high that one of those ends, and if one does then the bull market is over. If I were to hazard a guess, I would say it is the credit-spreads, private-equity boom that is the most important driver of the three.

With interest rates rising, aren't we starting to see more concern about spreads and private-equity funding?

Arnie Schneider

Yes, that is the first threat to the private-equity boom. Credit costs have gone up and that's making acquisitions more expensive. Wider credit spreads will be the second nail in the coffin. Last year, 8½% of the U.S. market was leveraged-buyout-related, which was similar to peaks in the late 1990s and late '80s. That's a pretty big number.

How are you approaching the market, given the risks?

The value markets are very difficult now because there are very few valuation differentials to exploit, and so we have concentrated our portfolios on our best ideas to a greater degree. We are focused increasingly in the financial area because it is one of the last remaining areas that is cheap. It is an area where we can find earnings streams that are still low and have the availability to improve, as opposed to paying big multiples on earnings streams that are not durable, in our judgment. There are opportunities in names that are high-quality institutions that should do well, irrespective of the housing debacle, and in some cases will benefit as their weaker competitors that lost their way move aside.

What are your expectations for the economy?

The risks of a domestic recession have risen with this bond-market back-up. The consumer is very fragile. Consumers, who are two-thirds of the economy, have hung in there, although clearly at a decelerating rate. They're the $64,000 question for which direction the economy goes. Exports are leading the economy, housing is dragging the economy and the consumer will be the ultimate arbiter of whether we avoid a recession or not. Employment has been slowing but is still solid. We are averaging about 130,000 jobs a month this year, which is down by about one-third from last year but not too bad. And incomes are growing nicely, so the consumer has hung in there. We were spending well above incomes and consumers, probably correctly, have ratcheted their spending down to equal their incomes. I think the next move is for spending to move below income growth, mostly because we've got the first housing-price depreciation since the Great Depression. It is just inconsistent to me that home builders are trading at new lows and retailing stocks are trading at new highs. That isn't the way the economy works. They're more closely linked than that.

But why the disconnect?

I think the reason is that 94% of homeowners have over 10% equity in their homes. They have unrealized losses versus a year ago, but they still have realized gains in their homes and they are not forced sellers. As long as they have a job, consumers are going to continue to spend and be confident, and that is why we are most likely to avoid a recession. But the foundation is weaker.

If you look at the financial-obligations ratio, it is at an all-time high. Mortgage-equity withdrawal is half its peak level, but it is still way above normal and there are lags there. The headwinds on the consumer have started and they are gathering, but it takes a shock to tumble the economy into a recession. Again, the most likely outcome is avoidance of a recession, but the odds have clearly gone up.

Are you looking not only for stocks that are inexpensive but also defensive?

Ideally, you would like to find those. The problem is the true defensive stocks -- the utilities and stocks of that nature -- are very expensive. Playing pure defense is too expensive to do. We haven't found a lot of pure defensive stocks. The food stocks are 17 times earnings. The telephone stocks are not cheap.

What about Big Pharma?

Pharma is defensive and the stocks are statistically cheap, unlike the others. But the question there is, what's the growth rate? Congress is attacking their franchise and there are a lot of patent expirations going on. So the growth rates in earnings over the next few years are quite sluggish.

So you're focused on financials, and what else?

Coal.

Let's start with the financials.

The first name is Countrywide Financial [ticker: CFC]. Countrywide is the largest and arguably the most efficient mortgage originator and servicer in the country. They've got an integrated operation and can respond quickly to changing industry conditions. Their servicing portfolio represents about 15% of U.S. mortgage debt outstanding. The key to this stock is that the current mortgage-industry turmoil should lead to less competition and more rational pricing. The pricing has been very, very thin, really throughout the mortgage chain, so they'll be a direct beneficiary of better spreads, which are already emerging in mortgages. Also, Countrywide has diversified into several new businesses in the last decade that should smooth out the earnings stream and provide some balance for the mortgage operation.

If we are looking at a possible recession and a bottom in the housing market has yet to occur, won't there be more pain for people who invest in this stock now?

