Charles Evans, Federal Reserve Bank of Chicago President, was on CNBC yesterday and nicely illustrated why bond yields could stay low for a considerable time. At times sounding as if he was running in a Democratic primary campaign, Evans commented repeatedly on the pain out there in the economy and the chronic unemployment. Interestingly he maintains that the “natural” rate of unemployment remains at 6% even while the numbers of long-term unemployed remains high. The Pew Research Center recently reported that nearly 32% of those out of work haven’t worked for a year – over time leading to an atrophying of skills, reduced employability and ultimately less excess capacity in the labor force as the jobs market moves on. It is no doubt a terrible human tragedy – if only Washington could stumble on the right policies to fix it. But the familiar partisan gridlock remains.

Therefore, since low interest rates are the time-honored solution to economic distress, we face more of the same. It is a recurring irony of recessions that while excessive exuberance and debt generally precede if not cause a slump, much pain is also borne by those whose affairs were managed altogether more prudently. So it is that bond investors today are paying for the sins of their more profligate neighbors through miniscule interest rates that erode the purchasing power of their savings. The over-indebted are helped with a transfer of real wealth from the frugal. Managing your own affairs carefully carries less reward than it might.

A consequence is that dividend yields on a number of blue chip stocks are higher than the yields on their own bonds. This used to be far more common in the early 20th century when bond coupons were regarded much more favorably than uncertain dividends, and you can’t rule out that this state of affairs could persist for many months. It maybe even turn out that this yield advantage of stocks is appropriate for the risk, if we endure a period of protracted slow growth or recession that sees no dividend growth. High dividend yields can indicate corporate stress. Transocean’s stock  (RIG) currently yields 6.4%, but the market recognizes some risk this will be cut, either through continued poor execution by management or following a larger than expected settlement with BP on last year’s Macondo spill. On the other hand, Johnson & Johnson (JNJ) stock yields 3.5%, comfortably above its twelve year bond yield of 2.6%. JNJ is not a stressed company and has raised its dividend annually for 49 years. They’re likely to earn close to $5 per share this year and consensus expectations are for 5% EPS growth in 2012. There are numerous other examples in this article for instance. Pepsi (PEP) and Kimberly-Clark (KMB) probably belong in the same category – companies whose stock is highly likely to outperform its own debt.

Falling and low bond yields have so far not dulled retail investors’ appetite. Strong returns on fixed income in recent years, for those who buy securities because “the chart looks good” reduce their return potential as assuredly as night follows day. The most you can earn on JNJ 6.75% corporate bonds maturing 11/15/2023 and yielding 2.6% is, well, 2.6%. That doesn’t even cover inflation, never mind taxes for the eager, momentum-driven buyer. If that return beats stocks over the next ten years it’s unlikely that most types of corporate risk (credit or equity) will have been comfortable places to be. Is it possible the buyers are actually expecting still lower yields and therefore some capital appreciation? Ben Bernanke has surely demonstrated that yields can always go lower. But if you like JNJ bonds at 2.6%, surely treasury bills for a couple of years at 0% with the retained option to invest on better terms later on must be a viable alternative? With a modified duration of just under 9, if the yield rose to 2.9% the capital loss would eliminate the coupon income. A portfolio of reliably growing, dividend paying stocks either in combination with a beta-neutral hedge or cash is far more attractive than high-grade bonds.

