Here is a comparison that illustrates the value of Cisco’s business: Apple (AAPL) – which arguably makes better personal computing products (Mac/iPad vs. PC), better smart phones (iPhone vs. other smart phones), and better music products (iPod/iTunes vs. conventional MP3s) than its competitors – may have what large groups of people want.  But Cisco has what large groups of people need.  If all of Apple’s products disappeared spontaneously from the face of the Earth tomorrow, there would be a lot of disgruntled people lining up to buy competing products to make do.  If Cisco’s products spontaneously evaporated, cities, countries, and companies all over the world would suddenly slip into IT darkness.

Still, Cisco’s stock has not been a star since the tech bubble burst in 2000-2001.  In the low $20’s ($22.05 at market close on August 17), Cisco is basically priced in the middle of its trading range for the last nine years even though its 2009 earnings per share (EPS) for the year of the financial crisis were 4.2 times its 2002 EPS.

Given the above, the investment case for Cisco is in my view intertwined with four particular reasons for downward pressure on the stock.  These are:

1)    No M&A premium. Lots of stocks benefit from an ongoing sugar high of takeover rumors that keep the price up.  Cisco isn’t one of them.  Given the dominant position and ultra large cap value of the company, including almost $40 billion in liquid reserves,² it’s hard to imagine a scenario where anyone could buy Cisco out.

2)    No dividends. Cisco is the only Dow component that does not pay dividends. ³ Consequently, many portfolios will not hold Cisco no matter how good the investment thesis, reducing demand for the stock.  This is especially true at a time of post-financial crisis uncertainty, when investors are biased towards the perceived security of holdings that pay cash dividends in real time, and also make up for lost interest income due to near-zero interest rates.

3)    Residual fear over tech bubble losses. On March 27, 2000, Cisco’s stock hit an all time high of $82 a share, and the firm was billed as climbing to a $1 trillion market capitalization. ⁴ By October 8, 2002, after losing a substantial portion of its customer base when the dot-com bubble burst, it fell as low as $8.12.⁵  This history provides a psychological barrier to big jumps in the stock price.

4)    General post-financial crisis fears about the economy and markets.

The first point is not likely to change anytime soon, though it’s a good point for understanding why Cisco stock may not make big moves when others do.  The second, third and fourth, however, may change over the next few years.

(Click below to go to next page.)

1. Cisco’s fiscal year ends on July 31, while Juniper’s ends on Dec. 31, though the comparison roughly holds for previous years.
2. See Cisco’s form 8-K filed August 11, 2010, available at http://investor.cisco.com/sec.cfm?NavSection=SEC.
3. See Wall Street Journal Data Center at http://online.wsj.com/mdc/public/page/2_3024-dowyield.html.
4. “Firm’s market cap climbing to $1 trillion,” March 17, 2000, San Jose Business Journal, available at http://sanjose.bizjournals.com/sanjose/stories/2000/03/20/story2.html.
5. See Financial Accounting Case Study: Cisco Systems, Universitat Pompeu Fabra (UPF) MBA program, December 11, 2003, available at http://www.econ.upf.edu/docs/case_studies/42.pdf, for a good summary and discussion of Cisco’s history through the tech bubble.

The news has initially sent shock waves about the stock with the price falling to close at $41.85 on August 6 when Hurd’s resignation was announced, losing 9.7% of its value from the previous day’s close at $46.35.¹  But there are reasons why this drop may be an overreaction:

• Hurd has a history of creating a foundation for value that outlasts his presence.  NCR (NCR) continued to flourish after he departed as CEO, with its stock price rising from $18.27 on March 28, 2005, the day before the announcement that he was moving to HP, to the mid-$50 in 2007 prior to spinning off Teredata, Corp. (TDC).  While NCR’s shares have recently languished, Teredata’s stock hit an all time high this summer.
• The fact that Hurd and the HP board quickly resolved the situation prior to rumors eroding internal morale and the company’s reputation is a big step towards maintaining internal and external confidence, and minimizing damage.
• HP’s stock was already beaten up, down from a high of $54.75 on April 16 earlier this year.

Hurd’s tenure as HP CEO was, other than the allegations that precipitated his departure, a major success.  But his departure—while a setback—does not pose the same degree of risk for the company and investors as the departure of a CEO whose personality is ingrained in the company, as I and others have argued is the case with Steve Jobs of Apple (AAPL).

Hewlett-Packard’s situation will become clearer as the direction of the search for a new CEO takes shape and CFO Cathie Lesjak takes the reigns as acting CEO in the interim.  But while the post-Hurd aftermath keeps the price down, there’s a good rational to support the risk of buying into HP.

Disclosure: The author is long on Hewlett-Packard (HPQ) as of the original publication date of this post.  The author does not hold a securities position in NCR (NCR), Teredata (TDC), or Apple (AAPL).  The information provided in this post does not constitute professional investment advice, and should only be used in consonance with all available information, including the opinion of a professional adviser, to make an investment decision.

1. There is some confusion over HP’s August 6 closing price, and it seems that the $41.85 indicated by major services as the market close reflects after hours trading following the announcement on Hurd’s resignation after 4 pm.  See “HP Stock Price on Electronic Exchange Direct Edge Lowered Closing Quote,” Nick Baker & Nina Mehta, Bloomberg, August 8, 2010, at http://www.bloomberg.com/news/2010-08-09/hp-s-stock-price-on-electronic-exchange-direct-edge-lowered-closing-quote.html.

