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Sizing Up The General Motors (Preferred) Stock IPO

November 21st, 2010 1 comment

General Motors just went public last week in a big hoopla of an IPO, in a dramatic return to the public markets only 18 months after the company went bankrupt. Well, it’s not the same company because the new one is called ‘General Motors Company’, while the bankrupt entity was called ‘General Motors Corporation’.

While there is a lot of coverage of the common stock, there was almost no discussion about the preferred stock. So, this post will cover the details about the preferred stock. We talk a lot about preferred stocks on this site and how they can enhance your portfolio, so I thought it would be a good idea to cover it.

To summarize it quickly, here are the key details about the preferred offering:

  • Symbol: GM-B
  • Type: Mandatory Convertible Preferred (12/2013 date)
  • Offering Price: $50 (common stock was $33)
  • Coupon Yield: 4.75%

Unlike other convertible preferreds, GM-B is a mandatory preferred, meaning that on December 1, 2013 it will convert to common stock if the holder didn’t otherwise exercise earlier. Given the specifics about its conversion, it is simple to understand the return profile for this security. Here are the possible scenarios and how the return profile looks compared to the common stock:

Common Versus Preferred

If on December 1, 2013, the common stock trades at:

  1. < $39.6 ==> Preferred holders lose/gain capital inline with common holders, but are ahead by the interest payments of 4.75%/year that were collected.
  2. $39.6 to $50 $44.99 ==> Preferred holders earn more than common holders, ending about even at $50.
  3. > $50 ==> Preferred holders give up some capital gains even after factoring in the interest payments.

The outcomes above are simplified because the return profile only applies on the end date. For dates earlier than 2013, the conversion ratio offers more common stock to compensate for the lower interest payments (as time goes on, the amount of common stock goes down to compensate for the interest payments made).

The preferred therefore has some downside protection at the expense of giving up some upside if the common stock does very well.

How To Play It

The preferred stock will likely appreciate less than the common since the conversion rate starts off low and increases over time. This will encourage holders to keep it longer term. If the common stock doesn’t perform that well, the interest payments offer the ability to salvage some return.

As far as attractiveness, the 4.75% yield doesn’t entice me because other preferreds are available at higher interest rates. Also, the common stock doesn’t interest me that much either since I don’t think that the automobile market will recover that quickly and I don’t think that GM has recovered fully to become a very competitive player in the market.

However, one way to play this would be to purchase the preferred if it sells off significantly below face value. This would offer the ability to get an effectively higher yield while at the same time getting all the upside that the common offers.

Categories: Investing Tags: ,

QE II Is Here: Why Gold Will Be A Bubble

November 3rd, 2010 No comments

As expected, the Federal Reserve announced Quantitative Easing II (QE II). There were no surprises here, the reports over the past weeks were indicating easing in the amount of a few hundred billion to up to $1 Trillion. The headline number is $600B, but the total will be closer to $1 Trillion if you include additional purchases to replace expiring mortgage bonds. The additional purchases don’t expand the Feds portfolio, they will simply replace existing positions.

This sounds like a lot of money, but put $600B in perspective. It’s less than 6 months worth of the U.S Federal Government’s budget deficit. The entire U.S economy is over $14Trillion dollars.

One of the important details about QEII is that the majority of the Fed purchases will be within the bond maturity window of 5-7 years. This is important because the Fed will eventually need to reverse QEII as well as unravel all its other existing positions.

How It’s Supposed to Work

The Fed is trying to accomplish a few things here with QEII. First, the purchases will cause interest rates to decrease because buying bonds increases prices. Bond yields go in reverse to bond prices, so these purchases tend to depress bond yields. Lower interest rates in theory makes credit more easily available (this argument doesn’t reflect reality though – just ask people who are trying to get those cheap mortgages).

Second, lower bond yields make government debt less attractive. This will make other productive, private market assets more attractive because the risk adjusted return rate of those assets should go up. This phenomenon is thought to be contributing to the rise in the stock markets, particularly income investments.  Why earn 2+% on a 10 year Treasury when much higher yields are available from the highest quality, AAA rated, stocks?

Will it work? Perhaps it might have some effect marginally though its clear that in the short term the markets think it will simply cause inflation as evidenced by the increase in prices of hard assets such as gold and commodities. In the end though, the Fed can’t make a recovery happen by printing money, that needs to happen from the private sector.

