Monday, November 25, 2013

A Stock Market Bubble?

There has been a lot of talk of a stock bubble in the financial media. One of the cover story for the weekly Barron's magazine was "Bubble Trouble?" (subscription required to read). Also, there was another good WSJ story that used Robert Shiller's favoured Cyclical Adjusted P/E (CAPE) ratio to argue stock valuations are getting frothy. The CAPE, which divides the S&P500 price by a 10-year average real earnings number,  is near 25.1 compared to the 130 year average of 16.  With the S&P500 rallying over 27% this year, NASDAQ over 30% and Dow Jones Industrial 22%, it definitely looks like a stock market bubble is building. However, I should caution investors not to call a top based on the YTD performance or the fact that the S&P500 is up over 170% since its low in March, 2009. 

The Frothy Side:

Let's not forget the cause of the market rally this year. The key reason is that low interest rates, caused by ultra loose monetary policies like QE, pushed many investors up the risk curve. Some fixed income yields, namely short term treasuries, were negative after adjusting for inflation (real yield) which forced investors to seek higher yielding assets in either corporate bonds, high yields or even conservative blue chip stocks. The key measure that determined whether investors prefer bonds or stocks is spread between the earnings yield (E/P or inverse of the P/E ratio) and the bond yield. At the start of the year, the 10-year US  treasury yield was near 1.8% and the S&P500 earnings yield was 7.5% or almost 4 times higher! It's a no-brainer why stocks rallied. The fact pension funds and mutual funds had low equity exposure also fueled the equity rally as those "big players" re-entered the market. 

Despite a small correction in the summer due to the taper tantrum, stocks kept on rallying. The current earnings yield of the S&P500 is about 6% while the 10-year US treasury is yielding near 3%, which reduced the attractiveness of stocks by 50%. The S&P500 is trading at 16.5X trailing earnings and 15.1X forward earnings. Those measures are slightly higher than historical averages but well short of the P/E north of 20X in the dotcom boom and 17-18X at the height of the 2007 bull market. This means that stocks can still rally further. Mutual fund asset levels are still low compare to 2007 and many pension funds are still under-weighing equities. Therefore, don't be surprised if stocks move higher. 

However, what worries me is that the equity rally is mostly due to P/E multiple expansion. Recall changes in price is the product of changes in earnings multiplied by changes in the P/E ratio. Given the aggregate S&P500 earnings is foretasted to increase only 6% in 2013, the 27% rally in the index was caused mostly by a 20% expansion in the P/E ratio. P/E doesn't expand forever and the fact earnings growth is unlikely to pick up is a cause for concern. 

The Problem of Calling a Top: 

In December 1996, former Fed Chair Alan Greenspan made his famous "irrational exuberance" speech questioning the valuation of equities at that time. Some investors agreed with Greenspan and started shorting equities. The fact the stock market advanced 31% in 1997, 26% in 1998, and 20% in 1999 proved many of those skeptics wrong. The point I want to make here is that calling a top is extremely hard. Many should not even waste the time or effort to because it is hard to get both the timing and thesis correct. 

So, What to Do? 

Bonds are still yielding close to nothing (after adjusting for inflation) while stocks may be in bubble territory. My opinion is that stocks should be preferred to bonds.


  • Earnings yield of 6% is still 2 times higher than long term treasury yield and higher than most fixed income yields (including junk bonds that are yielding near 5%) 
  • Stocks provide investors with great long term performance despite short term troubles. Let's not forget that in the 20th century, the Dow Jones returned 5.1% compounded annually. For those who are not aware, the market experienced several large drops greater than 50% with the Dow losing 90% from 1929-1933. That period also included 2 World Wars, the Great Depression, a Cold War, a decade of super high inflation etc. 
For the average Joe investor, a bubbly market should not deter them from a conservative dollar cost averaging strategy where one sets aside a fixed amount to put into an index fund every month or quarter. For more active investors, there are still bargain stocks available especially in the mining space. Trying to call a market top is foolish because no one has a perfect crystal ball. Investors should adhere to strict investment rules such as buying stocks at reasonable valuations (i.e. significantly below intrinsic value) in order to provide them with a margin of safety. Timing the market appears to be simple and easiest strategy to make money but its application is hard in practice. 

