Barrons has a good piece highlighting dividend stocks and MLPs as sources of investment income. Andrew Bary, the writer, sounds as if he’s been reading from our playbook!

Fiscal issues dominated the last few weeks of 2012 and are likely to provide headlines during the next several months as well. Therefore, it’s worth contemplating what it means for investors. Following this most recent skirting of disaster with the Fiscal Cliff, it’s possible to draw some inferences about how the ongoing budgetary debate will unfold. Both parties believe they won an electoral mandate for their policies. President Obama won re-election, but the House of Representatives remained Republican. Moreover, there is less reason to expect this form of divided government to lead to grand compromise. The partisan split in Congress with fewer tight electoral contests is increasing the importance of the primaries in selecting candidates. Less turnover in Congressional seats gives the dominant party’s core voters greater influence. This is most obvious in the House Republicans’ rejection of compromise recently, revealing a greater fear of Tea Party challengers in 18 months than a general election loss. Similar dynamics exist for Democrats. The New York Times recently noted that Americans are showing a greater tendency to cluster in neighborhoods of like-minded people, a development that will exacerbate the current trend towards argumentative government by further reducing the competitiveness of elections for the House of Representatives.

Given the absence of much long term budget repair in the latest brinkmanship combined with the polarizing dynamic described above, it seems that the most realistic expectation is for quite modest fiscal improvements albeit achieved under the threat of government-induced catastrophe. The debt ceiling will no doubt provide another flashpoint for differing philosophies fairly soon. The fact that the recent compromise relied mostly on taxes with no meaningful spending cuts probably means the Republicans will look to this next manufactured crisis as an opportunity to advance that aspect of their agenda. It won’t be long.

Moreover, for all the hand-wringing over the long term outlook, it’s not clear that there is much coherent political support for fixing it. Raising taxes and cutting entitlements are intensely unpopular. The near term benefits of prudence are hard to identify. The Federal Reserve is quite possibly shielding the economy from unhindered bond market feedback on the fiscal outlook through quantitative easing, so low interest rates don’t portend much actual trouble. It’s like predicting global warming during a blizzard – hard to get much serious attention.

For an investor, there is probably a little more certainty over public policy than was the case a month ago. Our government is not bold in confronting problems, but there is a certain predictable logic driving decisions. As a result, there is far more certainty about fiscal policy than was the case last month. Incremental improvements punctuated by a crisis with a dramatic conclusion are beginning to look like a pattern. It’s not exactly what the Bowles-Simpson Commission recommended, but it appears to be what the next couple of years at least have in store.

The increased certainty and the absence of any significant fiscal drag should allow corporations to make more confident long term decisions and be positive for growth, albeit punctuated with a political crisis from time to time. Equities continue to be attractive relative to fixed income. The Equity Risk Premium remains historically very wide, and with interest rates likely to remain below inflation (more so after taxes are included) government and high grade corporate bond markets remain a safe way to steadily lose purchasing power. It remains the case that 23 cents invested in equities will, with 4% dividend growth, deliver the same ten year return as $1 invested in ten year treasuries. After taxes with the new rates on income, dividends and capital gains the Math requires only 19 cents. High grade corporate bonds alter the comparison only modestly.

Income generating securities came under pressure late in 2012. As it turned out the increase in investment tax rates wasn’t as punitive as might have been feared. The Low Beta anomaly persists, so our Hedged Dividend Capture Strategy (“DivCap”) consisting of a long/short portfolio of $100 in stable, dividend paying stocks hedged with $50 short the S&P 500 provides a good way to pick up dividend income with minimal equity volatility. I’m currently adding to that strategy myself.

Master Limited Partnerships (MLPs) also gave up some ground in recent weeks. But the tax treatment of MLPs did not change and with higher ordinary income tax rates the tax-deferred nature of the distributions is now relatively more attractive compared with other income generating sectors on an after tax basis. If Congress decides to tackle tax reform this year MLPs will probably be vulnerable. However, their tax treatment has existed for over a quarter century (since the 1986 Tax Reform Act under Reagan) and improved energy infrastructure is an easily defended policy goal. Moreover, overhauling the nation’s tax code will require a grand compromise between both parties so far removed from recent discourse that it barely justifies consideration.