Disclosure: Author is Long RIG, JNJ, KMB, PEP

While the troubles in the Euro-zone have clearly been a major source of uncertainty for U.S. equity investors, it’s beginning to appear as if negative consequences will be largely imposed on Europeans with manageable fallout elsewhere. No doubt there’s still plenty to worry about and this assessment could be wrong, but the economic data is starting to point that way. EU-zone GDP growth of 0.2% was meager but pretty much as expected – the FT’s headline announcing that “Germany and France drive eurozone growth” seemed at odds with the numbers. Europe doesn’t look as if anyone’s driving except towards a cliff. As a result. it’s increasingly looking as if U.S. and Euro-zone growth will diverge significantly with the tail risk being for an even greater difference. Base Case forecasts from JPMorgan are for 2012 real GDP growth of 1.7% in the U.S. versus -0.6% in the Euro-zone. This is why there’s still a case to be short the €. Even without a financial disaster, plausible baseline assumptions favor the U.S. economy over Europe’s. But before you conclude that all the unthinkable outcomes have already been contemplated, read the op-Ed in the FT by Jim Millstein, chairman of Millstein & Co. Mr. Millstein argues that Europe’s banks are beyond too big to fail – they’re too big to save. The size of Europe’s biggest banks relative to their economies is disproportionate and far larger than in the U.S. If his warning of wholesale sovereign debt writedowns and bank recapitalizations comes true, new sources of private capital will be needed beyond whatever the IMF can supply. It’s a sobering scenario.

At least savers in Italy, Spain and even France are being offered a positive real return on ten year government bonds (nominal yields of 7%, 6.3% and 3.6% respectively). Given the sorry state of developed country finances every where including the U.S., it’s hard to see why anybody would lend to anyone for ten years at low single digit yields. 2% in the U.S. is derisory, and every day the Federal Reserve drives thinking fixed income investors away – to senior loans (we continue to own BHL and PPR) and to MLPs . In fact the 1 year return through October on the Alerian MLP Index AMZ is +7& compared with just 1.1% % for the S&P500 and 2.3% for REITS. MLPs are best accessed through individual holdings in order to fully benefit from the 6% tax-deferred yields available.

Dividend paying stocks remain a valid alternative. Ten year treasuries represent such poor value that only $20 in dividend paying stocks can generate the same after-tax return as $100 in treasuries (assuming 4% annual dividend growth).  A barbell, made up of cash invested in treasury bills and dividend paying stocks, is a valid alternative to today’s overpriced high grade bond market.

60 Minutes ran a piece last night revealing that Congressmen are not only exempt from the insider trading laws that apply to everyone else but also routinely exploit inside information to which they have access. That’s right, members of Congress can and frequently do profit from inside information, and it’s perfectly legal. Further description hardly seems necessary – you just have to believe that the leadership will be sufficiently embarrassed by the report that they’ll correct this glaring abuse swiftly.

The challenges facing the Euro zone including most recently Italy seem so enormous and intractable that it’s easy to contemplate previously unimaginable outcomes. Der Spiegel reports that the German government is preparing for a possible Greek exit from the Euro. The currency was designed without an exit – it’s unclear how Greece could extricate itself. A weekend nationalization of banks with all deposits converted to drachma? The new currency would immediately collapse from its initial level as unwilling holders of drachma sold, and in any case the days and weeks leading up to such an event would no doubt see a sharp run on deposits from Greek banks. As it is there’s a tax on money leaving the country. And we read every day that supporting Italy will require the IMF and a reinforced EFSF. What will happen if Italy can’t refinance its debt, €250BN of which rolls over in 2012?

But you don’t need to bet on disasters to see downside for the Euro. Just muddling through and avoiding any of the crisis scenarios is going to involve slower growth. The Austerity Solution so favored by the EU and IMF is assuredly lowering GDP growth in the region as well as consumer confidence. The growth differential between the U.S. and the Euro-zone continues to widen. JPMorgan now forecasts +1.7% 2012 GDP growth in the U.S. versus -0.6% in the Euro-zone. Solutions and non-solutions seem to lead to the same place. The next 10% move in the exchange rate looks far more likely to be lower.

The Financial Times notes that Liquid Natural Gas (LNG) tanker ships are experiencing increased demand, one of the very few areas of shipping for which that is true. The rest of the shipping industry has shot itself in both feet as every operator positioned for a 10% increase in market share, which has crushed shipping rates through overcapacity and made the sector even less friendly than U.S. residential construction (if that’s possible). But the virtual shutdown of the Japanese nuclear energy industry following the earthquake has increased Japanese demand for LNG imports and is raising prices. Regrettably, producers of domestic natural gas in the U.S. are not direct beneficiaries because the U.S. currently has no facilities at which natural gas can be compressed for export, but greater global demand is a positive over the long term (i.e. 3-5 years).