In short, although I worry about a stock market bubble, I'm still long stocks in my portfolio because they still provide the best risk-adjusted potential return. I use the margin of safety principle advocated by Ben Graham to help protect my downside by buying stocks with low valuations, healthy balance sheets and high future earnings power. I tried calling market tops and bottoms in the past but learned it's better to admit you can't. Many times, you get the thesis right, but the wrong timing can kill you. As Keynes famously said: "The market can stay irrational longer than you can solvent". 

Wednesday, November 6, 2013

Are Share Buybacks Really Meaningful?

After my article on stock splits, I believe I should discuss my thoughts on share buybacks, another important topic in corporate finance. I will write about other topics such as dividend payout policy, M&A, executive compensation etc in the future.

What are Share Buybacks?

Share buybacks, also know as share repurchases, are methods of returning cash back to shareholders. The net effect of repurchasing shares will result in less shares outstanding, which increase the ownership of shareholders who decide to maintain their stake. Companies usually purchase their shares on the open-market, although a tender offer can also be used. In Canada, an open market share buyback program is called Normal Course Issuer Bid (NCIB).

Rationale Behind Share Repurchases: Returning Free Cash Flow

Basically there are 3 main uses of free cash flow (often defined as operating cash flow minus capital expenditures): (1) pay down debt (2) make an acquisition (3) return it back to shareholders via dividends or share buybacks. Most executives hate option 1 because they want to maintain an "optimal structure" of debt and equity. In my own opinion,  it may be prudent to reduce debt levels when excessive free cash flow exists since high cash levels usually build near the height of an economic boom, which implies a recession may be on the horizon. Reducing debt levels in good times prepares the company for bad times such as a recession or economic slowdown. Also, it leaves excessive capacity to take on more debt in recessionary times when interest rates are much lower. Option 2 was popular but CEOs are now more cautions when it comes to acquisitions especially after the disastrous outcomes of serial acquirers like Tyco, Worldcom, or Citigroup. Accounting treatment is also less favourable with FASB and IASB abolishing the pooling of interests method. Option 3 is the most commonly used method of returning free cash flow and most executives prefer stock repurchases just because it is "tax-efficient" over dividends. Although the argument is valid, purchasing shares above intrinsic value is value destroying (see example below) despite being a little tax efficient  If the shares do trade above intrinsic value and the company has excessive cash, it should consider boosting its dividend instead.


Stock X is trading at $150, has 100 million shares outstanding, and earns $500 million a year. This implies a market capitalization of $15 billion and EPS of $5. Let's assume that the true intrinsic value (hidden from the public but can be roughly estimated by the intelligent investor) is only $10 billion or $100 per share, which implies the stock is 50% overvalued. 

If the company decides to repurchase 5% of its outstanding shares (5 million shares) at $150 and still makes $500 million a year, EPS would increase from $5 to $5.26, a magical 5.2% increase. However, if the share price corrects to the actual $10 billion (in the long run, the market is a weighing machine and will be efficient) , the high purchases made at $150 are clearly value destroying. If the company did not conduct the share repurchase, intrinsic value would still be $100 per share (10 billion value divided by 100 million shares). If they did the share repurchase, they would destroy $250 million of value by buying shares for $750 million when intrinsic value of those shares is only $500 million. Thus, intrinsic value of the company after the repurchase is 9.25 billion or $97.37 per share. ([$10 billion - 0.75 billion]/ 95 million shares). Well congratulations shareholders of company X, it just destroyed $2.63 of value on a per share basis. The company may had good intentions, such as returning cash to shareholders, but buying back shares above intrinsic value is dumb. Many would argue against me by stating there is no exact method of determining the intrinsic value. Nonetheless, I believe experienced managers who is familiar with industry trends and the company's financials should have a rough idea on the company's intrinsic value. Academic studies have shown that following the insiders (after they disclose a purchase or sale) can earn abnormal returns. 

If the shares was 300% overvalued, this transaction would destroy over $11.50 of value on a per share basis. The prior examples are typical in the real world. Why? This is because corporations usually have large cash hoards in boom times or just before a recession hits, which also corresponds to when their share prices are often overvalued in the market. Many corporate executives are often pressured to return cash to shareholders and believe buybacks are the most efficient method. 

Rationale Behind Share Repurchases: Growing EPS or Offset Share Dilution 

Short term earnings accretion get the attention of analysts and the financial press, but prudent investors should look for underlying value creation, not earnings accretion. As the example above shows, there is earnings accretion with EPS growing 5.2%. However, the actual intrinsic value of the business, on a per share basis, is lower as a result of repurchasing shares above intrinsic value. 