That's the point. I look at 2007 as the trough year for their earnings. Mortgage margins are extremely low. Originations are down by over a third from the peak in 2003. The new-home market is extraordinarily weak and the refi market is somewhat weak, and so we view mortgage spreads as being at a low. We view mortgage originations as being at a low. We think volumes will go up next year and spreads will go up next year as competitors exit. Even if housing starts go down next year, Countrywide's earnings likely would go up. Remember, they are generating tremendous amounts of capital. This year they are going to earn a 15% return on equity on trough earnings. Their capital base will grow, enabling them to grow earnings.

Let's talk about the numbers.

The market expects them to earn $3.80 this year, which we think is the trough year of earnings. The stock is 10 times trough earnings, and trough earnings have a 15% return on equity. Over time, ROE has averaged in the high teens to low 20s, so earnings power clearly is higher, not only as the capital base grows but as the return on equity returns to median levels.

Any other financials?

The other pick is Luminent Mortgage Capital [LUM], a small-cap mortgage REIT. Luminent is different than Countrywide in that they don't originate mortgages. They are just a disciplined buyer of mortgage product and can sit on the sidelines when spreads are tight. When spreads are wide, as they were in March and April, they can buy as much as their balance sheet allows. Luminent is selling below book value, and it is a fairly hard book.

A hard book?

It's solid. The portfolio is marked to market at the end of the quarter. They have very strong credit management. Their portfolio is showing significantly better credit performance than portfolios with similar metrics, and the stock is selling for a whopping six times Wall Street's estimated '08 earnings. They are buying back stock and, most important, they benefit from the wider credit spreads, mortgage spreads that have existed since February.

Does Luminent pay a dividend?

Yes, it's yielding more than 12%.

On to coal. What's to like?

Coal has a promising future. Last year was kind of a perfect storm for the coal industry. There was a warm winter and a cool summer, strong hydroelectric and relatively low natural-gas prices. Demand was weak and in response to the strong coal prices in 2004 and 2005, supply was in the process of really ramping up. Inventories exploded, prices collapsed and stock prices collapsed. Coal is now in the process of reversing the ugly 2006 trends.

What's changing?

There are three main regions of the coal industry: the Powder River Basin in the West; the North Appalachian area; and Central Appalachian, which is the high-cost area in the U.S. Under current conditions, Central App is shutting down capacity. They are about 20% of U.S. production. Year to date, Central App production is down about 20 million tons, and we think it will be down about twice that for the entire year. More Central App capacity will shut in 2008 because most coal contracts are multiyear.

At the end of this year, a whole new set of contracts will roll off that were priced two, three, four years ago when prices were better, and they will be facing the new lower prices of today and therefore there will be further shutdowns. Overall U.S. production is down almost 3% year to date and so it's under very good control. On the demand side, we are assuming a normal summer and electricity generation in general will be up roughly 4% this year. Inventories are slowly moving back to a lower level and supply and demand will be more balanced in 2008.

What about China?

China is exploding. They are adding a coal-power plant a week, and China has now crossed over to become a net importer of coal in 2007 for the first time.

What about pricing?

Coal is extremely cheap on a BTU basis. At $7 natural gas, on a comparable basis, coal should be about $70 a ton for high-quality steam coal. Today, the price is about $45. That cost arbitrage is going to narrow over time.

Which region and what companies should benefit the most from developments in the industry?

You could throw a dart at the industry. All companies will benefit from the closing of the price gap between natural gas and coal. But Northern Appalachia is the area specifically that will benefit the most. Central App prices will probably move up the most, because they have the biggest swing capacity. And the PRB is the low-cost growth area. But Northern Appalachia has the most going for it now because the sulfur-emission restrictions mandated by the government will result in the amount of scrubbers installed at coal plants almost tripling in the U.S. by 2010.

Northern App coal is very high-sulfur. Before scrubbers, they were significantly disadvantaged and had to sell their coal at a discount to lower-sulfur coals elsewhere. But with scrubbers, they can operate on a more equal footing with the low-sulfur coals. We see Northern Appalachian coal prices moving more in line with the lower-sulfur coals.