• Now is generally a good time for U.S. investors and others with portfolios heavy on U.S. equities to consider diversifying by adding holdings in European shares while the Euro is still near multi-year lows, though this should be done carefully to avoid companies heavily impacted if there is a protracted European recession.
• The bulk of what ING needs to do to make amends for the state aid received from the Dutch government during the peak of the financial crisis has likely already been revealed, including splitting its banking and insurance business and selling the ING Direct U.S. operation.¹
• It’s fair to expect that the European Commission will be reasonably flexible in dealing with ING going forward because the current European debt crisis is largely a struggle for the wealthier Northern European nations to save more debt-laden Southern members, making the players reluctant to overly burden the economies of Northern states like the Netherlands.
• When divestments and special items are subtracted, ING made € 0.27 per share in the first quarter of 2010,², which using an exchange rate of 1.24 (approximately the rate at this writing) rounds to $ 0.33 per share.  Just sustaining those earnings over a year would produce a P/E ratio of 6.32 at current share levels, supporting a higher share price even if the Euro stays in the same place against the dollar.
• Intangibles also weigh in ING’s favor.  The company has been very successful in marketing its highly regarded ING Direct savings account,³ and even if it the company does eventually sell ING Direct by 2013 as currently expected to meet the Commission’s requirements,⁴ it should command a good price.

Finding exactly the optimal time to buy is always a challenge—there may still be dips below $8 given the volatility of the current European situation but waiting for a perfect situation for too long may result in a good one being be missed.  I also think that those who can hold out for the long haul with ING will do best, as many of the key events that will add value, like reviving dividends and selling ING Direct, may not happen for a few years.

Disclosure: The author is long on ING ADR’s (ING) and ING 6.2 % preferred perpetual securities (ISP).

1. See “ING to separate banking and insurance operations,” October 26, 2009, at http://www.ing.com/group/showdoc.jsp?docid=417610_EN&menopt=prm|pre|apr|010.
2. See ING Group Quarterly Report, published May 12, 2010, available at http://www.ing.com/group/showdoc.jsp?htmlid=419558_EN&menopt=ivr|qtr|qtr.
3. For an assessment of ING Direct, see “ING Direct Review,” Bargaineering.com, at http://www.bargaineering.com/articles/ing-direct-review.html.
4. “EU Forces ING To Sell Off ING Direct US By 2013,” October 27, 2009, at http://www.mybanktracker.com/bank-news/2009/10/27/eu-forces-ing-to-sell-off-ing-direct-us-by-2013/.

But as an investor, the current valuation of Apple shares ($260.83 at market close on June 1, with a peak on April 26 of $272.46) makes me nervous.  Apple maintains a corporate image of a young, free-spirited growth company.  While this may genuinely reflect aspects of Apple’s internal management, that is not the external reality.  Apple has become one of the biggest companies in the world, now the second largest U.S. company by market capitalization, outflanked in the U.S. only by oil behemoth Exxon.  Consistent with this disconnect between image and reality, Apple is the only one of the top ten companies by market capitalization not included in the Dow Jones Industrial Average.  Tech powerhouses Microsoft (MSFT) (3^rd in market cap), IBM (IBM) (8^th), Cisco (CSCO) (15^th), Intel (INTC) (18^th), and Hewlett-Packard (HPQ) (23^rd) are all Dow components. ¹

All together, there are three reasons why I see Apple shares as risky for long-term investors at current prices.  First—and I am not the only person to say this ² —whether the company will be able to maintain its momentum when returning founder Steve Jobs eventually relinquishes his leadership role is open to question.  I don’t give credence to rumors of that happening soon, but nobody can run a company forever so it’s always wise for long-term investors to consider potential succession issues.  In Apple’s case—given the disaster to the company when Jobs was forced out in 1985—the question is particularly relevant.

Second, I believe that the intellectual and business forces allied against Apple are formidable.  Companies that compete with Apple include in computers Microsoft (MSFT), Hewlett Packard (HPQ), and Dell (DELL); in wireless Google (GOOG), Sprint Nextel (S), and Motorola (MOT); and in on-line music Amazon.com (AMZN).  It stands to reason that at some point so many minds working to make inroads into Apple’s pie will eventually make progress.

Third, history teaches that when a big company gets super lucrative, the likelihood that some aspect of its business model will cross swords with public policy interests rises.  The breakup of the Gilded Age railroad and oil trusts, the 70’e era anti-trust suits against AT&T (T) and IBM (IBM), and the 2001 Microsoft anti-trust settlement all followed this pattern.  There are already rumblings that investigators are poking around Apple’s tracks. ³

Heretofore, there is no particular reason to believe that Apple has crossed the line.  Even so, when a company becomes ultra‑powerful political forces can change the rules, as many say has happened in the recent securities case against Goldman Sachs (GS).  So even if Apple has done nothing that would get an ordinary player into the soup, the company’s newfound dominance may subject it to higher regulatory scrutiny.

This is not to say that Apple is in trouble.  I think that the company itself is going to do just fine, and I wouldn’t be surprised if the stock makes a legitimate run at $300 a share given the iPad’s early success.  But in the long term, there are reasons to be concerned that Apple’s shares may hit choppy waters.

Disclosure:

The author is long on Microsoft (MSFT), Cisco (CSCO), Intel (INTC), Hewlett-Packard (HPQ) and IBM (IBM) as of the original publication date of this post.  The author does not hold a securities position in Apple (AAPL), Dell (DELL), Google (GOOG), Sprint Nextel (S), Motorola (MOT), Amazon.com (AMZN), AT&T (T), or Goldman Sachs (GS).

1. Market capitalization ranks are as of June 2, 2010.  For a real time list of the largest U.S. companies by market capitalization, see http://247wallst.com/page/real-time-500/.
2. See, e.g., Apple After Jobs, Kevin Maney, Feb. 11, 2009, Portfolio.com at http://www.portfolio.com/executives/features/2009/02/11/Analysis-of-Jobs-Leave-of-Absence
3. See, e.g., “ABCs of Antitrust: What Apple Could Learn from Intel, May 28, 2010,” Dawn Kawamoto, Daily Finance, http://www.dailyfinance.com/story/company-news/apple-amazon-intel-antitrust/19492941/.

First, sentiment is growing that while Sprint’s network is not yet on par with U.S. quality leader Verizon (VZ), it is significantly improved, keeping Sprint’s reputation solidly above quality laggard AT&T (T).¹

Second, Sprint is developing its business for prepaid phones. ²   While pre-paid phones are not the “by all end all” of the mobile phone marketplace, this is an interesting development.  Aside from being profitable, the pre-paid market could be a feeder for traditional contract customers through a pipeline of younger users and people who will get a regular plan when they get on their feet as the recession subsides.

Third, I believe that Sprint’s marketing campaign with CEO Dan Hesse making the pitch has finally shifted into a broadly effective message.  Using top executives in advertising can work well if done right.  Lee Iaccoca’s commercials for Chrysler arguably saved the company in the 80’s,³  though the pathetic YouTube video done by pre-bankruptcy General Motors (GM) CEO Rick Wagoner was a signal for prudent investors to abandon a sinking ship. ⁴  While the original Hesse commercials projected a detached persona that may not have connected with some viewers (I know it didn’t with me), ⁵ the new ones show Hesse as an executive who can acknowledge that Sprint’s products needed improvement  while speaking with conviction about the quality of his team’s present offerings.⁶ Take a look yourself and see what you think.  Equity analysts may be more comfortable with numbers than qualitative judgments like evaluating the effectiveness of an ad campaign, so if the Sprint ads are better than analysts are willing to assume there may be hidden value.

Fourth, AT&T’s contract with Apple (AAPL) to be the exclusive U.S. wireless carrier for the iPhone runs out in 2012,⁷ and its expiration represents an opportunity that could help Sprint.  It’s widely thought that the new scheme will let iPhone owners use Verizon, bowing to consumer demand for Verizon’s superior service.  Whether or not that happens—Apple has been known to be unpredictable in its supplier decisions—the result is likely to hurt AT&T and ultimately handicap the company in its run against Sprint.  And while it would be completely speculative to say that Sprint could become an iPhone carrier, Hesse’s public acknowledgement of the iPhone’s quality signals that it’s not outside the realm of possibility that Sprint could get in on the iPhone’s action if it can’t deploy a meaningful competitor.⁸

So while nothing is certain in investing, there’s a good case for giving the call to Sprint for those who can wait.

I may be contacted at comments@thougthsworththinking.net.

(Sprint shares had closed at $4.15 a share  when this post was originally published on the evening of May 12, 2010.)

Disclosure: The author does not hold a securities position in Sprint (S), Verizon (VZ), AT&T, or Apple (AAPL).

I remind readers that the information provided on this web site does not constitute professional investment advice, and should only be used in consonance with all available information, including the opinion of a professional adviser, to make an investment decision.

1. Will Park, “AT&T customers log the most dropped call complaints, Verizon claims fewest,” IntoMobile.com, May 5, 2010, http://www.intomobile.com/2010/05/05/att-customers-log-the-most-dropped-call-complaints-verizon-claims-least.html; Harry McCraken, “Verizon vs. Sprint vs. AT&T,” June 29, 2009, http://technologizer.com/2009/06/29/verizon-vs-sprint-vs-att/.
2. Niraj Strern, “Spring Nextel Adds Prepaid Cellphone Brand,”  Wall Street Journal, May 7, 2010, p. B5.
3. A classic Iaccoca ad for the Chrysler LeBaron can be viewed at http://www.youtube.com/watch?v=v6nmCFTmPnE&feature=related
4. The video can still be viewed at http://www.youtube.com/watch?v=NhJ7LXxShCc.
5. See this early Hesse ad, that says nothing about the Sprint network’s quality, at http://www.youtube.com/watch?v=ni-VeMEx6pA.
6. See a March 2010 Hesse ad at http://www.youtube.com/watch?v=ox4w02Xj2QE&feature=player_embedded.
7. Bard Dybwad, “AT&T has iPhone exclusivity until 2012,” cnn.com, May 11, 2010, http://www.cnn.com/2010/TECH/05/11/iphone.att.2012.mashable/index.html.
8. See Hesse’s praise of the iPhone and the Apple brand at http://www.youtube.com/watch?v=3aDspxhNtvQ.

I believe that at current price levels Barrick shares represent a good value.  There are reasonable arguments in support of gold’s long-term prospects, particularly because of potentially increased demand from emerging nations.  However, many of the medium-term risks to gold investing I outlined in November—that the Fed will eventually raise interests and that hyperinflationary fears are exaggerated—remain.  But Barrick’s faster than initially planned closing of its hedge book—contracts to sell gold that reduce exposure to the company if gold prices tank—has at least so far positioned Barrick to profit before that turbulence hits.  Supporting that thesis is that Barrick’s CEO Aaron Regent acknowledged back in November the prospect that gold could experience a sell off, though he did not see prices falling below $900/oz.¹  If Regent is running Barrick based on the same assumptions in his public statements, the decision to close the hedge book should yield healthy profits for Barrick if gold continues to hold above $1,000/oz.

Barrick, founded in 1980, only became the world’s leading gold producer in 2006 with its acquisition of Placer Dome.  Its practice of hedging against falls in the gold price goes way back in the company’s history,² so Barrick’s full profit potential with gold at $1,000 has not yet been proven to the market.  While spot gold has declined about 5% since its November 16-20 trading range, Barrick shares have fallen 27%, to some extent pricing in market fears that gold will fall.  I believe this differential provides a good opportunity for investors who want to round their portfolio with gold-related assets to buy into an equity that has potential to appreciate even if gold itself runs in place.

Disclosure:  The author is long on Barrick Gold (ABX) as of the original publication date of this post.