Another common argument is that companies often issue stock options and exercising those options could dilute existing common shareholders. The problem of offsetting that dilution with share repurchases is that buying shares above intrinsic value would destroy more value than merely letting its shares outstanding increase. Let's go back to the prior example. If there is 5 million of options, the shares outstanding would increase to 105 million and EPS decreases to $4.76. Most executives doesn't like that lower EPS so they decide to repurchase shares. If the company doesn't do anything, intrinsic value reduces to $95.24 ($10 billion/ 105 million shares) or $4.76 lower. If the company decides to repurchases 5 million shares at $150 (greater than $100 intrinsic value) to offset the 5 million share dilution, intrinsic value is reduced to $92.50  ([10 billion - 750 million] / 100 million shares)  or $7.50 lower. Clearly $95.24 > $92.50, so repurchasing shares when the shares are overvalued is a dumb idea. Buying loonies for tonnies is plain silly (For non-Canadian readers, loonies = $1 while tonnies = $2) 

Share Buyback Lesson from the Oracle of Omaha:

We pay so much tuition to learn finance in University but the best source, Buffett's Annual Letters to shareholders, is available on the Berkshire Hathway's site for free. Regarding share buybacks, Buffett's clearly explained his position in his 2011 Annual Letter (see the section on "Share Repurchases" on page 6-7). Here is a quote taken from the letter:

"Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated"

Buffett explains how CEOs, even the honest and hardworking ones, fail the second test miserably. A CEO may think his company's share price is cheap no matter what price it is selling at. Even the honest executive is led to believe that returning excessive free cash flow is necessary. Buffett argues that this is not true. There is no point of a share repurchase UNLESS the you can repurchase the shares below intrinsic value, hopefully conservatively calculated as Buffett suggests. Notice Buffett never mentions earnings accretion or returning excessive free cash flow as criteria when deciding a share repurchase.

Here is another interesting thought from Buffett: "When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock UNDERPERFORMS in the market for a long time as well ." 

Wait, what? Did Buffett just say he hopes the share price would underperform the market for a long time? This is not a typo. The logic is a simple one, but often not well understood. If the share price underperforms, the company can purchase more shares and the remaining shareholders would own more of the company (and receive more share of the company's long term earnings as well). If IBM's share price remains at $200 for the next 5 years, Berkshire's 5.5% stake in the company would indirectly increase to 7% through the ~$50 billion share buyback program. But if IBM averaged $300 in the same period, then Berkshire's stake would only increase to 6.5%. The 0.5% may seem small but it makes a big difference in the long run. If net income is $20 billion for IBM per year, then Berkshire will get an additional $100 million share of that income. IBM's stock price is in fact languishing right now as expected and sell-side analysts are cutting their price targets like crazy. While analysts criticize IBM for poor share performance, Buffett must love the lower share price right now. It's hard to think long term but let's not forget the moral behind the turquoise vs. hare story. 

If the company is pursuing a large buyback program, shareholders should cheer when the stock price languishes. As Buffett says: "The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply." Very well said Mr.Buffett, I thank you for sharing this point many people miss. 


To answer the question in the title, share buybacks is definitely meaningful method of returning capital to shareholder only if the company can repurchase shares under intrinsic value, conservatively calculated. Investors should be cautious when CEOs announce buybacks because their intent is to offset share dilution or increase EPS growth. If CEOs announce buybacks because they want to return free cash flow, carefully assess the company's intrinsic value. If the company's shares are trading below intrinsic value, you should applaud the move and give a big thumbs up. If it is not (especially if it is significantly above your estimate of intrinsic value), you should  re-consider your investment thesis in the company. No matter how great a business may be, investors should not invest in the company if the CEO makes poor capital allocation decisions because those decisions can lead to a lot of value destruction. (An exception would a net-net special situation but I'll again save this topic for next time)

Tuesday, November 5, 2013

Some Real Thoughts On Stock Splits

Another post inspired by a WSJ CFO Journal article. (The article is found here. My prior article inspired by WSJ was on non-GAAP measures, which is here). The WSJ article discuss how corporations should consider revisiting stock splits. The author claims that academic studies have shown that the companies who split their stock will outperform the market. It is clearly the author supports the idea that a stock split will create value for its shareholders. However, my own opinion on share splits is quite the opposite: It's distracting tactic that management use to boost the stock price in the short term and does not create any value at all. Why would management want to boost short term share performance? The answer is simple: stock options grants (I'll save the topic of executive compensation for another day).

For those who are not familiar with the concept, a stock-split is a transaction that increases the company's shares outstanding by a specific multiple (usually 2 times or 3 times) and reduces the trading price of the stock by the same multiple. Here is an example to illustrate a stock-split: stock X is trading at $100 and has 1 million shares outstanding.  If it announces a 2:1 stock-split, the number of shares outstanding  doubles to 2 million and the stock's trading price would halved to $50. The company's market capitalization remains at $100 million (market capitalization is the market value of equity calculated by multiplying shares outstanding by the share price). No matter how you slice and dice it - i.e. $50 x 2 million, $33.33 x 3 million, $20 x 5 million -, the market capitalization is still $100 million. The famous Yogi Bear once said to the waiter after he ordered a pie: "Please cut it in 4 pieces instead of 8 because I can't eat 8 pieces". It doesn't matter how the pie is cut, Yogi Bear will still eat one whole pie. The fact he thinks he is eating less because he ate less pieces is plain silly.

This quote from the article made me laugh: "Kenneth Fisher, Noble Energy’s CFO, says the company’s research indicates companies that split outperform their peers by 2% to 3% in the near term.". The emphasis in that quote should be on the last two words in his sentence: NEAR TERM. 

If stock splits do create value, then companies with the high trading prices should be less attractive to investors. History suggest otherwise. Lets take the three highest priced stocks in the S&P500 which had no stock split in the last 10-years and look at their performance. The three companies with the highest trading prices are Berkshire Hathaway (at $171,700), (at $1080), and Google (at $1020). In the past 10 years (November 2003-present), the S&P500 only returned 60%. What about those stocks with the highest trading prices? Berkshire returned 120%, Priceline returned 5000% and Google returned 800% in the same period. Granted, although Priceline and Google were trading at prices below $100 in 2003, their executives never considered a stock split when their shares soared above $100 like most other S&P500 chiefs. Thus, the evidence suggests that high trading prices do not hurt share performance at all. So why do most CEOs want a stock split? 

Most S&P500 CEOs usually do a  2:1 or 3:1 split when the price of the company's shares soar above $100 because they believe they can create value by lowering the share's trading price. By lowering the trading price, CEOs think they can psychologically impact investors' perception of value just because the price per share is lower or liquidity in the stock has increased. While I agree most companies may experience short-term outperformance after a share split, the long term costs of the share split is negative for shareholders. Stock splits increase administrative and market listing costs because the shares traded more often (more turnover). Also, stock-splits generally attract more short-term oriented investors and increase management's incentive to try to meet quarterly earnings forecasts as the shareholder base becomes increasingly short-term oriented. There is nothing more value destroying in the long run than management trying to play the earnings beat game. Management may try various schemes to meet short term earnings expectations such as cutting expenses (instead of growing revenue), focusing on short term payback projects (instead of projects with the highest NPV), or doing ridiculously high priced acquisitions (which maximize short term earnings accretion but hurt long term value because they often overpay or issue undervalued stock to finance such acquisitions).

Therefore, stock-splits add zero value and it's just a short term tactic aimed at boosting investor's short term enthusiasm. If you hear a CEO talk about the benefits of a stock split, ask him/her whether 1 x 10 =  2  x 5  If he/she says yes, then you should reply why consider a stock split in the first place when the left hand side of the prior equation is equal to the right hand side. Actually the equation should be 2 x 5 - costs < 1 x 10  because stock splits will increase costs. Long term shareholder value can only be created if management focuses on building the underlying business (invest in positive NPV projects, return excessive free cash flow, and allocate capital efficiently) and generate a high return on capital. As Buffett famously said: "If the business does well, the stock will follow". If a CEO thinks his/her company should consider a stock split because the trading price is too high, he/she is spending way too much time looking at the company's stock price and not enough time building the underlying business. 

Sunday, October 20, 2013

With Debt Ceiling Debate Out of Way..What's Next For the Market? (An Investment Strategy Update)

Perhaps I was too pessimistic in my prior post to expect a market correction. Stocks hardly experienced a correction at all! The S&P500 and TSX both reached new 52-week highs of 1745 and 13,150 respectively. Investors are cheering over the fact there was a temporary kick the can down the road solution that avoided a U.S. default. Yes, a disastrous default was avoided, but the fight will come up again. Let's all hope Santa gives politicians a merry Christmas so they all can maintain their rationality in the new budget/debt ceiling negotiations in the new year. 