Any particular company that stands to benefit?

Consol Energy [CNX]. And Consol Energy owns 80% of a public company called CNX Gas [CXG], which represents about $20 a share of Consol Energy's stock price. CNX Gas is a terrific low-cost player with long-life reserves. It is a nice property in its own right.

If you consider the earnings that Consol could generate if gas trades on a BTU-equivalent priced with coal, they could earn over $6. If it were to occur, it would be a ways away. There are really only two cost-effective power options: nuclear and coal, and the United States has 250 years of reserves of coal, while new nuclear plants won't be available until at least 2016.

If we are looking at a possible recession and a bottom in the housing market has yet to occur, won't there be more pain for people who invest in this stock now?

That's the point. I look at 2007 as the trough year for their earnings. Mortgage margins are extremely low. Originations are down by over a third from the peak in 2003. The new-home market is extraordinarily weak and the refi market is somewhat weak, and so we view mortgage spreads as being at a low. We view mortgage originations as being at a low. We think volumes will go up next year and spreads will go up next year as competitors exit. Even if housing starts go down next year, Countrywide's earnings likely would go up. Remember, they are generating tremendous amounts of capital. This year they are going to earn a 15% return on equity on trough earnings. Their capital base will grow, enabling them to grow earnings.

Let's talk about the numbers.

The market expects them to earn $3.80 this year, which we think is the trough year of earnings. The stock is 10 times trough earnings, and trough earnings have a 15% return on equity. Over time, ROE has averaged in the high teens to low 20s, so earnings power clearly is higher, not only as the capital base grows but as the return on equity returns to median levels.

Any other financials?

The other pick is Luminent Mortgage Capital [LUM], a small-cap mortgage REIT. Luminent is different than Countrywide in that they don't originate mortgages. They are just a disciplined buyer of mortgage product and can sit on the sidelines when spreads are tight. When spreads are wide, as they were in March and April, they can buy as much as their balance sheet allows. Luminent is selling below book value, and it is a fairly hard book.

A hard book?

It's solid. The portfolio is marked to market at the end of the quarter. They have very strong credit management. Their portfolio is showing significantly better credit performance than portfolios with similar metrics, and the stock is selling for a whopping six times Wall Street's estimated '08 earnings. They are buying back stock and, most important, they benefit from the wider credit spreads, mortgage spreads that have existed since February.

Does Luminent pay a dividend?

Yes, it's yielding more than 12%.

On to coal. What's to like?

Coal has a promising future. Last year was kind of a perfect storm for the coal industry. There was a warm winter and a cool summer, strong hydroelectric and relatively low natural-gas prices. Demand was weak and in response to the strong coal prices in 2004 and 2005, supply was in the process of really ramping up. Inventories exploded, prices collapsed and stock prices collapsed. Coal is now in the process of reversing the ugly 2006 trends.

What's changing?

There are three main regions of the coal industry: the Powder River Basin in the West; the North Appalachian area; and Central Appalachian, which is the high-cost area in the U.S. Under current conditions, Central App is shutting down capacity. They are about 20% of U.S. production. Year to date, Central App production is down about 20 million tons, and we think it will be down about twice that for the entire year. More Central App capacity will shut in 2008 because most coal contracts are multiyear.

At the end of this year, a whole new set of contracts will roll off that were priced two, three, four years ago when prices were better, and they will be facing the new lower prices of today and therefore there will be further shutdowns. Overall U.S. production is down almost 3% year to date and so it's under very good control. On the demand side, we are assuming a normal summer and electricity generation in general will be up roughly 4% this year. Inventories are slowly moving back to a lower level and supply and demand will be more balanced in 2008.

What about China?

China is exploding. They are adding a coal-power plant a week, and China has now crossed over to become a net importer of coal in 2007 for the first time.

What about pricing?

Coal is extremely cheap on a BTU basis. At $7 natural gas, on a comparable basis, coal should be about $70 a ton for high-quality steam coal. Today, the price is about $45. That cost arbitrage is going to narrow over time.

Which region and what companies should benefit the most from developments in the industry?

You could throw a dart at the industry. All companies will benefit from the closing of the price gap between natural gas and coal. But Northern Appalachia is the area specifically that will benefit the most. Central App prices will probably move up the most, because they have the biggest swing capacity. And the PRB is the low-cost growth area. But Northern Appalachia has the most going for it now because the sulfur-emission restrictions mandated by the government will result in the amount of scrubbers installed at coal plants almost tripling in the U.S. by 2010.

Northern App coal is very high-sulfur. Before scrubbers, they were significantly disadvantaged and had to sell their coal at a discount to lower-sulfur coals elsewhere. But with scrubbers, they can operate on a more equal footing with the low-sulfur coals. We see Northern Appalachian coal prices moving more in line with the lower-sulfur coals.

Any particular company that stands to benefit?

Consol Energy [CNX]. And Consol Energy owns 80% of a public company called CNX Gas [CXG], which represents about $20 a share of Consol Energy's stock price. CNX Gas is a terrific low-cost player with long-life reserves. It is a nice property in its own right.

If you consider the earnings that Consol could generate if gas trades on a BTU-equivalent priced with coal, they could earn over $6. If it were to occur, it would be a ways away. There are really only two cost-effective power options: nuclear and coal, and the United States has 250 years of reserves of coal, while new nuclear plants won't be available until at least 2016.

Being a stock-market bear is excruciating right now.

It's bad enough taking a beating from constantly climbing stock prices. The Dow Jones Industrial Average ($INDU) and the Standard & Poor's 500 Index ($INX) are both up 7% this year.

But there's something even worse than losing money when you’re a bear: It's losing money while knowing that you're right. This stock market is overvalued, as these market pessimists argue. This rally is built on a flood of cheap money. Earnings growth is slowing. There are speculative bubbles all over the world, from the apartment market in Spain to the stock market in Shanghai. And yes, there will be a day of reckoning for the global financial system.

But in the meantime, while they wait for Armageddon and the days that will divide the prudent from the reckless, bears are getting killed.

Why it matters

But the kind of big "I-told-you-so" downturn -- a drop of 15% to 20% or more -- that the bears have been calling for could be as much as three to five years away.

Bears are notoriously early, of course. Yes, bearish pundits did call the bear market of 2000 to 2003, but they started to call it as early as 1995. An investor who heeded those early warnings and moved to the sidelines would have lost the chance to make a lot of money.

Bears are so frequently early in their calls because they have a rather admirable and idealistic faith in fact and logic. If they can show that global liquidity has been expanding at the kind of breakneck pace that always produces a crash, that earnings growth is slowing, that earnings-per-share numbers are overinflated and that housing prices are falling, then they believe that investors will act rationally and sell their investments. The markets will crumble.

For a group of investors that spends so much time decrying the irrationality of other investors, bears curiously underestimate the ability of investors to maintain their beliefs in the face of the bears' facts.

Slow on the uptake

Market history shows that overvalued and undervalued markets go to extremes of valuation because investors don't like to face facts until they've been hit over the head with them.

For example, it's amazing to me that the stock market has rallied for all of 2007 in the face of falling earnings growth rates. It looks like operating earnings per share for the S&P 500 companies will grow by 8% to 9% in the first quarter of 2007 versus the first quarter of 2006. That's certainly not bad but a drop nonetheless from the double-digit growth rates reported for the last 19 consecutive quarters. Eight times in that string, operating earnings growth rates topped 20% in a quarter. (We don't have final numbers for the fourth quarter of 2006, but it looks like earnings growth topped 10%.)

The market's rally gets even more perplexing if we look further into 2007. Forecasts now call for earnings growth to drop to 5% in the second quarter of 2007 (versus the second quarter of 2006) and to 2% in the third quarter.

These facts, logically, should have led investors to sell stocks rather than buy.

But bullish investors are perfectly capable of looking past this bearish logic. Some investors simply don't believe the numbers. After all, at one point this year it looked like first-quarter 2007 earnings growth might come in as low as 3%-4%, but that didn't happen. Many bullish investors apparently believe that real earnings will come in above projections again in the second and third quarters, keeping the rally going.