As we approach the Fiscal Cliff, or more properly Slope, I thought the Republican negotiating strategy was very revealing. Gerrymandering, the process by which Congressional districts are tortured into shapes that resemble something drawn by a drunk with a permanent marker, are certainly part of the issue. Although the original intention was  to allow for districts that reliably elect minority candidates, the result has been districts that don’t turn over. The strength of incumbency in the House of Representatives has the consequence that general elections matter less than the primary for the dominant party in that district. If a district reliably votes 60% Republican (or Democrat) the winner of the election will be the successful primary candidate from the party that normally prevails. Primaries matter a great deal for the House. Therefore, the failure of House Speaker John Boehner’s Plan B two weeks ago is not an example of Republican self-destruction, but rather of enlightened self-interest.

A House Republican is more concerned about a Tea Party primary challenge than a general election loss to a Democrat, given the polarization of so many districts. Therefore it makes little sense for Republicans to compromise their principles in trying to resolve the fiscal cliff. They have little upside in any case from strong economic growth (it is Obama’s Economy after all) and plenty of downside from a more Conservative challenger.

The New York Times added an interesting perspective to this last week, when they noted that on top of gerrymandering there appears to be a tendency of people to live in districts where their neighbors share similar views. This is not a welcome development for those who believe that compromise is the only solution to America’s fiscal challenges. In fact, further electoral polarization would seem likely to drive even more partisan disagreement in Washington.

This is one reason why optimism about the fiscal future is not warranted. The tight races in elections are steadily diminishing, and we are headed for now in a direction of increasingly shrill disagreements. But under these circumstances one decision does appear illogical. In an era during which both political parties appear to be moving away from one another and towards their base, why would any voter split their vote? For just as President Obama won a renewed mandate from the American people, so did the House Republicans who retained their majority. Some districts, and some voters, clearly split their vote between a Democratic President and a Republican member of the House of Representatives. This happened notably in Florida where Obama barely clinched the state’s electoral college votes with 50.0% while the state chose Republicans for 17 of its 27 members of the House of Representatives.

Clearly a substantial number of voters in Florida split their vote between a Democratic President and a Republican member of the House of Representatives. When Congressional relations were altogether more cordial such as under President Clinton the implicit desire for compromise possibly made sense. But following the last few years who can seriously expect compromise rather than the perpetual stalemate that has brought us to the edge of the Fiscal Cliff? The voters who split their vote don’t really hold a coherent view. The parties are sufficiently far apart that expecting grand compromise appears rather naive.

Instead of blaming Washington, a portion of the problem lies with an electorate that in some cases has failed to carefully consider what type of government they want. As a result, hasty, superficial decision making based on sound bites has brought us the government we deserve, rather than the one we need.

Hedge Funds will continue to deliver mediocre results at great expense for those unwisely hoping an over capitalized industry can emulate its smaller, formerly profitable and ever more distant past.

I had inexplicably missed this on Dec 14th, but The Hedge Fund Mirage made it on to this list.

Click Here for the article.

The Economist, without doubt my favorite weekly magazine (or newspaper as they refer to themselves) has brought its clear thinking and analytical skills to hedge fund returns. As usual they’ve provided a balanced perspective that includes important points. They note the poor decade hedge funds have had relative to a simple 60/40 stocks/bonds portfolio. They suggest that most likely hedge fund fees have exceeded the returns earned by investors (in fact fees have completely swamped overall returns for investors as I’ve noted in my book and on this blog). “The average hedge fund is a lousy bet” they note, and this is true. There are great hedge funds and happy clients, but this is not the norm.

The vast majority of hedge fund professionals have sensibly stayed away from this debate. Defending a diversified portfolio of hedge funds as vital to an institutional portfolio requires nimble debating skills given the absence of factual data in support. And I continue to find many open minds among hedge fund allocators and investors. The industry has drawn people with highly developed commercial skills and most recognize well the need to transfer more of the investment skill that does exist to their clients with less drag from high fees and mediocrity. I have no doubt that business models will evolve and improve in response to the sorry decade of results. Hedge funds will not disappear. The many problems with the existing structure will eventually be solved to the benefit of the clients.

However, Tom Schneeweis, a Finance professor at UMass Amherst,  has offered some criticisms of my book, including describing it recently as, “…baby hedge fund analysis 101 at best.” I imagine among the Ivory Tower crowd this must represent quite an insult. Further demonstrating Mr. Schneeweis isn’t overly reliant on hedge fund returns to provide a comfortable retirement, he asserts that investors should be indifferent to fees. He says that, “…if an investor is receiving a positive benefit from owning a  product, the net profit to the creators of the product may be regarded of  secondary concern.” That may pass for accepted wisdom in the classroom, but out in the real world investors care deeply about the fees they pay. The long-standing trend towards greater disclosure of fees in Finance is a natural response. Mr. Schneeweis sounds like someone who hasn’t spent much of his own money on hedge fund fees, just other people’s.