Still on the subject of shipping, we continue to be invested in Aegean Marine Petroleum (ANW). They provide bunker fuel to the shipping industry and so operate a very different business model than their customers. Their stock price has been beaten down with their peers, although they continue to generate operating profits and just reported a third quarter of solid margins. If you can believe their book value (assets are ships and fuel inventory) the stock trades at a 40% discount. On their earnings call last week management asserted that market value for their ships was no lower than carrying value – much of the fleet is recently purchased so that ought to be true, although they did take a loss versus book value on the sale of one vessel in the third quarter. Even after rallying on last week’s earnings it still trades at less than 7 X ’12 estimated earings. We continue to hold a modest position in ANW.

Berkshire Hathaway (BRK) remains one of our biggest holdings, for reasons articulated the other day. Warren Buffett’s appearance on CNBC this morning was never boring, and he revealed an investment in IBM which is not a stock we would have bought ourselves. Many large cap U.S. stocks appear attractively priced, and the dividend yield on the S&P500 (SPY) remains more attractive than long-term government or high-grade bonds. The equity risk premium is not as wide as it was but remains nonetheless attractive in favoring equities over fixed income.

Disclosure: Author in Long EUO, BRK, ANW, SPY

A friend brought my attention to a recent article in the FT by James MacKintosh in which he noted how hedge funds have increasingly been delivering returns that are correlated with the S&P500. It looks as if increasingly the search for alpha includes trying to time beta. The media isn’t normally so negative on hedge funds – perhaps Mr. MacKintosh has looked at the website for my book.

One of the problems with selecting hedge funds is that so few of them consistently outperform their peers. Manager selection is really the only way to justify a hedge fund portfolio. If you can’t pick funds with skill then it’s best not to bother, because average hedge fund returns have trailed treasury bills . An investor can be a passive investor in equities through mutual funds and need not possess any security selection skill to justify exposure to the assets class. The same cannot be said for hedge fund investors.

But the challenge of picking good managers is compounded by the fact that returns mean revert. For the vast majority of funds, not every year is a good year. I did some analysis earlier this year for my book using data from BarclayHedge. Suppose your objective is to pick managers in the top 40% – seemingly not exactly a tall order you might think. However, of those managers that are ever in the top 40% only 7% are able to stay there for every year of their existence. The best managers have mediocre years. Whereas an equity investor can try and exploit mean reversion and sell his winners to reinvest in that year’s underperformers, such an option doesn’t easily exist for the hedge fund investor given the lengthy time involved in due diligence. And hedge fund managers who concluded this was their clients’ strategy would quickly tire of such a flighty investor, perhaps refusing to take them back.

It’s not that hedge funds are all bad – and indeed the hedge fund industry has generated fantastic results. It’s just that those results haven’t really made it back to the investors who provide the capital. Hedge fund investors need to do better than they have.

At least Italian savers are offered a decent return on their money. 7% on ten-year debt is a bit more like it – at least after taxes and inflation you stand a chance of being ahead of the game, unlike in the U.S. where government policy is hostile to savers and seeks to inflict real losses of purchasing power on anyone desperate enough to invest in government bonds. We could use some Italian yields here in the U.S. However, in Italy there’s just the non-trivial question about ultimate repayment. Meanwhile, Senior loans in the form of two closed end funds, PPR and BHL, yielding around 6% seem a much better bet. Diversified credit risk to leveraged corporate borrowers with short duration, versus concentrated sovereign credit risk with dysfunctional government and long duration. There’s no yield at which we’d invest in Italy; we did buy more of these two funds yesterday.