Other investors are apparently looking past the projected slowdown in second-quarter and third-quarter growth to the projected pickup in the fourth quarter. For that period, Wall Street analysts, according to S&P, are now projecting 14% year-to-year growth in operating earnings.

And a third group of investors is apparently willing to simply disregard these bearish facts. The earnings growth figures are irrelevant because of the continued boom in corporate buyouts, because of continuing low interest rates, because of continued cash flow into the U.S. market from overseas. Whatever.

There's more to the irrational behavior

These three groups of investors won't be convinced by the facts, no matter how many times the bears wave them around and no matter how many additional facts the bears muster to buttress their arguments. It will take a market downturn to get their attention. Then these facts, ignored or dismissed, may seem relevant.

Or maybe not.

Because there's another big source of irrational behavior in these market that bearish arguments tend to overlook.

To my mind, one of the strongest elements in the bearish case is the growing use of riskier and riskier kinds of debt to prop up everything from buyout deals to corporate dividend payouts. (For the role of risky debt in share buybacks and dividend payouts see my May 8 column, "How cheap debt overinflates stocks.") The leverage in buyout deals is increasing, the junkiness of the junk bonds used in these deals is increasing, the amount of debt on balance sheets is increasing and the use of complex and sophisticated, but untested, derivatives to insure against loss in these deals is increasing.

Yes, this is a debt bubble, and at some point it will pop.

But those bears calling for it to pop soon are underestimating the degree of irrationality now coloring the thinking of CEOs, CFOs and investment bankers. Yes, it makes no sense to borrow money to pay a dividend if you're running a growth company. And yes, this practice puts extra debt on the corporate balance sheet. And yes, a rational CEO would recognize the danger signs and stop playing the game, putting an end to the rally in stock prices based on this risk-taking behavior.

But if a CEO is capable of behaving irrationally enough in the first place to load up the balance sheet with debt when debt is getting more expensive and harder to obtain, then that CEO is capable of borrowing even more cheap money to keep the game going.

The flood of cheap money that has produced reckless risk-taking is indeed, as the bears point out, the big worry in this market. But the flood of cheap money also postpones the day of reckoning. CEOs who haven't seen the risk in borrowing so far aren't likely to see any reason not to borrow some more.

In the case of earnings growth, it will take an actual slowdown to 3% to 5% earnings growth for a couple of quarters to get investors attention. And then we'll get our seasonal 5% to 10% correction.

In the case of the debt bubble, it will take a real credit squeeze that substantially raises the cost of debt and makes borrowing money much more difficult to wake up investors.

Creating the crunch

I can see a prototype for such a credit crunch in the recent reduction in mortgage lending in the United States in reaction to rising defaults in the subprime mortgage market. Dozens of specialists in these mortgages for borrowers with less-than-pristine credit histories have gone out of business, while others have tightened their lending standards. The last report from the Federal Reserve, in January 2007, showed that mortgage lending conditions were at their tightest since 1991. After growing at a 20% annual rate six months ago, residential mortgage lending growth has tumbled to a 0.4% growth rate, a record low.

That's a model for the kind of credit crunch that would get the attention of CEOs and investors. But the subprime market simply isn't big enough to cause a tightening in the corporate lending market as a whole. So we're left waiting for something to blow up -- and the likelihood that it will blow up big when it does. And a high probability that the blow up is further away than a purely rational, logical analysis of the financial markets indicates. Human nature, good ol' highly irrational human nature, just about guarantees that.

Until that global debt market gets a good fright -- enough of a scare to shut some lenders entirely and to get others to withdraw from the market -- this irrational, irresponsible and illogical cheap money bull market will continue, after a possible seasonal correction, with investors, bankers and executives doing the same irrational things tomorrow that they did today.

The bears will go on being right. And getting more and more frustrated that the market refuses to face facts. And angrier and angrier that investors who behave irrationally are making money while they're left licking their losses.