Fortunately, The Economist with its substantially wider readership is providing investors with more thoughtful advice.

I gave an interview yesterday to Stansberry Radio discussing hedge funds and our investment strategies. If you’re interested you can find it here.

One opinion shared by many investors nowadays is that stocks are risky, and the near term outlook is especially unclear. Today’s Wall Street Journal profiles a financial adviser in Chicago, Jeffrey Smith, who spends much of his time persuading clients that they should remain in equities in order to achieve their long term investment goals. One client apparently found his mind wandering to Edvard Munch’s painting titled,  “Scream” as he contemplated the many potential disasters waiting in the wings. Mr. Smith’s cause can’t be helped by daily headlines from Washington which largely serve to remind investors what a dysfunctional place it is. The very creation of a Fiscal Cliff was ill-considered, representing as it does a totally blunt instrument to control future deficits. While the original intent was to force tough decisions on a reluctant Congress so as to avoid automatic tax hikes and spending cuts, in fact the focus is really just on avoiding its consequences. News reports show that the most likely outcome is higher taxes on the 2%, some spending cuts and no doubt solemn commitments to do the heavy lifting of budgetary discipline next year.

It’s not what was intended but is the best we can expect. Congress created the cliff and Congress can modify it. It’s not really a tool to force action.

In fact, there’s little reason to be long term optimistic on the U.S. fiscal outlook. Opinion polls regularly expose the incongruity of voters’ desires for improved fiscal prudence combined with broadly unaltered tax policies and entitlements. On top of which, while there’s much hand wringing about the future there’s little visible cost to current policies. If Congress and the Administration did miraculously come together on a meaningful plan to achieve annual deficits of 2.5% of GDP (thought by many to be a long term sustainable target) bond yields could hardly fall very far in response. When Clinton raised taxes in the 90s to reduce the deficit interest rates fell and softened the blow somewhat. No such payback is likely today. So low expectations on this issue are appropriate.

Nonetheless the Math of equities remains compelling. $22 in the S&P 500 will deliver the same after tax return as ten year treasury notes held to maturity, assuming 4% dividend growth on the former. You can make your own synthetic bond with $78 in 0% yielding cash and $22 in 2% yielding equities. Even a disastrous 50% collapse in stocks would cause an $11 fall in your portfolio value or 11%. It would only take a 1.25% rise in bond yields to cause a similar 11% loss in ten year treasuries.

Choosing the stocks/cash combination with its range of possible outcomes instead of the fairly certain loss of purchasing power through bonds requires a long term perspective. However, that is the most reliable way to maintain the purchasing power of your savings.

Most recently we invested in Dollar General (DG). For some time we’ve followed this company as a comparison to Family Dollar (FDO) which we have owned in the past (although not at present). DG has better sales per square foot, operating margins and growth than FDO, but in recent months its valuation has slipped to where it’s now comparable to FDO. These businesses tend to hold up fairly well during tough economic times and although DG is weaker today following its earnings release we think it represents an attractive investment.

Well, of course they are! From my Bloomberg interview yesterday.

This morning’s news that Freeport McMoran is acquiring two E&P businesses (Plains Exploration and McMoran Exploration) is the first real M&A activity since BHP’s acquisition of Petrohawk in the middle of last year. Subsequently BHP had to take significant write downs on their newly acquired assets and the fervor for buying E&P names steadily cooled.

Some names in the sector are relatively attractively priced. Devon Energy (DVN) trades below the price of its proved reserves and is 100% U.S. so no geopolitical risk. At some point they could represent an attractive way to supplement depleting energy reserves for one of the major integrated oil companies. Range Resources (RRC) has also been weak lately and offers some significant upside if they can successfuly extract a good percentage of their 50 Trillion Cubic Feet Equivalent (TCFE) of potential natural gas reserves. Comstock Resources (CRK) is also at the low end of its recent range. With a market cap of less than $1BN it would be an easy acquisition for many big companies. The 25% short interest in CRK also reveals some healthy skepticism.

We are long DVN, RRC and CRK.