How The Fed Will End It

I think the more important question to ask is how will the Fed end it. If you have been making the right moves recently, you will want to keep an eye out for new bubbles developing that could blow up on you because of the Fed’s actions. All this Fed manipulation is after all artificial market fingering. Markets are smart, and they adapt. The best example of this is that these artificially low interest rates really haven’t done that much to make credit more available because lenders have rightly raised standards.

Buying Treasury Bonds gives the Fed a clear and easy exit strategy: hold the bonds to maturity then retire the money. The Fed’s action to focus on the 5-7 year time frame leads one to conclude that this might be their exit time frame.

Inflation could occur more than otherwise if the Fed was forced to sell the assets at lower prices or worse simply write the money off. Because bond prices are so high, any sign of a growing economy will only make these bonds lose value. So, the risk of extra inflation will depend upon if the Fed takes a bath on its assets when it starts tightening. Simply letting the bonds expire to maturity enables the Fed (or anyone else invested in Treasury bonds for that matter) to get all of their principal back. This is the best that can be hoped for to keep inflation in check.

Gold Is A Bubble

The biggest risk I see going forward is a gold bubble. Not next year, maybe not even in the next few years but at some point gold won’t be a good trade anymore (at least a long trade). Here’s why:

  1. Gold doesn’t make you money. If you buy quality stocks and overpay because of bubble pricing, at least you won’t lose your shirt because stocks can outgrow overvaluation if earnings increase. Gold can’t do this.
  2. Inflation won’t be the problem it was in the 1970s when gold was a bubble last. Don’t expect 18% interest rates, the Fed will move.
  3. Gold has technicals in the market that make it a good trade. When the trade goes against it those market speculators will be weeded out.

Gold will probably never be $300 again because world demand for jewelry and industrial uses will continue to increase as markets develop around the world. But, at some point this trade won’t work anymore.

Categories: Economy, Market Analysis Tags:

What’s At Stake (Financially) In This Election

November 2nd, 2010 No comments

As I write this, polls across the country will be closing within hours. It’s been an unusual year in politics, to say the least. The Democrats run the entire Federal Government and this year has been an awful year to be an incumbent.

Politics is messy. One would think, that the Democrats would repeal much if not all of the Bush Tax Cut legislation. I’m still surprised that the Democrats didn’t do anything about the estate tax. This year and only this year, the estate tax at the Federal level is ZERO.

The problem is, of course, that the Bush Tax Cuts are popular. Bush after all did get re-elected and his mark lives on even though he left office two years ago.

What’s a Democrat to do? From a politics point of view, they need to come on the side against the tax cuts. From a re-election point of view, if they try to repeal them they potentially will offend some of their own voters as well as independents (which pols need to win). So, in the end, after all the problems of unemployment, foreclosures, housing market, etc in the minds of the voters, the Democrats “punted” and decided to do nothing.

Unfortunately, this causes a lot of uncertainty if you are an investor. Because they punted, the following policy is essentially in limbo, in order of importance to investors:

  • The dividend tax rates, specifically whether or not the special lower “qualified” rate will continue to exist.
  • Capital gains tax rates.
  • Wage income tax rates, which applies to some investment income.
  • Estate tax, which affects the taxes for your descendants from your investments.

Because of this uncertainty it is harder to compare investments because taxes are an important (though not the only) factor to consider. After almost a year of inaction, it’s a fairly good bet that this issue will be resolved in the next few months, either in the lame duck session later this year or first thing next year when the new Congress is sworn in.

Categories: Economy, Taxes Tags:

Market Analysis: Where To Put New Money

October 14th, 2010 No comments

The market has discovered “dividend” investments over the number of months. This is both good news and bad news.  Tobacco, Energy Partnerships, Oil Trusts, and Real Estate stocks, which are  long time boring income investments are on fire. These are the gains in these stocks just in the month of September:

  • Phillip Morris (PM) – 10%
  • Altria (MO) – 8%
  • Enterprise Products Partners (EPD) – 9%
  • Enerplus Trust (ERF) – 15%
  • Realty Income (O) – 4%

These are reasons why:

  • Interest rates are near zero, which depresses bond yields. Given the language of the Federal Reserve recently, its likely to stay that way for longer than perhaps was expected earlier this year.
  • All asset classes (stocks, bonds, commodities, gold, etc) are appreciating as a response to the depreciating dollar. When the dollar depreciates, everything denominated in dollars goes up in price to compensate.
  • Stocks are cheap. Investors realized that some stocks, adjusting for risk are cheap.