A 11th Deal...Again:

The Reid-McConnell dual did it again. Once again, it was up to the Senate to break the stalemate given the House cannot formulate any reasonable bill.  The deal was extremely favourable for the Democrats given the bipartisan bill re-open the government and provides funding until January 15th without any large changes to the Affordable Care Act (Obamacare) that conservative GOP lawmakers demanded. Also the bill suspends the nation's debt ceiling to February 7th, giving lawmakers a small breathing room of 4 month to come up with a credible deficit reduction plan.  A bipartisan committee is set up to negotiate over the budget, trying to bridge the differences between the House budget and the Senate budget. The deadline is to present a proposal to congress by December 13. 

Damage of Political Bickering:

The GOP's strategy of combining the Obamacare debate into the debt ceiling negotiation backfired. Even senior GOP members like McConnell admitted the strategy was "flawed" in the beginning. Unfortunately, the biggest losers are not those adamant conservative GOP lawmakers. The real losers of the 16-day government shutdown are actually the ordinary Americans that depended on the government. Most economists estimate that there was a direct 0.2% GDP hit because the loss wage income of the 400,000 furloughed government workers. There could be another 0.3-0.4% GDP hit in the fourth quarter because of indirect impacts, i.e. tourism/travel businesses saw a huge decline in customers due to the shutdown of many national parks and government sites. Adding both the direct and indirect impacts, there could be a 0.5-0.6% drag on the fourth quarter GDP. Prior to the government shutdown, the U.S. economy was expected to grow at 2.6% in Q4 (Q1 growth of 1.1% and Q2 growth of 2.5%). Therefore, the 16-day government shutdown would reduce Q4 GDP to approximately 2%. 

Here is a million dollar question: If the economy just experienced a slowdown, why is the equity market rallying to new highs? The simply answer is the Fed. Given a 0.5-0.6% cut in GDP in Q4 and the fact that the Fed policymakers are literally flying blind (important data such as non-farm payrolls, inflation, industrial production, housing reports were all suspended due to the government shutdown), it is likely there may not be any further tapering talks for the remainder of the year. According to a Bloomberg survey of Wall Street economists, the Fed is not expected to taper until March next year, a complete change in opinion since August when the Fed was expected to taper last month but did not. The expected path of QE3 is completed altered and additional stimulus is likely to provide further boost prices of risky assets. As former Citigroup CEO Chuck Prince used to say, "as long as the music is playing, you gotta get up and dance"

Equity Outlook:

The outlook for equities is positive for the next few months (up to New Years Day), although the author is still slightly cautious given current valuation. The S&P500 is valued at 16.6X trailing earnings and 14.5X forward earnings. The long term average for trailing earnings is 16.4X (50 year) and 14X (20 year) for forward earnings according to Bloomberg data.  Although valuation may look high, there is no doubt that the current least path of resistance for equities is up, meaning further gains ahead. Moreover, equities tend to gain from late-October to December based on historical seasonal trends with December being the best month for stocks. Finally, stocks current have positive price momentum and that will trigger further buying to support the current advance.  A combination of seasonality, positive momentum, and monetary stimulus all point to a positive outlook for equities for the remainder of the year. 

In my July Investment outlook report, I expected the S&P500 to finish 2013 at ~1625. Because tapering is delayed and the debt ceiling problem is avoided, I now expect the index to finish around 1720-1770, a valuation based on expected earnings of $122 in 2014 and a 14-14.5X forward multiple. Although the multiple is slightly higher than the average 14X, I expect the positive investor sentiment and the high level of monetary stimulus to justify recent multiple expansion. The index rally this year was 70% attributable to multiple expansion and only 30% to actual earnings growth. Given earnings is expected to grow only 8% while revenue is only expected to grow 5% this year, a 24% rally (YTD) in the index is not justified purely on fundamentals alone. The search for yield  has force many investors, small or large, to invest in riskier assets like equities in order to fulfill their expected returns requirements. 

Nonetheless, there are slight positives that can at least maintain the current price momentum to year-end. First, according to Factset, out of the 97 S&P500 companies that reported Q3/2013 earnings, 53% reported  sales above consensus estimates. That is slightly better than 40-50% rate in prior earnings seasons. Top line sales growth is paramount to further earnings growth. In addition, profit margins is near 2007 highs.

Sector-wise, I still favour cyclical sectors like financials (banks benefit from steeper yield curve and insurers can benefit from higher interest environment. Author likes MFC and IAG), industrials (GM, F, UNP), energy (downstream refiners like VLO looks attractive given the low crack spreads), and technology (look for the cash cows and good ROIC like CSCO). Despite putting a underweight outlook on materials in July, the author feels many names in this space are becoming undervalued such as AGU and YRI/AUY. 

FICC Asset Outlook: 

The outlook FICC (Fixed Income, Currencies and Commodities) remains relatively unchanged since my July Investment Outlook Report. I am keeping most of the expected price targeted unchanged such as the year-end target for 10-year treasuries at 2.8%-3.0% (despite a huge change in tapering expectation!).  A slight change would be a less favourable outlook for the U.S. dollar given delayed tapering,  which is positive for commodity currencies like the CAD and AUD.

This piece is for information purposes only. The list of stocks suggestions provided only serve to provide readers with ideas that they can further conduct research on. The author is not responsible for any losses readers incur by buying any names suggested. 

Out of the names suggested, the author owns a large stake in MFC

Monday, October 7, 2013

The Debt Ceiling Debate: A Possible Repeat of 2011?

In this piece, I will update everyone on the current situation in Washington regarding the government shutdown and the debt ceiling debate. Given both parties are publicly attacking each other and negotiations to re-open the government failed to yield any results, investors should not be expecting a smooth negotiation to raise the $16.7 trillion debt ceiling. Treasury Secretary Jack Lew already stated that by October 17th, the Treasury would only have $30 billion to pay claims including interests on debt.   

One party Zigs, other Zags:

Because of political differences, the U.S. government had to shutdown last Tuesday because of the U.S. congress's inability to pass a funding bill to fund the government for the new fiscal 2014 year. (U.S. government has fiscal year ending September 30). Republicans insisted on delaying the implementation of Obama's Affordable Health Care Act (Obamacare) as a condition to pass a funding bill. Democrats did not yield to Republican's demands and merely blamed Republicans for the cause of the shutdown. It is clear that each party is using this opportunity (government shutdown & debt ceiling debate) to try to lay blame on the other party and to seize some political gains for the upcoming election (mid-year election next year for the house/senate and 2016 Presidential election). Furthermore, Republicans already conceded too much in the last budget debate on New Year's eve that led to the sequester. Therefore, Republicans wanted to act tougher this time to force the Democrats to concede more during this round of budget debate. 

Given the hard stance taken by the two parties publicly, it is difficult to reconcile the two parities and form an agreement to open the government. Also, the vote to increase the debt ceiling appears more difficult given politicians can't even agree to end the government shutdown. The political game of chicken is starting to look awfully similar to 2011 and may have similar consequences. 

U.S. Won't Default, But That is Not What Investors Should Worry About: 

Yes, I can safely assure investors that U.S. won't default on its debt. Given U.S. treasury yields are used as benchmark yields for almost every financial instrument and the U.S. dollar is also the reserve currency, politicians know they can't risk a default, no matter how small it is. The effects of such a default would be unimaginable. For those who are curious, yields on treasuries would soar (not a safe haven anymore!), stocks prices would tumble and foreign investors may attempt to exit their U.S. investments. The consequences of these actions will trigger a long recession or even depression if policymakers do not act quickly. 

Let's move away from the doomsday scenario to a more realistic scenario.  The U.S. will not default, but politicians will continue to avoid making progress on discussions until the last minute regarding the debt ceiling. As the October 17th deadline date approaches, investor confidence will slowly erode to reflect a rising probability that politicians may fail to reach an agreement by the 11th hour. The erosion of confidence will be detrimental to the financial markets. Stocks will face some short term headwinds and bonds yields will decline due to the safe haven trade. 

Current investor sentiment is high because of the Fed's commitment to keep rates low (accommodative monetary policy) and the continuation of its asset purchase program (QE3). Nonetheless, history has provided many evidences where confidence can erode quickly. As investors saw in 2011, the debt ceiling debate suddenly went sour 2 days before the deadline and investors quickly dumped all risky assets (such as stocks) to avoid a potential U.S. default. When investors are nervous, emotions will take over. This means that anxious investors will sell everything because they only care about the return OF their capital rather than return ON their capital. Investors must realize that they are creatures of emotion, not creatures of logic especially in times of uncertainty. T-bill investors are already anxious enough to push the yield on T-bills due in late October from 0% to 0.13%. The CDS market is also showing some signs of stress with the cost of U.S. CDS rose to 64 bps from 30 bps. 