1. “UPDATE 1-Barrick chief says sell off in gold possible-FT,” Reuters, November 11, 2009, http://www.reuters.com/article/basicMaterialsSector/idUSSP46116320091112.
2. See “Barrick Gold,” Fundinguniverse.com, at http://www.fundinguniverse.com/company-histories/Barrick-Gold-Corporation-Company-History.html.

What does all this have to do with a uranium enrichment company headquartered in Bethesda, Maryland?

USEC (USU), the parent company of United States Enrichment Corporation, which came into being in its current form when the U.S. Government privatized its uranium enrichment operations in 1998, currently operates the only uranium enrichment plant in the United States in Paducah, Kentucky.   But it’s working on a next-generation facility in Piketon, Ohio.  In order to complete the Piketon facility, dubbed the “American Centrifuge Plant,” USEC needs money.  That’s where the politics comes in.

On July 27, 2009, the Department of Energy denied USEC’s longstanding loan application for the Ohio project.  Two days later, USEC CEO John Welsh wrote President Obama, quoting a September 2008 letter that then candidate Obama had apparently sent to Ohio Governor Ted Strickland promising support for the program:

Under my administration, energy programs that promote safe and environmentally-sound technologies and are domestically produced, such as the enrichment facility in Ohio, will have my full support. I will work with the Department of Energy to help make loan guarantees available for this and other advanced energy programs that reduce carbon dioxide emissions and break the tie to high cost, foreign energy sources.⁴

Welsh also pointed out in his letter that the American Centrifuge Plant will ultimately support about 8,000 jobs.⁵

Taking a step back to look at the big picture, nuclear energy in the United States may be on the cusp of a revival.  The need for environmentally friendly domestic energy sources, along with 1) technical advancements that make nuclear energy safer, and 2) the passage of time since the Three Mile Island (1979) and Chernobyl (1986) meltdowns, has opened the door for a wave of new nuclear power plants. ⁶  The last new plant in the U.S. began operation in 1996—it was already under construction in 1979 when the Three Mile Island incident vilified the industry—and the recent credit crunch has likely had some effect on the new projects.⁷   However, whether the current recession will dim the industry’s long-term prospects is far from certain.  There are currently a full slate of new construction applications pending before the U.S. Nuclear Regulatory Commission (NRC),⁸ and since anything in nuclear power construction seems to move at glacial speed several economic cycles may pass before most new U.S. plants go online anyway.

This new activity may also be spilling over to the enrichment side of the industry.  General Electric (GE) is operating a test facility using a laser-based technology in North Carolina that it hopes will eventually be a massive plant. ⁹  Urenco, which is jointly owned by the British and Dutch governments and German utilities, ¹⁰ is also building a centrifuge plant in New Mexico that should go into production soon. ¹¹

All this comes back to the politics surrounding USEC’s loan application.  When the application was originally denied, USEC issued a strongly worded statement saying that they would begin to demobilize the project. ¹²  An Energy Department press release followed a week later on August 4 reporting that the final decision on the application had been delayed, that “both DOE and USEC recognize that meeting these criteria will likely take six months or more,” and that $45 million in funding would be provided to USEC for eighteen months while the company worked to meet technical milestones to beef up its loan guarantee application. ¹³

There is no reason to doubt that the Department of Energy, headed by Nobel prize wining physicist Steven Chu, had legitimate cause to delay the application, and will only give it the go ahead if USEC gets its act together.  However, given the political stakes of denying the loan—which are further increased because Ohio Governor Strickland, a Democrat, faces a tough election in 2010—it’s also reasonable to expect that nothing will stop USEC from getting a fair shot to make its case.  Another aspect of the situation is that USEC’s chief competitor for the loan money is AREVA (ARVCY, AREVA IC),¹⁴, which is 93% owned by the government of France.¹⁵.  If USEC lost the loan to a foreign competitor, no less one backed by a foreign government, the political fallout could be even greater.

This is not to say that investing in USEC is a slam-dunk.  Much of what will happen is shrouded in the rarefied world of nuclear technology, and if USEC fails to meet the requirements for the loan it will be denied.  USEC’s credit rating has also taken a beating, and there are concerns that the Kentucky plant will not be profitable after its electrical contract expires in 2012. ¹⁶ But if USEC gets its act together there is every reason to believe they will get the loan guarantee, or something like it.  With the stock hovering around $4 a share ($4.07 as of market close on December 21), the risk that the company will falter has been priced in, and with 12.89% short interest (as of December 21) at the already depressed share price quite a few people have already bet on USEC’s demise.  But the political advantages on USEC’s side have not been fully appreciated by the market (see my posts on investing by arbitraging Wall Street’s misunderstanding of public policy), and if the company gets the financing its share price could jump as the shorts scramble to cover themselves.   The window formed by the timelines discussed in the Energy Department’s August 4 statement—six to eighteen months from then—opens on February 4, so those who want to ride the USEC train should board soon.

Disclosure:  The author is long on USEC (USU) and General Electric (GE) as of the original publication date of this post.  The author does not hold a securities position in AREVA.

1. See “Ohio’s Presidential Election History,” The Plain Dealer, http://www.cleveland.com/open/presidentialelections/.
2. See “Distribution of 2008 Electoral Votes, National Archives and Records Administration, http://www.archives.gov/federal-register/electoral-college/2008/allocation.html.
3. See 2008 Presidential Election:  Popular Vote Totals, National Archives and Records Administration, http://www.archives.gov/federal-register/electoral-college/2008/popular-vote.html.
4. Letter from John K. Welsh to President Barack Obama (hereinafter “Welsh Letter”, July 29, 2009, available at http://blogs.knoxnews.com/munger/obama.pdf
5. See Welsh Letter, available at http://blogs.knoxnews.com/munger/obama.pdf.
6. See Rebecca Smith, “The New Nukes,” Wall Street Journal, September 8, 2009, R1 & R3.
7. See Bernie Woodall & Scott DiSavino, “Economic Woes Delay U.S. Nuclear Power Expansion,” Reuters, March 17, 2009, http://www.reuters.com/article/idUSTRE52G4UF20090317.
8. See Combined License Applications for New Reactors, U.S. Nuclear Regulatory Commission, http://www.nrc.gov/reactors/new-reactors/col.html
9. See Jonathan Fahey, “Riches in Enrichment,” Forbes, November 16, 2009, p. 50 & 52.
10. See http://www.urenco.com/Content/3/Investors.aspx
11. See http://www.urenco.com/content/33/LES.aspx.
12. “Department of Energy Denies USEC’s Loan Guarantee Application, Company begins demobilization of American Centrifuge Plant,” USEC Press Release, July 28, 2009, http://www.usec.com/NewsRoom/NewsReleases/USECInc/2009/2009-07-28-Department-Of-Energy-Denies.htm.
13. Department of Energy and USEC Announce Decision to Delay USEC Loan Guarantee Application Final Review, Department of Energy Press Release, August 4, 2009, http://www.usec.com/NewsRoom/NewsReleases/USECInc/2009/2009-08-04-DOE-And-USEC-Announce.pdf.
14. “U.S. DOE Cancels Loan Guarantees for USEC Uranium Enrichment Plant,” OilandGasEurasia.com, July 29, 2009, http://www.oilandgaseurasia.com/news/p/0/news/5344/
15. Reuters, ANALYSIS-France faces tough choices on Areva T&D sale, Forbes, November 20, 2009, http://www.forbes.com/feeds/reuters/2009/11/20/2009-11-20T123044Z_01_LK630671_RTRIDST_0_AREVA-FRANCE-ANALYSIS.html.
16. See Associated Press, “Moody’s Downgrades USEC Ratings,” available at http://www.thestreet.com/story/10649787/1/moodys-downgrades-usec-ratings.html; Jonathan Fahey, “Riches in Enrichment,” Forbes, November 16, 2009, at p. 52.

While this experience (and my speculation that the man had just unearthed the gold from his yard) forever cemented my impression of gold as a safe-haven asset, other aspects of the situation are instructive regarding the current gold market.  The man was selling his gold at a price that was probably around $450 an ounce, and history showed that he was wise to do so.   Even with gold’s recent appreciation and the financial crisis crushing the stock market, large cap equities (going from Dow 2500 to 10,332 as of market close on November 19) have outperformed gold (about $450 to $1141 an ounce) by a large margin since 1987.  And that doesn’t even take into account that stocks can earn dividends, while holding gold can incur costs in the form of storage and/or insurance expenses.  (For that reason, other than for people who want to keep a stash of gold at home to prepare for the most extreme scenarios, I suggest that people who want to invest in gold consider equity-based investments like the dividend yielding shares of one of the established gold mining companies such as Barrick Gold (ABX), Newmont Mining (NEM) and Gold Fields Limited (GFI)).

The shorter term of the current decade paints a different picture.  Gold was in the high $200’s in 1999, and now stands over $1,100 an ounce, while the Dow crossed 10,000 for the first time in 1999, to where it has just about returned.  In this decade, with the 9/11 attacks in 2001 and the financial storm beginning last year, the United States has experienced the most significant challenges to its national and economic security in generations.  Given that gold is marketed as a hedge against events that disrupt other markets, there is a strong temptation to correlate its rise to the heightened risks of the current environment.  There may be some truth to this perceived causation, as reflected by reports of investors piling money into gold and other defensive assets as unemployment persists.  (If your family or a friend has been impacted by the unemployment situation, see my post on How to Help Your Unemployed Spouse Find a New Job After a Layoff.)  But it’s also possible that the relationship between these risk factors and the gold price is exaggerated.

This leads me to the main point of this post:  while there are long-term factors that will support gold prices regardless of where the U.S. economy goes, principally consumer demand in emerging nations, there are some significant short and medium term risks.

A combined 2.5 billion people live in China and India, over eight times the population of the United States (307 million).  But China and India are already the world’s two leading gold consumers, India being first, and both already have far more demand for gold jewelry than the United States. ¹  This means that while there is still lots room for China and India to develop more gold demand as large segments of their huge populations morph into a massive middle class, temporary reductions in their demand can move gold down.

Such downward pressure is particularly likely in the case of India, where people of modest means have traditionally preferred to put their savings in gold instead of banks, and the government has long sought to discourage gold hoarding to catalyze development of the banking system. ²  Currently in India, people who have purchased gold all along are selling it to profit from the high prices. ³  While gold buying typically picks up during the Indian wedding season that runs from October through December,⁴ once that’s over the downward pressure from Indian gold selling may resume.

Also, to the degree that the current financial turbulence is driving the gold market, there is a significant risk that the party will end.  At some point, the U.S. Federal Reserve will raise interest rates, making dollar denominated bank accounts more attractive to international investors, and creating pressure for the dollar to rise against other currencies and gold.  While deficit spending in the U.S. has created a concern for coming hyperinflation and further deterioration of the dollar, I have argued in a previous post that the current fear of hyperinflation is exaggerated because U.S. tax rates are still well below those of other nations with a triple-A credit rating.  These possibilities both provide potential catalysts for the gold price to eventually experience a correction, compounded by reduced demand when the Indian wedding season ends.

In comparison, the transformation of the Chinese and Indian populations into a broad consumer group with enough wealth to further support long-term gold appreciation is likely to take place on a longer and less predictable path than the recovery from the current recession.  What this means for investors is that now is not the time to bet big on gold or gold-related assets.  It’s good to diversify and having some gold-related holdings can be a good defensive position.  For those who don’t currently have assets tied to gold and have resources to invest, given the uncertainty of the current times it’s rational to start to gradually cultivate a gold related position in conjunction with building other investments.  But in my view those who assume that they’ll turn a big short-term profit at current gold price levels risk being disappointed.  The recent statement by Barrick Gold CEO Aaron Regent that gold could fall from current highs acknowledges that risk. ⁵  Those who are prepared to accumulate gold-related assets over time are more likely in my view to be able to capitalize on future dips and long-term appreciation.

Disclosure:  The author is long on Barrick Gold (ABX) as of the original publication date of this post.  The author does not hold a securities position in Newmont Mining (NEM) or Gold Fields Limited (GFI).

1. See “China’s Gold Demand Sparkles in Q2,” Chinamining.org, August 24, 2009, http://www.chinamining.org/News/2009-08-24/1251102403d28434.html.
2. R. Kannan & Sarat Dahl, Indian Journal of Economics and Business, India’s demand for gold: some issues for economic development and macroeconomic policy, June 2008, http://findarticles.com/p/articles/mi_m1TSD/is_1_7/ai_n28026379/?tag=content;col1, screens 1-3 & 8.
3. “India Buys Gold; Indians Don’t,” Goldnews, November 9, 2009, http://goldnews.bullionvault.com/india_gold_110920093.
4. “India gold demand abates after early week’s pick-up,” Reuters, October 30, 2009, http://in.reuters.com/article/businessNews/idINIndia-43556220091030;“Gold hits new high on weak dollar,” BBC News, November 9, 2009, http://news.bbc.co.uk/2/hi/business/8351154.stm.
5. “UPDATE 1-Barrick chief says sell off in gold possible-FT,” Reuters, November 11, 2009, http://www.reuters.com/article/basicMaterialsSector/idUSSP46116320091112.

Life is full of second chances, sometimes even in investing. In that connection, ING’s (ING) cumulative preferred shares plunged with the shares of the broader financial services community when the financial crisis reached its depths. ING’s 6.2 % perpetual debt securities issued in 2003 with a $25 a share denomination (ISP) reached a low of $3.20 a share this March. Since then ISP had gradually trended up again past $18, until it took a big fall back to the $11-$13 range in August. Other preferred shares originally issued with $25 denominations such as ING’s 7.05% perpetual debt securities (IND) and 8.5 % perpetual hybrid capital securities (IGK) followed the same trend at moderately higher price levels, falling respectively to $14-$15 and $16-$18. The issues yield dividends of 11.75% (ISP), 12.28% (IND), and 12.52% (IGK) at market closing for the week on September 4, 2009.

As far as I can tell, here’s what happened. On March 31, the European Commission (EC) issued a finding temporarily clearing the Dutch government to backup ING’s portfolio of Alt-A mortgages for 6 months.¹    Then, on July 22, the EC issued a paper entitled “The return to viability and the assessment of restructuring measures in the financial sector in the current crisis under the state aid rules.”² In this paper, the Commission stated:

[Page 7] In order to limit distortions of competition and address moral hazard, aid should be limited to the minimum necessary and an appropriate own contribution to restructuring costs should be provided by the aid beneficiary. The company and its capital holders should contribute to the restructuring as much as possible with their own resources. This is necessary to ensure that rescued banks bear adequate responsibility for the consequences of their past behaviour and to create appropriate incentives for their future behavior.

[Page 8] The banks should be able to remunerate capital, also in the form of dividends and coupons on outstanding subordinated debt, out of profits generated by their activities. However, banks should not use State aid to remunerate own funds (equity and subordinated debt) when those activities do not generate sufficient profits. Therefore, in a restructuring context, the discretionary offset of losses (for example by releasing reserves or reducing equity) by beneficiary banks in order to guarantee the payment of dividends and coupons on outstanding subordinated debt, is in principle not compatible with the objective of burden sharing.[Footnote 33] This may need to be balanced with ensuring the refinancing capability of the bank and the exit initiatives.[Footnote 34] In the interests of promoting refinancing by the beneficiary bank, the Commission may favourably regard the payment of coupons on newly issued hybrid capital instruments with greater seniority over existing subordinated debt. In any case, banks’ [sic] should not normally be allowed to purchase their own shares during the restructuring phase.

[Page 8] Footnote 33 provided: [citation to unpublished decision omitted] However, this does not prevent the bank from making coupon payments when it is under a binding obligation to do so.

[Page 8] Footnote 34 provided: See Impaired Asset Communication, point 31, and the nuanced approach to dividend restrictions in the Recapitalisation Communication, points 33, 34, and 45, reflecting that although temporary dividend or coupon bans may retain capital within the bank and increase the capital cushion and hence improve the solvency of the bank, they may equally impede the bank’s access to private finance sources, or at least increase the cost of new future financing.

Nothing in the text of the Commission’s paper itself is alarming. The idea of modifying capital structure to pay dividends while sustaining huge operating losses and receiving government aid to keep a financial institution afloat is basically a sham, and it’s no surprise that governments don’t like it. But as recognized by footnote 34, this strategy may be necessary for an institution to retain access to capital markets since once dividend or coupon payments on hybrid or debt instruments are suspended, its credit ratings crash.

As demonstrated by the CIT (CIT) experience on the eastern side of the Atlantic—where the company paid its preferred dividends after receiving $2.3 billion in TARP aid from the U.S. Government despite turning only one profitable quarter in two years—this strategy can be a disaster for investors when the company appears to lack a viable strategy to recover. But there has been no such indication that ING’s condition is anything close to CIT’s “on life support” predicament. ING recently reported a small profit of $.04 a depository share for the second quarter of 2009 following three quarters of losses concentrated in the 4^th quarter crisis epicenter. Even after the release of the EC’s communication, the prices of ING’s common and preferred shares continued to rise through early August.

What turned the tide was a decision on August 20 by credit ratings agencies Moody’s and Fitch to cut the ratings of ING’s hybrid debt. The decision was connected in particular to KBC, a Belgian bank, halting its payments of preferred dividends in response to the pressure of EC regulators, raising the possibility that ING would be forced to do the same.³

A comparison of KBC to ING may not be entirely fair. Having received its third bailout in May⁴, KBC’s case—at least form a public relations perspective—may be more akin to chronic/multiple bailout brethren Citigroup (C) and AIG (AIG). Also, ING appears to have a head start at raising capital by selling assets, as reflected by recent reports that its sale of its Swiss and Asian private banking assets is on track.⁵

I’ve argued that investors can make money by identifying an instance where Wall Street’s misunderstands public policy (see my post How to Make Money in Stock by Arbitraging Wall Street’s Misunderstanding of Public Policy), and this may be an instance of such an opportunity with a European flair. The policy standard articulated by the European Commission is rational on its face, and did not by own terms turn the market against ING’s preferred shares. Moreover, with KBC’s triple bailout status and the American experience of CIT paying preferred shareholders after receiving government aid and then begging for more fresh on regulators minds, it’s not surprising that the Commission pushed KBC to stop the payments.

With a an arguably less motley bailout history (a EUR 10 billion cash injection in October 2008 and a backup facility for Alt-A mortgages announced in January 2009),⁶  and asset sales proceeding at a respectable pace, the Commission may be reluctant to upset ING’s applecart. So there’s a good argument that the credit agencies and market have overestimated the risk that ING will suspend the payments.

But it’s not inconceivable that the credit agencies will be right, and the Royal Bank Of Scotland’s decision not to call $1.6 billion of subordinated bonds because of regulators’ objections may reflect an acceleration of this trend.⁷ If they are and the dividends are suspended, the stock price will probably go down more, though it’s possible that most of the decline from halting the dividends is already priced in.

Trying to figure out what the regulators will do is guesswork. What seems far more predictable, however, is that ING will recover, so that the share prices will eventually trend back up towards their $25 par value. Either ING will pay preferred dividends without interruption, or it will halt them if the Commission presses the issue and pay up later—including the missed payments with interest for the cumulative preferreds.⁸ If these scenarios play out, patient investors who buy now will likely make money down the line, though possibly with a short-term decline if the dividends are deferred. Another strategy is to hold out to see if they defer the dividends, but if they don’t the share price may jump and the opportunity will be lost. A middle of the road option would be to decide the maximum to invest, put half in now, and put the other half in later if the stock price goes down due to dividends being suspended.

My own sentiment is that one of the two above scenarios will happen. ING is a conglomeration of traditional European and modern mass-marketed financial services that has returned to profitability and is not likely to go under. Its on-line banking platform, ING Direct, has become a mature on-line financial services operation that is effectively marketed with a contemporary orange ball alongside ING’s venerable orange lion.⁹ ING has recently deployed its captivating “find your number” campaign to draw consumers into its retirement oriented financial services.

There are arguments that ING’s earning prospects have been abridged by deleveraging. But even if true those theories are a far cry from establishing that ING will not be a stable and profitable concern. Remember, we’re talking about preferred stocks that pay a fixed dividend—and are required to do so if any dividend is paid on common shares—not common shares that will respond to the potential for higher dividends. The idea is to establish that the business is stable for the long term to get the share price back to par and keep the dividends coming.

Interested? Investing in preferred shares is a complicated business that can depend on the terms of the individual issue, so you’ll want to take a close look. Fortunately, the prospectuses for ING preferred issues are accessible on-line on ING’s web page at http://www.ing.com/group/showdoc.jsp?docid=075252_EN&menopt=ivr%7Cfis.

Disclosure: The author is long on ING ADR’s (ING), ING 6.2 % preferred perpetual securities (ISP), and CIT preferred Series A (CIT.PR.A) as of the original publication date of this post. The author does not hold a securities position in CIT common shares or in any issue of KBC Group (KBCSY).

1. “State aid: Commission temporarily authorizes illiquid asset facility for ING, March 31, 2009, at http://docs.google.com/gview?a=v&q=cache:USBKvXaGGvkJ:europa.eu/rapid/pressReleasesAction.do%3Freference%3DIP/09/514%26format%3DPDF%26aged%3D0%26language%3DEN%26guiLanguage%3Den+ing+european+commission+burden+shairing&hl=en&gl=us
2. Commission Communication: The return to viability and the assessment of restructuring measures in the financial sector in the current crisis under the State aid rules, July 22, 2009, at http://docs.google.com/gviewa=v&q=cache:pgxQ41T8Ie8J:ec.europa.eu/competition/state_aid/legislation/restructuring_paper_en.pdf+July+European+commission+bank+restrucrturing+burden+sharing&hl=en&gl=us .
3. “Fitch cuts European bank hybrid debt ratings,” Reuters UK, August 20, 2009, at http://uk.reuters.com/article/idUKN2042464020090820.
4. “Belgium Moves onto Crisis Mode on KBC Bailout,” The Wall Street Journal, May 15, 2009, http://online.wsj.com/article/SB124225248484816987.html
5. See “UPDATE: HSBC Bids for ING Private Banking Asserts-Source,” The Wall Street Journal, September 4, 2009, at http://online.wsj.com/article/BT-CO-20090904-704808.html.
6. “Transactions with Dutch State,” at http://www.ing.com/group/showdoc.jsp?docid=363620_EN&menopt=ivr|tdt&menopt=ivr|tdt
7. “RBS Told Not to Call Subordinated Bonds After Bailout,” Bloomberg.com, September 4, 2009, http://www.bloomberg.com/apps/news?pid=20601087&sid=afiEP8f7OhaA.”
8. Investors should review the prospectuses to fully understand the conditions concerning the payment of cumulative interest, including extraordinary situations where cumulative interest or payments would not be made.
9. See “The history of the ING Lion,” at http://www.ing.com/group/showdoc.jsp?docid=168408_EN&menopt=abo%7Chis%7Chil.

Do you believe that Asian economies like China and India will lead the economic recovery, and you’re looking for a way to make money from that? Take a look at Diana Shipping (DSX).

At current prices, Diana is about significant upside and limited downside. The shipping industry, which is characterized by incredible volatility, is facing two countervailing forces. On one hand, there is excess construction of new ships dating from the pre-crisis market high. During this period, the Baltic Dry Index (BDI), which measures the price of shipping dry bulk commodities (the service that Diana provides), hit a high of 11,793 points in May 2008. The BDI hit a low of 663 points in December 2008, a 94% drop,¹ and has now come to a low intermediate point of 2,468 as of August 21. Although new ship orders have nearly disappeared and there is some pressure to cancel existing projects, the shipbuilding industry has been sustained by existing orders through the financial crisis, including an effort by the Chinese to beef up the size of their own mercantile fleet.²  This suggests an oversupply of ships and lower shipping rates down the road.

The countermanding trend, however, is that aside from the lengthy process of completing these ships in the current environment, there are financial obstacles to getting them in the water to move goods, and incentives to not do so. The first is financing. Shipping was hammered by the crash in shipping prices during the crisis, and shipping banks are not well positioned to write loans.³ When the shippers do buy, the need for cash flow will press them to deploy the ships as soon as possible regardless of how low the price.

The second is that because of how the shipping sectors work, shipyards and ship owners have a mutual incentive to delay the completion of pending orders. Even though contracts may be in place, the yards are motivated to work with the owners to delay delivery because they don’t generally want to keep the ships. While shipyards do sometimes become ship owners, providing unwelcome competition to the traditional owners—and there is evidence that is presently happening in some quarters—that kind of conglomerate structure ultimately dilutes profit. Ship owners make money from effectively managing their risks as shipping fees go up and down, trying to make the best decisions on when to lock their ships into contracts and when to purchase new ships to meet future demand. Shipbuilding is more focused on steadier margins, getting the best contract price to produce a ship and then constructing it to specifications. Combining the two deprives the shipyard of its basic and arguably most predictable opportunity for profit, a good contract price for a ship, because the ship will be sailing on the yard’s own account.⁴ Diana is keenly aware of this backdrop.⁵

Sailing above all this, Diana built a fleet that is lean, new, and was largely booked when the bottom fell out of the market.⁶ Its debt/equity and debt/asset ratios, 0.23 and 0.17 respectively, are stunningly low compared to peers Genco Shipping (GNK) (1.49 and 0.59), DryShips (DRYS) (1.12 and 0.47), and Navios Maritime (NM) (1.41 and 0.49). Now with a bundle of cash from a well-timed equity offering in May that raised $218 million at $16.67 a share, Diana can afford to buy ships meeting its exacting specifications at fire sale prices, all while it continues to profitably function.⁷

Of course a big unknown is what will happen in Asia. Commentators tend to focus on certain big commodities and customers, like iron ore and coal ordered by China, as driving the train since that’s what they’re familiar with. My own sentiment is that this focus tends to overlook all the other possibilities for increased demand in this wildly developing region—whether it be aluminum for new car industries, cement for new construction, or grain for expanding economies shifting from agriculture to manufacturing—so that the potential for the market being surprised to the upside at some point is high.

Finally, as well run as the company is, I would not view Diana as the best stock to hold for the long term without watching it. The lows in shipping are low, and investors may want to trim holdings after a big rise before the next downturn. That being said, we are now far enough along to see who in the dry bulk sector is best positioned to make money when the East shifts back into high gear. The case for Diana is strong, and those who jump on board now in the $12-$13 range ($13.36 at close on August 21) will likely be able to make an attractive profit.

(Note:  The author is long on Diana Shipping as of the original publication date of this post.  The author does not hold a securities position in Genco Shipping, DryShips, or Navios Maritime.)

1. “Baltic Dry Index,” from Wikipedia, July 30, 2009 at http://en.wikipedia.org/w/index.php?title=Special:Cite&page=Baltic_Dry_Index&id=305084682
2. See public download of the China Research and Intelligence (CRI) Report, “Report of Chinese Shipbuilding Industry under the International Financial Crisis,” March 16, 2009, http://www.shcri.com/reportdetail.asp?id=252. See also OECD, “Fall in shipbuilding set to continue for some time, says OECD Council Working Party on Shipbuilding,” July 17, 2009, at http://www.oecd.org/document/16/0,3343,en_2649_34211_43319760_1_1_1_37461,00.html.
3. See Diana Shipping Q1 2009 Transcript (August 6, 2009), p. 5, May 6, 2009, http://seekingalpha.com/article/135800-diana-shipping-inc-q1-2009-earnings-call-transcript?page=5.
4. The Rise of “Shipbuilder Owner,” World Yards, June 8, 2009, at http://download.hellenicshippingnews.com/pdf/worldyards/47138-The%20Rise%20of%20Shipbuilder%20Owner.pdf.
5. See Diana Shipping Q2 2009 Transcript (August 6, 2009), p. 4, http://seekingalpha.com/article/154452-diana-shipping-inc-q2-2009-earnings-call-transcript?page=4.
6. See “Diana Shipping” at Wikinvest, June 30, 2009, at http://www.wikinvest.com/stock/Diana_Shipping_(DSX)?oldid=420589&timestamp=20090630050644.
7. See Diana Shipping Q2 2009 Transcript (August 6, 2009), at http://seekingalpha.com/article/154452-diana-shipping-inc-q2-2009-earnings-call-transcript.