Dividends Dry Up

Even though motorists are happy with lower gas prices, investors in oil and natural gas companies are feeling pinched away from the pump as $7.4 billion in dividends have dried up. For example, Anadarko Petroleum reduced its dividend by 81 percent and Kinder Morgan and Devon Energy both reduced dividends by 75 percent. Kinder Morgan was the largest dividend cut in terms of dollars ($3.44 billion), followed by ConocoPhillips ($2.42 billion). Chevron has chosen another alternative as it is reduced its capital spending and is considering increasing its debt to maintain the company's dividend. The steep decline in energy prices has also hit capital budgeting as oil and gas companies have resulted in the cancellation of more than $100 billion in new projects.

Cat Bonds

Historically, cat bonds have been issued by insurers or reinsurers to cover major losses. For example, a cat bond could have a trigger if the insurance company had to pay more than $2 billion in claims dues to a hurricane. However, many companies are finding that insurance companies are unwilling to cover major risks, or are charging a large premium to do so. As a result, corporations are seeking to insure losses directly with capital markets rather than through an insurance company. For example, Amtrak just issued $275 million in cat bonds that cover damage to its Northeast corridor infrastructure due to storm surges, wind damage, or earthquakes. And, last year, Kaiser Permanente issued $300 million in cat bonds to cover earthquake risk.

Activist Investing Increases

Activist investing has been on the rise in recent years. According to CFO, FactSet reported 355 activist campaigns in 2015, with 127 resulting in at least one board seat, while Ernst & Young reported 516 activist encounters. However, today's activist investors seem to be more collaborative than corporate raiders of the past. Importantly, the rise in activist investors appears to have lead to increased conversations between management and investors, which is a positive result. In fact, clear conversations between management and investors can head off confrontations as management may have information that shows an action desired by investors is a bad idea. While activist investing does not seem to be slowing any time soon, it does appear that in many cases, it has resulted in management becoming more focused on company performance and becoming more transparent.

Junk Bond Defaults Rise in 2016?

Moody's Investor Services expects default rates on junk bonds to increase to 4 percent this year, up from the 3.5 percent default rate in 2015. The default rate for all bonds is expected to be 2.1 percent for 2015. Low commodity prices, widening yield spreads, and potential interest rate increases by the Federal Reserve are reasons given by Moody's. During 2015, there were 109 corporate defaults, totaling $97.9 billion.

Valuation Models Go Up In Smoke

Students often ask us how stocks are valued in the "real world." While analysts go into more depth than we do in this textbook, commonly used models are PE ratios, EV/EBITDA ratios, and free cash flow models, which we have discussed. However, in some cases, these valuation models go up in smoke. Take a look at Cannabis Sativa (CBDS), which is trading at just under $2 per share and has a market cap of about $31 million. The company has had negative earnings for the past three years, but more importantly, had revenues of $8,000 through the first 9 months of 2015 and $7,000 in 2014! Since the company has had no earnings, the PE ratio is not reported, but the PS ratio is almost 2,000. All-in-all, CBDS is priced at an extremely high growth rate.

Warren Buffett Vs. GAAP

A basic purpose behind accounting procedures, including GAAP, is to standardize financial statements. However, many companies are currently pushing non-GAAP earnings, which can exclude a number of non-recurring items. The write-down of an asset or restructuring are common non-recurring items. Another major item than can cause a big difference between GAAP and non-GAAP earnings is stock-based compensation, often in the form of employee stock options or restricted stock. As Warren Buffett argues: "If compensation isn't an expense, what is?"  We would advise you to learn about accounting, not only because a lot about a company from reading its financial statements, as Buffett warns "Accounting tells you a lot and it can be used in many ways to deceive."

Correlations They Are A Changin'

From what you have learned about what is often referred to as Modern Portfolio Theory (MPT), a diversified portfolio can significantly lower the risk of your investment. To create a diversified portfolio, you should choose assets with low correlations (covariances). However, this can be more difficult than it seems. A recent article on Bloomberg discusses how correlations between various asset classes have changed over time. For example, if you look at the 1988 to 1997 period, the correlation between the S&P 500 and the S&P GCSI Total Return Index, which measures the return on a broad class of commodities, you would find the correlation between these two asset classes was –.20, a very low correlation that would provide substantial diversification benefits. However, in the past 10 years, the correlation between these two asset classes has increased to .50, which would only provide moderate, if any, diversification benefits. We agree with the author's conclusion that even with a high correlation, owning a greater variety of assets is safer than owning only a few assets.  However, we would like to extend this conclusion and state that you should rebalance your portfolio based on the changing correlations.