Investment Strategy:

In times of uncertainty, cash is king. Keeping some cash on hand is wise especially if markets will react negatively if negotiations continue up to the 11th hour of the debt ceiling deadline. Markets are not worried now because they assumed the debt ceiling will be raised and the agreement would be amicable. However, the final agreement on the debt ceiling would be far from amicable and investors' anxiety will increase with each passing day. More anxiety will likely lead to a market correction in the short term despite the U.S. congress will eventually raise the debt ceiling.

While it is possible for a debt ceiling agreement without creating too much investor anxiety, markets would hardly respond at all to a positive outcome because it has already been "priced in". However, markets will decline if negotiations become too hostile. Hence caution is warranted for now. 

Going back to the question I proposed in my title, it is quite possible for a repeat of 2011. However, equity market declines are likely to be much smaller than the 19% experienced in 2011 because of the Fed's stimulus and better economic conditions. Nevertheless, if the U.S. congress fail to raise the ceiling by the deadline, a 5-10% equity decline is definitely possible. Market declines are actually good for investors because they allow prudent long term investors to add to their positions when prices are down. Unlike most investors, I welcome market declines -especially large ones like 50%- so I can buy additional shares of the companies I own. If everyone likes big discounts when they go shopping, they should learn to appreciate market declines the same way. 

Wednesday, October 2, 2013

BlackBerry Q2 MD&A: More Bad News But Not All Negative

Quietly on a Tuesday afternoon, BlackBerry released its full Q2 report on EDGAR. I had the opportunity to skim through the filing and found some interesting data points. Readers are welcome to read my analysis, but could skip to the conclusion if they want to a quick read on what is the outlook for BlackBerry's shares. The financial media quickly pointed at all the negatives in the report without painting a full picture of the company. That being said, the Q2 report was more negative so I'll start of with the negatives. 

The Negatives:

(1) Hardware Fiasco:

According to, the word fiasco is defined as "A Complete and Ignominious Failure" and those words describe perfectly the performance of BlackBerry's hardware division in Q2/2014. We already knew from the pre-announcement on September 20th that hardware had a 50% decline year-over-year but new details are also very disappointing (see chart below). Quarter-over-quarter, the region that saw the hardest decline was Latam and EMEA (Europe, Middle East, Africa).  Weakness was wide-spread in all of the regions, even in emerging markets such as EMEA and Latam where the BlackBerry brand was favoured . 

$ in millions
North America
Asia Pac

Another confusion in the quarter was the accounting for BB10 devices. According to the quarterly report, the company did NOT change its revenue recognition policy. However, BB10 devices did not meet the company's revenue recognition criteria. Under U.S. GAAP (BlackBerry reports under U.S. GAAP), one of the revenue criteria is for the price to be fixed and measurable. Given BlackBerry must deduct estimated return returns and sales incentives (marketing, rebates) to estimate net revenue, the final price is not fixed if return rates or sales incentives cannot be measured reasonably. BlackBerry had trouble selling its BB10 devices and cannot accurately forecast the return rates/sales incentives in order to book the BB10 revenue. Due to the low sell-through rates and additional sales incentives needed, the company decided to not book revenue on BB10 devices until they are sold in the channel as described below: 

"Where a right of return cannot be reasonably and reliably estimated, the Company recognizes revenue when the product sells through to an end user or the return period lapses.For shipments where the Company recognizes revenue when the product is sold through to an end user, the Company determines the point at which that happens based upon internally generated reporting indicating when the devices are activated on the Company’s relay infrastructure."

Nevertheless, the company expected the change in BB10 revenue recognition did not "materially" impact revenue and they merely deferred the BB10 revenue. As I stated in my prior post, the big $500 million jump in deferred revenue could account for some of the deferred BB10 revenue. 

The future outlook for the hardware division is not encouraging. Device sales may continue to decline and BB10 sales are not picking up. Based on the company's provided BB10 sell-through rates, I estimate around 3 million BB10 devices have sold through to end-users vs. company's old expectation for "tens of million" units. The company needs to re-position its devices to attack specific markets it wants to target. The decision to make Z10 a low-cost devices could boost near-term sales as the high selling price on Z10 was main factor why many consumers decided to buy Android phones or iPhones. The Q5 also needs further price reduction in order for the company to remain competitive in emerging markets.  