If the sellers of Italian bonds over the past few days have been banks, it would be wholly understandable. The “voluntary” 50% haircut they agreed to over Greece clearly sets a precedent rather than being unprecedented. Combined with the natural consequence that sovereign credit default swaps have questionable value (since the 50% write-down likely won’t trigger a default event) return of capital is trumping return on capital. Forecasting where the crisis will end remains a complex struggle, but by now we’re becoming trained to contemplate the unthinkable. Markets even seem to have moved beyond the EFSF and that leaves just the IMF to bail out with real money and strings attached, or ultimately the ECB to create money. What a surreal outcome that would be given that the ECB’s constitution was modelled on the Bundesbank’s and more or less dictated by Germany. And of course it may not happen. But with Italy now “in play” so to speak, yet another unthinkable is now a headline. German policymakers will have to wrestle with their deep-seated fear of inflation and their perhaps equally strong desire to maintain the Euro in is present form. We maintain a short € position (through being long EUO) as a hedge on some of our leveraged strategies. We reduced the position yesterday – it’s not that the crisis is over, but obviously everyone gets the joke by now so the $/€ exchange rate provides less protection than it used to.

Disclosure: Author is Long PPR, BHL, EUO

Of the many ways in which Silvio Berlusconi thought he could be forced from power, rising Italian bond yields was probably not high on his list. Even his titillating escapades seemed to have been insufficient to persuade the Italian electorate he should leave. But it turns out 7%+ bond yields, with €300Bn of new borrowing required in 2012, is the the breaking point. Less than a month ago the focus was on Greece and building a secure firewall with the EFSF to prevent contagion spreading to Spain or Italy. Now here we are, and we’re running out of unthinkable developments.

It’s not that Europe doesn’t possess the savings to fund profligate countries while they adopt the German fiscal model. It’s just that the money is in the wrong place – northern Europe not Southern.

So another test of equity investors’ fortitude looms. The S&P 500 (SPY) will once again shift from greed to fear. But it’s always worth looking at the fundamentals of the companies you own. For example, in our Hedged Dividend Capture Stategy, McDonalds (MCD) reported 5.5% Year-on-Year sales growth in restaurants open more than a year. Even in Europe sales grew 4.8%. It yields 3% (more than 1% over ten year U.S. treasuries) and could grow earnings at 10% next year. Kraft (KFT) just revised up their 2011 guidance from $2.25 to $2.27 and continues to exploit synergies from their Cadbury’s acquisition. KFT is also likely to grow at double digits as it prepares to break itself up into two companies and yields 3.3%, more than 1.3% over ten-year U.S. treasuries. The Federal government wants your tax dollars, but really doesn’t want your savings. That’s the message of today’s bond yields.

The near term is usually uncertain, and especially so right now. But the prospects of these and other companies remain solid.

In yesterday’s election the voters of Ohio rejected by 62% to 38% a state law that limited the ability of public sector workers to collectively bargain and to strike. It’s a remarkable reflection of how Ohio voters feel about their government – I mean, who do state employees work for if not the people of the state? Ohio employs 769,000 people in government which represents only 13% of the labor force, substantially less public sector employment than in other states. Union membership as a percentage of the labor force in Ohio is less than 14%, although modestly above the national average of 11.9%.

The law that the Republican-controlled legislature had passed included limits on the ability of public sector workers to collectively bargaining or strike and required greater contributions to their retirement and health plans. The average voter in Ohio must think that all these public sector workers work for some foreign government. I think they’re emulating the Greeks. Perhaps it’s because I grew up in Britain during the 70s when unions periodically held the country to ransom. At times in Europe they still do.

But as an investor you take the world as you find it. I don’t have any plans to invest in Ohio, nor live there. Democracy allows people to vote for concepts that are not obviously good for them. Ohio is adopting some of the values of Europe that have created the current Euro sovereign debt crisis.

Yesterday we lightened up on some of our position in Coeur d’Alene (CDE). We’ve liked this silver mining company for quite some time – it’s been trading at a substantial discount to the NAV of its mining assets and represents a good way to invest in bullion at a discount. Earlier this year there were fears that Bolivia would change the terms under which CDE mines silver at the San Bartolome mine, but even though such fears were unfounded the stock persisted at a wide discount to its underlying assets.

With yesterday’s earnings release the valuation of the stock has largely retraced its steps, and while it remains cheap to its assets we don’t believe it’s as mispriced as it has been. We still own some shares but not as much as before.

We invested the proceeds in McMoran Exploration (MMR). How could you not invest in a company run by someone called Jim Bob? We’ve never met, but he sounds as if he grew up on Walton’s Mountain (a syrupy TV show from the 70s about a Depression-era family). Joking aside, MMR is engaged in drilling for natural gas and oil in the Gulf of Mexico (GOM). Shallow water (as little as 100 feet) but deep wells (up to 32,000 feet so far). The theory is that the geology onshore continues offshore. It’s worth checking out their recent presentation. If you’re not a geologist, it represents a high risk but potentially high return opportunity that will likely resolve itself within the next couple of months when they expect flow test results from Davy Jones No. 1. Jim Bob Moffett, MMR’s CEO, knows a bit about finding valuable minerals having founded Freeport McMoran which is perhaps best known for mining gold and copper at the Grasberg Mine in Indonesia.

The extraordinary depths at which MMR is drilling in the GOM require the development of new technologies to handle the high heat and pressure. There are some interesting and presumably well-informed shareholders, including Plains Exploration (PXP) who owns 23% of MMR’s shares and is restricted from selling until year-end. PXP’s CEO Jim Flores recently stated on a conference call that, “I think you’re going to hear some exciting things out of McMoRan in the next 3 to 6 months, about plans for 2012 that are mind-blowing.”

Admittedly that doesn’t look like detailed financial analysis. Short of having the technical knowledge and information access to independently evaluate MMR’s findings so far, it’s a story stock and not a solid investment. But the different moving parts add up to something interesting, and we have a modest position because we think MMR provides sufficient potential upside for the risk of failure.

Disclosure: author is Long CDE and MMR

If you’re into this kind of thing, which is to say that examining financial statements is a source of stimulating mental gymnastics, figuring out the value of Berkshire Hathaway (BRK) could keep you entertained. BRK released their third quarter’s earnings over the weekend. It’s an insurance company transforming itself into an operating business as Whitney Tilson has pointed out before. It’s true that the acquisition of Burlington Northern has pushed their non-insurance operating earnings to a new level. Breaking the company into its two pieces (insurance and non-insurance) and adding its securities portfolio is an interesting exercise.

Non-insurance businesses generated pre-tax operating income of $5.4BN during the first nine months of the year. There are many moving parts, but assume positive surprises will net out with negatives and you get $7.3BN of full-year pre-tax earnings. Most insurance companies operate an underwriting loss (i.e. they only reach profitability because of investment earnings on the float) but BRK seeks to make a profit on underwriting. Averaging the past two years and annualizing the result generates $765MM in pre-tax operating income. In fact over the past eight years underwriting has produced $17BN, or over $2BN per year.  These two add up to $8BN of pre-tax income, after 35% tax $5.2BN.

Using the S&P500’s trailing P/E multiple of 13 values this at $68BN. This is the value of Berkshire’s insurance underwriting and disparate operating businesses but excluding investment income.

But in addition, BRK has an investment portfolio consisting of marketable securities, non-public investments and cash worth $147 BN. Adding this cash and investment portfolio to the businesses above produces $215BN, compared with BRK’s current market capitalization of $190BN, or in other words the company’s valued at a 12% discount.

Aspen Reinsurance noted that around $95BN of global reinsurance capacity has gone following many events from the earthquakes in Japan and New Zealand to weather-related losses in the U.S. and Australia. Given a harder market (i.e. one of rising premiums given the reduced industry capacity) it’s not unreasonable to expect BRK’s underwriting results to improve next year. If they get back to the eight year average, the company’s worth almost $230BN or is at a 17% discount.

This is a summary of how we look at BRK. It seems to trade at a conglomerate discount. But their underlying businesses are going well, they’re buying back stock and they had their most active quarter of investing in fifteen years, putting almost $21BN to work. We think it remains an attractively priced investment.