Of course cheap is relative. While some stocks may still be cheap, it looks at though prices have moved too quickly. The bad news, higher prices mean less income.

One of the trades that I am making this month is to buy into preferreds, as I talked about over the weekend.

Here in summary are what I see developing as good investments in this market:

  1. Preferreds still are paying good yields, if you buy investment quality below par.
  2. Defense contractors are very cheap right now, in response to expected lower defense spending going forward. See this article which talks about Lockheed Martin. This is still developing, the key is to find the ones that are beaten down but can otherwise survive with businesses outside of defense contracts.
  3. The foreclosure mess has come up again, this time as banks are stopping foreclosures due to bad paperwork. Banks stocks are taking a hit, but I think the better play here is the bank preferreds. These stocks survived the 2008 Recession, so its unlikely that this wave will kill them this time.
Categories: Market Analysis Tags:

How To Make Money Investing

October 11th, 2010 No comments

I had a moment with one of my brokers…

They sent me a slick, glossy brochure that talked about how to achieve your goals, different type of investment products and how the macro environment and business cycles impact your investments. I couldn’t help but think about that slick politician who after speaking for 30 minutes in the end has said nothing. The only thing I got out of the brochure was confusion.

Professional investors and brokers try to help, but in the end they want you to pay them to invest for you. Investing is too difficult for the average person after all. Bunk.

There are many different paths one can take to make money investing. For most people, they invest either using an investment manager who actively picks components just for you or more typically advises you about what kinds of mutual funds to buy. Mutual funds themselves are either actively managed by teams, or they track market or sector indexes. The components of the indexes are determined by established third parties, such as Standard and Poor’s which, e.g., is well known for the S&amp;P500 large capitalization index.

In a more general view though, investments are much more than stocks, bonds and mutual funds. However, no matter what the investment is, there are pretty much only a few ways you make money.

How do you make money with mutual or index funds?

The simple answer is that most of the funds largely bank on you making most of your money through capital gains, and a smaller amount through income. The often quoted benchmark long term return for the market of “8-11% average/year”, is comprised of about 2% of income and the other 6-9% for capital gains. Historically, income has accounted for a larger percentage of long term gains, but more recently the amount of income has gone down (the dividend yield for the benchmark S&P500 index is about 2% today).

So then, what is a Capital Gain? That’s a fancy word for getting someone to pay you more for your shares than you did. If they pay your more for your shares you have a gain, if they offer you less (and you sell), that’s a capital loss.

When it comes to traditional company stocks (which when combined together makeup the typical mutual or index fund), an investor will want to pay you more because of the companies earnings. If the investor believes that they will earn more in the future or if those earnings have actually materialized they might want to pay you more.

Ways To Make Money

I’ve already mentioned two of the ways above, capital gains and income. There is also a third one that I call valuable assets.

  1. Capital Gains. Sell your investment for more money that what you paid.
  2. Income. The investment periodically pays you income out of the money that the investment earns.
  3. Valuable Assets. Things that have value but don’t create any earnings, you make money by selling higher (capital gain). This includes precious metals (gold, silver, platinum), art, sculpture, precious stones and other hard goods.

In the article Investing Basics, I talked about how you should evaluate investments by their earnings potential (even if the earnings never appear). If you look at #3 above, you might point out that valuable assets don’t make money. This is true, so it qualifies as a special case because you can still make money by capital gains on valuable assets.

How You Should Make Money

Don’t leave your investing life to chance. Don’t turn your money over to a professional without first understanding what your investments are, and how they make money. Don’t blindly buy an index fund and simply hope that you make money in the future.

I’m not suggesting that you go alone and start stock picking and day trading. I am simply saying that, whoever manages your money, you need to understand what it is that you own, how it makes money, and align this with your expectations. Investor success is not about beating the market, but matching your returns with your expectations.

Next Steps

On this site I have been writing about how to invest as well as other topics in personal finance. If you want to learn more check out these additional resources: More articles about investing.

Categories: Make Money Investing Tags: