On Sunday evening Rich Kinder, CEO of Kinder Morgan Inc (KMI) announced the transaction that many had been expecting as a response to the persistently low price of Kinder Morgan Partners (KMP) and El Paso (EPB), two MLPs in which KMI owns the General Partner (GP). The problem was that Kinder expects an increasing amount of M&A activity in the energy infrastructure space they inhabit, and his ability to participate has been greatly hampered by the high distribution yields on KMP and EPB. Their high yields (i.e. low prices) make them an expensive source of capital should he wish to acquire any assets by issuing new securities to the seller. He’s long complained that the market didn’t fully recognize the value in the Kinder Morgan complex.

The deal greatly simplifies Kinder’s structure in that four existing public equity securities will be collapsed into one. The drag of Incentive Distribution Rights (IDRs), which direct half of the distributable cashflows to the GP, will be gone and the new KMI will offer a higher dividend and faster growth than the old one. Much has already been written about the transaction. What hasn’t received much attention is the tax issue.

Because KMI is acquiring assets at above their carrying value, they’ll be able to use the new, higher purchase price as their cost basis for taxes. This is quite different than when one corporation buys another. If A buys B for $100 and B’s equity value is $70, A holds $70 of assets and $30 of goodwill. You can’t do much with goodwill. You can’t depreciate it; you can’t write it off against taxes and from time to time you have to test it for impairment. You certainly can’t borrow against it. Many businesses are worth more than their book value equity, which is why goodwill as a concept exists in the course of an acquisition. But the accounting definition of goodwill plays no role in this transaction.

Because Master Limited Partnerships (MLPs) are pass-through vehicles, the LP unitholders own a direct, proportionate share of the underlying assets (rather than shares in a corporation which in turn own the assets). If KMI was acquiring another corporation, they’d wind up with an asset of goodwill equal to the difference between the purchase price and the book value of the acquired company.

Because KMI is buying the underlying energy infrastructure assets directly (since MLPs are pass-through vehicles) the newly acquired assets go on KMI’s balance sheet at the new purchase price. It means they can be depreciated from this new higher value, and depreciation is tax-deductible. KMI used to benefit from depreciation of these assets before the transaction, but only from their lower, original purchase price. And over time the difference between depreciated value and actual value grows, since many pipelines increase in value. For example, Williams Companies (WMB) owns a pipeline network that runs down the east coast from NY to Texas called Transco. On an investor call recently a WMB executive commented that they had once tried to estimate what it would cost to build Transco today if it didn’t already exist, and had come up with a number of $100 billion. To put this in perspective, WMB’s entire enterprise value is $58 billion. It doesn’t mean Transco is worth $100 billion, but it illustrates that easements with perpetual ownership are much harder to replicate in today’s America of 310 million people than they were 30 or 50 years ago.

KMI’s tax savings through the higher depreciation afforded through a higher asset value is worth, they estimate, $20 billion. This is an important source of the higher dividend and the faster, 10% annual dividend growth they now forecast.

Meanwhile, taxes work in a different way for KMP and EPB unitholders. MLP investors pay less tax today on distributions than if the same cash was a dividend, but owe the tax not paid when they eventually sell the MLP. Some investors hold their MLPs for a long time, and maybe even until death (when their heirs are not liable for the taxes). As an MLP investor you’re trying to put off paying taxes as long as possible. The Kinder Morgan transaction is a taxable event for the KMP and EPB unitholders. KMI estimates that the typical KMP unitholder will owe from $13.81 to $18.16 per KMP unit owned, depending on the closing price of the transaction later this year.  That’s more than the cash component of the deal and makes it substantially less attractive for some unitholders (the longer you’ve been an investor the worse off you are). Even if you assume that the taxes would have been paid in 10 years (and assume a 10% return on the money* that would have been invested in KMP but now has to go to the IRS) it still eats up $8.49 to $11.16 of value.

So although the deal was priced at a 12% premium to Friday’s close (in the case of KMP) or a 15.4% premium (in the case of EPB), the impact of having to pay taxes now rather than later gets the typical KMP investor roughly back to where they were with no transaction. KMI though has better prospects, in part due to the tax savings from higher depreciation.

It’s not always appreciated how much control GPs have over their MLPs. Although KMP’s high dividend yield represented a high cost of equity, this never actually precluded them making new acquisitions. The GP, KMI, could have directed KMP to raise capital at a cost above the return on the assets acquired which, while it would have diluted the LP’s returns would still have been good for KMI which would have shared in 50% of the increased DCF without having to put up any extra capital. A GP who so wished could exploit the LPs in his MLP by issuing equity to make acquisitions no matter how bad it was for the LP unitholders because the GP would still get its IDR-based share of the additional cashflows.

So while the transaction may look slightly less attractive to LP unitholders once taxes are considered, they could have received far worse treatment from an unscrupulous GP. Rich Kinder is not like that.

So the lesson here is, to invest alongside the people who run the businesses, which is in the GP. Rich Kinder’s a taxpayer and you can be sure that he gave careful consideration to what his own tax outcome would be. This is why we’ve long been owners of KMI, but had avoided KMP, EPB and indeed most other MLPs where a GP has a claim on the cashflows. If you invest in the GP at least your tax situation will receive more careful consideration from the billionaire alongside whom you’re investing.

*There is a theoretical case for using the investor’s borrowing cost to discount the tax liability. This results in a lower set of numbers and makes the tax analysis less adverse for the KMP unitholder.

Barron’s has one of their by now regular articles on MLPs this weekend as they interview their “MLP Roundtable”. These write-ups are invariably constructive, and the most recent one is no exception. As well as noting the many opportunities offered to build out infrastructure in support of America’s shale boom, General Partners (GPs) received a mention. Roundtable member Douglas Rachlin of Neuberger Berman pointed out that, “GPs are not required to contribute capital to the organic-growth projects or acquisitions their MLPs make; yet they benefit in a disproportionate manner through their ownership of distribution rights.”

Becca Followill of U.S. Capital Advisors added, “Some MLPs don’t have a general partner, which makes them easier to take out and can make a deal more accretive more quickly.”

These are both features of MLPs that we’ve long identified and reflected in our own MLP strategy.

Quite a few names reported quarterly earnings last week. The numbers were generally good and MLPs are overwhelmingly reporting increases in future capital investment which for GPs at a minimum assures continued growth in distributed cashflow received and therefore in dividends paid. But not everything was good. Buckeye Partners (BPL) issued a surprisingly disappointing report which included losses in their Merchant Services division. We’re investors in BPL and have been for years.

The most attractive businesses for MLPs are fee-based whereby they earn recurring income from storage and pipeline assets. BPL largely does this, but like a handful of other MLPs they also have a marketing division which incurs basis risk on its underlying products on behalf of customers, often in exchange for quite narrow margins.

These activities can be quite tricky to manage. MLPs face a principal-agent problem here, in that their desire is to generate a return through using their inside knowledge and control of product to charge more than the cost of the basis risk incurred. However, there is inevitably judgment involved, and while the MLP wants to exploit an additional element of its franchise, if not properly managed the traders involved will seek to make money from the risk taking side of this. In fact, risk-averse basis trading maximizes the firm’s franchise value and minimizes the value added of the trader. The trader’s incentive can therefore be to minimize the apparent value of the franchise so as to maximize the apparent value of his skill-based activities. It can lead to excessive risk-taking, since profits from properly exploiting the MLP’s position in the middle of all kinds of information about supply and demand can appear to value the trader less than trading profits generated through his own skill/judgment.

It’s not only banks that can get themselves into trouble with risk. And in BPL’s case, it appears that a poorly constructed hedging strategy went wrong during the 2Q, causing the Merchant Services unit to swing to an operating loss.

Positions were liquidated, people fired and a more modest business model adopted. But it shows that unwelcome surprises can come from units that appear to offer steady if unspectacular returns, if the principal-agent conflict described isn’t carefully managed.

Unlisted registered REITs (Real Estate Investment Trusts) have a well deserved reputation for enriching their sponsors more readily than their investors. A recent case in point is Strategic Realty Trust, Inc. (formerly TNP Strategic Realty Trust, Inc.), a REIT once run by Tony Thompson (who recently closed his broker-dealer and handed in his securities license). Although Strategic Realty raised around $100MM equity in 2009, directly following the financial crisis and seemingly a good time to buy almost anything, they’ve managed to lose their investors’ money. It’s not that the properties they bought didn’t appreciate, but that appreciation was more than wiped out by fees.

One of the selling points of untraded REITs is that they don’t experience the volatility associated with listed products. Somehow the absence of a public market and the ability to exit your investment is supposed to be a good thing in the minds of those who push such things. It doesn’t mean that the assets aren’t changing in value of course, simply that investors don’t know it from the company’s financial statements.

Strategic Realty recently announced its NAV had dropped from $10 to $7.11. Adding insult to injury, its by now former CEO had sold his holdings to an affiliate for $8 earlier this year.

Transaction costs, offering fees and organization costs on Strategic Realty added up to over 27% of investors’ capital, substantially accounting for the losses suffered by investors. Underwriting fees of 10% and more are common in this sector. Since there’s no index on unlisted registered REITs there’s really no coherent basis on which to make an allocation to the asset class at all. And although Strategic Realty pays an annual dividend of 24 cents, its operations don’t generate enough income to fund this so it’s in effect a partial return of investor’s capital rather than a result of profitable operations. Still, it looks like about the only way to get any of your money out of this company.

Meanwhile, the Financial Industry Regulatory Authority (FINRA) filed a complaint against former CEO Tony Thompson last year alleging fraud on a related transaction.

Investors should be warned – any broker-dealer recommending such an investment may well be placing his interests in high fees ahead of the client’s desire to earn a fair return.

IBM must be one of the least liked large cap stocks around. The criticisms are easy and familiar: they haven’t grown revenues in years, they are involved in financial engineering to prop up earnings, they are taking on lots of debt to support cashflows. Recently, Barron’s Roundtable noted that Fred Hickey had IBM as a short recommendation.

It’s true IBM has been a poor performer against the S&P500 over the past year. However, it has less volatility than the market with a trailing Beta of 0.66 so all other things being equal you would expect it to lag somewhat when prices are rising. And it’s true that revenue growth for years has been non-existent, hovering frustratingly around the $100BN annual level. However, earnings have grown nicely over the past ten years aided by improving margins and a reduced share count. So although revenues are flat since 2004, over that time EPS has more than tripled from $4.93 to an estimated $17.90 consensus forecast. The sharecount has dropped from 1.7 billion to around 1 billion as they relentlessly return cash to shareholders through buybacks.

As for debt, it’s true that it’s risen although IBM is hardly a leveraged company. They’re expected to finish the year with $48BN of long term obligations less Cash of $17BN for $31 BN of net debt, supporting pre-tax operating income of $21BN. This hardly seems like reckless leverage. Meanwhile, they still look to be on track to hit their target of $20 in operating EPS next year. At $194 a share it just doesn’t seem ridiculously expensive.

As for innovation, in 2013 IBM inventors received 6,809 patents, the 21st consecutive year of being the most prolific recipient of such awards.

So IBM isn’t that exciting on a daily basis, but it does look like a fairly compelling place to invest some of your money if you’re not one of those people who requires daily gratification on your stock picks. Fred Hickey’s price objective on his short IBM was $150 in the abovementioned article. At the time of his interview it was trading at $182 but has since risen $12, over a third of Hickey’s sought after gain. Shorting isn’t easy, and don’t imagine we’re claiming victory because we still own IBM and anything can happen. But there must be better ways to make money than trying to short IBM. They just keep generating cash, $18.1 BN in Cash from Operations (less change in Financing receivables) over the past 12 months, or about $18 per share.

For excitement, watch Amazon (AMZN) as they continue to break records for the most inefficient converter of revenues into profits. In ten years sales have increased sevenfold while EPS has halved. In their most recent quarter over $19BN in revenues, up 23% year on year, generated a small operating loss. The best investment you can make in Amazon is to sign up for Amazon Prime. Being a customer is far more likely to be satisfying than being an owner.

In reading the July/August edition of the CFA Institute’s magazine, an article called “Fragile Trust” by Susan Trammell caught my attention. There’s no doubt that popular confidence in financial services firms was sorely shaken by the 2008 crisis. But it’s still sobering to consider the results of a 2013 survey by Edelman Trust  showing that only 46% of respondents expect financial services firms to do the right thing, dead last out of 18 industries considered.

A survey by the Economist Intelligence Unit last year asked financial services executives about the benefits of improving ethical conduct at their firms, and the most popular choice was that it would improve their ability to “withstand unexpected and dramatic risks”. People who work in Finance recognize the value of high ethical standards, and yet the public doesn’t perceive that the industry operates in this way.

Part of it relates to confusion or simply misunderstanding of the difference between brokers-dealers versus investment advisors, or “sell-side” versus “buy-side” in Wall Street parlance. And indeed, why should non-institutional investors even need to know the difference? The structure of  U.S. financial regulatory oversight need not be a concern of those outside it. Most investors simply want to invest their money through people whom they can trust. And while that does qualify a pretty healthy majority of finance professionals, the lower standard applied to broker-dealers (sell-side firms) versus investment advisors (buy-side) can expose unwitting investors to abuse.

Broker-dealers don’t have a fiduciary obligation to their clients, simply a requirement to meet a lower standard of suitability and disclosure. Their clients are regarded as being responsible for their own decisions, so while a broker can offer advice (“I think this is a good investment”) he’s not under the fiduciary obligation of an advisor to put the client’s interests before his own.

Many investors find this subtle distinction meaningless or are unaware of it. But it’s what enables, for example, unlisted registered REITs (Real Estate Investment Trusts) to be sold to clients in spite of underwriting fees that can reach 15% of the invested amount. I wrote about just such an example, of Inland American Realty and its underwriter Ameriprise, last year. The fees were in the prospectus so deemed to be disclosed, although it’s expecting a lot to think people will wade through 100+ pages of a legal document. And the regulators were not totally absent as subsequently Massachusetts settled civil claims with Ameriprise on just this security, complaining of high fees and conflicts of interest. The conflict of course comes from the fact that the broker recommending (i.e. selling) the security to their client is receiving the egregious underwriting fees. A fiduciary standard would disallow such a transaction. Such applies to investment advisors but not to broker-dealers.

It seems to me that for the financial services industry to raise itself from being 18th out of 18 industries in surveys of public trust, more and more individuals will need to willingly behave as if the fiduciary standard applies to them even if it does not. Every profession needs to retain the trust of its clients, and Finance needs to as much as any other. The CFA Institute’s Future of Finance Initiative is a good place to start, and professionals on both the sell-side as well as the buy-side can choose to conform to its principles voluntarily. Many already do – the rest ought to.

If you didn’t have the data, you might reasonably assume that any fund manager worth his salt was heavily invested in his own fund. This ought to apply to an overwhelming percentage of all the actively managed funds out there. In fact, as a recent article in Barron’s points out, it’s the exception rather than the rule. Using data from Morningstar, they find that almost half the funds tracked were led by a manager with no money invested at all. This sorry bunch may think they’re good, and their marketing materials presumably make the case, but by investing their own money elsewhere they tell you what they really think.

And of the 7,700 funds tracked by Morningstar, only 910 had a personal investment by the manager of at least $1 million. This isn’t a high hurdle; less than this threshold either means the manager doesn’t have $1 million to invest, a paucity of personal resources that should give any potential client pause, or chooses not to.

It’s not just that it feels right to know your manager is invested alongside you. For the client, this is the only way to ensure alignment of interests and protect themselves from the principal-agent problem so prevalent in finance. If you’re a fund manager only managing OPM (Other People’s Money), your compensation is fully linked to the size of the fund you manage. The most reliable way to grow your fund is to outperform your competition. A seductively simple way to outperform is to take more risk than the others. Because if you take more risk in a rising market, you will assuredly do better than most and money, which chases performance, will follow. If the market goes down and you underperform, you haven’t lost much because it’s only your clients that suffer the returns. And if performance is really bad, you can always start a different fund.

The money manager who’s invested elsewhere has a free option at the expense of his clients. He has far more to gain from outperforming than he has to lose from underperforming. For the investors, their risk is linear. Bad returns hurt, and good returns help.

The analysis of the Morningstar data supports other research which shows that active managers in aggregate take more risk than the overall market. They are biased towards stocks with more volatility than average, and as a consequence their actions underpin the Low Beta Anomaly, the tendency of low volatility stocks to outperform over the long run. This is because high volatility stocks draw more demand from active managers which raises their prices, thereby depressing future returns. An active manager owning low volatility stocks is failing to exploit the optionality that his role as agent provides at the expense of the principal (i.e. client). It’s one of the reasons we like low volatility stocks – because although they’re widely owned, they’re not widely owned by active managers. And we think that active managers under-invested in their own funds are likely to continue exploiting their advantage which will cause the low volatility bias to persist.

For the investor, it’s not a bad rule to simply eliminate from consideration any investment manager not personally and significantly invested in his own strategy. It makes intuitive sense but it also provides for an alignment of interests. Don’t let the uninvested take advantage of you.

Recently the Financial Times (FT) noted that the number of U.S. companies raising their dividends had hit the highest level since 1979. Much research has been done on the merits of companies that pay out a large percentage of their profits in dividends (high payout ratio) and those that retain most of their earnings so as to reinvest in their business. Payout ratios have been falling steadily for decades and currently the FT notes that S&P500 companies pay out only 36% of their profits. However, share buybacks have increased over that period so one can’t conclude that the total cash returned to shareholders as a percentage of profits has fallen.

Buybacks are a more efficient way of returning cash because they create a return (through a reduced share count and therefore a higher stock price) without forcing each investor to pay tax on the cash distributed (as is the case with a dividend). Theoretically, publicly listed companies need never issue dividends since any shareholder desiring, say, a 2.5% dividend can always sell 2.5% of his holdings.

One might think that companies with low payout ratios are retaining more of their earnings so as to invest in the high return opportunities they see in their business. This ought to lead to faster dividend growth in the future as the projects provide their payoff. I’m currently reading Successful Investing is a Process by Jacques Lussier, PhD, CFA. The author kindly sent me a copy as I’ll be speaking at a CFA event in Montreal he’s organizing later this year. Mr. Lussier notes some interesting research by Arnott and Asness in 2003 that sought to compare low dividend payout ratios with faster subsequent growth.

In fact, they found just the opposite, that low dividends don’t lead to higher dividends later on. In too many cases it seems that managements are overly optimistic about the opportunities to deploy capital either internally or on acquisitions. And in fact this is the real power of stable dividends with a high payout ratio. Rather than suggesting the company has few interesting projects and therefore nothing better to do than return capital to owners, it imposes a level of capital discipline on management that ultimately leads to higher returns. Companies that return more cash to shareholders have less to squander on ill-judged investments, and the shareholders ultimately benefit.

Incidentally, Master Limited Partnerships (MLPs) represent an extreme case of this. Since they routinely distribute around 90% of eligible cashflows they have very little retained earnings and therefore have to raise new debt and equity capital for any project. This imposes a wonderful discipline on MLP managements in that they’re always having to explain to underwriters and investors what exactly they’re planning to do with the proceeds of a debt or equity offering. It’s one of the reasons MLPs have had such consistently strong performance; so many of their management really focus on return on capital.

It’s all part of the Low Beta Anomaly, the concept that low volatility (or low Beta) stocks outperform on a risk-adjusted basis and even on a nominal basis. So far this year the returns to low volatility investing have been good (for example, the S&P500 Low Volatility ETF, SPLV, is +8.6% through June) as many of the high-flying momentum names crashed during the first quarter. Slow and steady dividends with growth may not appear that exciting, but boring is often better where you’re money’s concerned.

Denis Kessler, CEO of Scor, a large reinsurer, is the most recent critic of today’s low interest rate environment. It’s not only the stereotypical retiree clipping bond coupons that is suffering from current interest rate policy. Insurance companies typically hold substantial amounts of their investment portfolios in bonds, both because of regulatory requirements as well as the need to respond to claims whose timing is often unpredictable. Kessler claimed that central banks were “ruining” the insurance industry, and claimed that insurers were the unwitting victims of the aftermath of the financial crisis even though they didn’t create it (AIG and its credit derivatives portfolio presumably notwithstanding).

Warren Buffett has described an insurance company’s “float”, that is, the premiums they receive in return for making payments in the future, as akin to being paid to borrow money. This is true to the extent that insurance companies can operate with a Combined Ratio below 100% (that is, the sum of underwriting losses plus operating expense as a % of net earned premiums). If they spend more than their premiums then of course the float costs money and the difference needs to be made up on the investment side.

Most insurance companies either through poor underwriting or competitive pressure slipped into just this model, whereby positive investment results were needed to cover a Combined Ratio above 100%. One of the capital disciplines practiced by Warren Buffett’s Berkshire Hathaway (BRK) in its insurance business is to separate out the management of the float from the underwriting, so as to prevent success at the former from compensating for poor execution of the latter. BRK’s insurance businesses have generated a net underwriting profit for eleven straight years. One clear benefit of separating underwriting from investing is that the insurance executives at BRK have  little incentive to grow via unprofitable business expecting to rely on strong investment results as support.

However, for many insurers persistently low interest rates have heaped pressure on one side of this equation. One might have expected the market to adapt, through a “hardening” market (insurance-speak for rising premiums) given lower investment returns, and while this has happened to a degree pricing hasn’t adjusted as much as needed. This is why so many insurance companies trade at a discount top book value – because while profitable, they’re not yet earning an appropriate return on equity.

Aspen Insurance (AHL) is one that we have liked in the past because of their well regarded management but it still trades at only 87% of book value (we don’t currently own AHL). Another name we have owned in the past but don’t at present is CNA also at 87% of book value. We continue to own AIG which is valued at 83% of book value excluding unrealized investment gains (or only 76% of book value if you include such mark-to-market gains, which isn’t an unreasonable approach). And we also own BRK, which trades at around 140% of book value but is of course a diverse conglomerate with  large operating businesses and a substantial investment portfolio. You don’t often hear them complaining about low interest rates, either.

Our Hedged Dividend Capture Strategy is designed to extract dividend income from equities while mitigating equity market risk through hedging. It’s designed for investors used to better returns from high grade bonds.

Although the equity research business is dominated by large, sell-side firms hoping to generate trading commissions from their (usually bullish) recommendations, there are alternate business models out there. Prescience Point is a hitherto unheard of research firm with no known location (so presumably outside the U.S. since they’re not registered) and no publicly disclosed employees. They focus on research uncovering companies’ fraudulent activities. Although they write about what they find, so as to (presumably) sell their research to subscribers, they also short the stocks they cover.

Short sellers are a fascinating bunch. The odds are stacked against them. Company managements and sell side research (both of which are generally bullish) are in the opposite corner from them. In addition, short positions have almost unlimited potential loss with gains limited by the proceeds received for the sale of the stock. Markets generally rise over time, so these headwinds to success mean that short sellers need to carry out pretty detailed work, and they need to be right.

What Prescience can do (based on their website) is:

(1) Produce a bearish report

(2) Share it privately with paying subscribers

(3) Short the stock themselves prior to its public release

(4) Buy back the shorted stock when the report is out

Chicago Bridge and Iron (CBI) is a $7.5 billion market cap company that builds energy infrastructure. Nuclear plants, oil pipelines, LNG plants (for transporting liquid natural gas) and other related projects. Their contracts are lumpy since completion can take many years. They recently acquired a competitor, Shaw Group, almost doubling their revenues.

CBI’s stock recently behaved as if Prescience had imposed its business model described above on it. When CBI began to weaken in early June on no apparent news, we assumed perhaps investors were becoming more wary of their backlog of infrastructure orders given the developing tumult in the Middle East. The stock weakened further (as shown in the chart below) until Prescience released their report. At this point reasons for the earlier weakness became clear, and additional sellers unwilling to subscribe but now finally aware of the report’s insight, were convinced to sell.

There doesn’t seem to be anything illegal with this. In any event, Prescience appears to be outside the U.S. and their website is pretty clear in warning that they trade both before and after releasing their reports. And it’s not obvious that there’s even anything wrong with what they’re doing. They have a point of view; they share it with clients; they act on it; they publicize their view. And they tell you this is what they’re doing.

In fact, their research doesn’t even need to be right. To be valuable, all that’s required is for the stock price to drop after Prescience and its clients have sold. What’s needed is a group of sellers who will sell after the report is public, for it’s this last drop that creates the profit opportunity. As long as there are enough uninformed sellers willing to sell the stock on the public release of the report so that the earlier, informed sellers can cover their positions, the business model will work. This presumably limits the number of subscribers because too many of them might cause the stock to rally on the report’s publication as they overwhelmed the fewer sellers involved. It’s quite an interesting business model; not quite God’s Work, as Goldman’s CEO Lloyd Blankfein so regrettably once described what his company does, but it’s a living of sorts I guess.

We’ve held a small long position in CBI for some time. We were puzzled by the early June sell off, but when the report was published on June 17th,the reason for the stock’s weakness became clear. Warren Buffett has famously said that in a poker game, if you don’t know who the patsy is, you’re the patsy. June 17th was a day during which we guess that patsies were unusually active in CBI. We just don’t know if the patsies were the sellers (late to the party, having missed the opportunity to sell at higher prices during the prior few days) or the buyers (willfully ignoring the now public  short thesis offered by Prescience).

For our part, we didn’t find much compelling in their report and so bought more CBI on June 17th. We just don’t know yet if we’re the patsies or not.

The chart above doesn’t look like much, but it represents a snapshot of the thinking of the Federal Open Market Committee (FOMC) on interest rates. Their communication has come a long way since the days of cigar-chomping Paul Volcker in the 1970s, when they went out of their way to disguise their intentions. Alan Greenspan inherited this culture and while in his early years he clearly relished confounding Senators with his unintelligible responses during Congressional testimony, over time he initiated a move towards greater transparency around the Fed’s decision making process and objectives. Ben Bernanke continued this and no doubt the trend will be maintained under Janet Yellen.

On the chart above (reproduced from the Fed’s website), each dot represents the view of a single FOMC member on the year-end level for short term interest rates (specifically, the Fed Funds rate). There are 16 voting members and each provides a forecast for the end of this year, 2015, 2016 and the long term. I’ve been watching these releases for nearly three years because over time they provide a fascinating picture of their evolving interest rate views.

The first three annual forecasts (2014-2016) can almost be used to construct a yield curve. Indeed, interest rate futures contracts are now often described as priced above or below the Fed’s forecast. Of course, their rate forecast can be wrong, just as the economic forecasts on which it’s based can be. Circumstances change, and there’s nothing intended to be inflexible about these figures. But it does allow us to see more clearly whether economic events alter their view. For example, U.S. GDP growth in the first quarter was quite weak at -1.5%, due largely to the harsh winter those of us in the north east endured. However, the FOMC has a reasonably positive view of growth for the remainder of the year (2.1%-2.3% for all of 2014 which implies around 3.4% on average for the remaining three quarters). As a result, they very modestly tweaked their rate forecasts higher over 2015-2016 (by about 0.07%-0.10%).

More significantly in my view, their long run forecast of interest rates fell from 4.0% to 3.75%. This is the equilibrium rate at which they think rates should settle assuming they had no bias to run monetary policy with either an accomodative bias (as it is now) or a restrictive one. 3.75% is neutral. It takes account of their long run estimate of inflation and of GDP growth.

Back in early 2012, their median long run forecast for rates was 4% and they raised it to 4.25%. They brought it back down to 4% last Summer and then 3.75% yesterday. If their forecast is right (and their forecasts are more important than anybody else’s) it means the fair value yield for, say, a ten year treasury security is a little lower. An investor now ought to be willing to hold it at a somewhat lower yield than before since in theory a ten year bond represents roughly the average short term yield over that period of time.

Steve Liesman from CNBC picked up on this and asked Janet Yellen in her press conference yesterday what was behind this shift. She noted that the composition of the FOMC had changed since the last forecast in March which might make the comparison less meaningful (two voting members were replaced according to a rotating schedule). But she conceded that it also probably reflected a more modest view of long term GDP potential in the U.S. economy.

For investors, it confirms what we’ve long felt, which is that interest rates are likely to stay relatively low for a long time. The Fed’s not about to make bonds more attractive by pushing rates sharply higher, so they will remain a fairly unattractive investment choice. And while you can’t infer too much about equities from the Fed’s interest rate view, it still seems likely that stocks will provide superior long term returns compared with bonds over the medium term.