(2) Services Businesses Still in Decline:

Service revenue declined 8.8% quarter-over-quarter from $794 million last quarter to $724 million this quarter. However, both quarter included service revenue deferrals due to the currency crisis in Venezuela ($72 million last quarter and $67 million this quarter). Without the Venezuela currency impact, service revenue actually declined 11.5%. Going forward, the company project a 12% quarter-over-quarter decline in Q3/2014, which is much higher than the single-digit decline projected in prior quarters. The faster than expected decline in service revenue is attributable to lower device sales and the migration to BB10 devices which receive lower service revenue than older BB7 devices. 

(3) The Restructuring Process is Costly:

The company already announced a planed reduction of 4500 employees. In the Q2 report, the company further elaborated that this plan will cost $400 million ($0.76/share) over the next three quarters.  To help alleviate the financial strain, the company is putting up $122 million ($0.23/share) of assets up for sale immediately. 

The Positives: 

(1) Ample of Liquidity:

The company burned $500 million cash in the quarter;  however, the cash burn rate should decrease after the company cut expenses and cash is received from selling its massive inventory. Z10 devices are now worthless on the company's books (thanks to the $934 million inventory charge) and could be sold at very low prices to protect its market share and increase BlackBerry's cash flow. With nearly $2.5 billion of cash on hand and a $500 million tax refund in Q1/2015, BlackBerry does not face a liquidity problem and could survive for the next few quarters. However, if it does quickly restructure its businesses, the long-term survival of the company could be at risk. 

(2) Purchase Obligation Less of a Drag on Valuation: 

BlackBerry bears like to point at the $5.3 billion purchase obligation stated in the Q1/2014 report as drag on the company's valuation. In its new Q2 report, purchase obligation decreased significantly to only $3.1 billion and could be reduced further as the company further re-align its purchase obligation with expected demand for its products. 

(3) Lost Service Revenue can partially recover:

The company deferred $72 million of service revenues in Q1 and $67 million in Q2. Of the $72 million deferred last quarter, $25 million has now been collected and the company expect further payments. Therefore, the lost service revenue could partially recover although it may be difficult to recovery the full amount. 

(4) Channel Inventory is Reduced: 

Sell through this quarter was 5.9 million units vs. shipment of 3.7 million units, which decreased channel inventory by 2.2 million units. Usually shipments increase after channel inventory is decreased significantly, a slight positive for the next quarter. 


Overall, the Q2 report revealed a more negative picture but there are also some positives as well. The $9 preliminary offer from Fairfax is discounted by the market because Prem Watsa is still seeking financing. Nonetheless, investors should not doubt his 28-year track record at closing deals and making good on his promises despite negative developments. He will keep his word and the $9 offer will be finalized. Other bidders may emerged but the $9 offer price still represents a 16% gain from today's market price of $7.75. The headlines may not be friendly to BlackBerry and the future prospects of the company is not 100% positive, but it looks like the maximum point of pessimism has been reached on the stock.

UPDATE( 1:00pm EST), Dow Jones reported that there are "other parties" interested in BlackBerry including Cerberus Capital Management. It is more likely than not that maximum point of pessimism has been reached.

Source: BlackBerry Q2 Report 

Friday, September 27, 2013

BlackBerry's Q2 Press Release: No Surprises But There Are More Data Points

After BlackBerry's terrible pre-announcement last Friday, the earnings release today is almost a non-event. The main financial drivers were in-line with the pre-announcement so there were no real surprises to shareholders and analysts, although the media is still using the bad financials to create fancy headlines such as "BlackBerry loses $1 billion". 

Key Results:
  • Revenue was $1,573 million, slight below the guided $1.6 billion in the pre-announcement
  • Adjusted gross margin of 36.2%, slight above the mid-range of guided 35-37% in the pre-announcement. Adjusted gross margin adds back the $10 million restructuring charge and $934 million non-cash inventory/supplier commitment charge. Both were included in the Cost of Sales line on the Income Statement 
  • GAAP loss of $965 million (guided $950-995 million) or $0.47/share (guided $0.47-0.51)
  • Ending cash (plus investments) balance of $2,569 million at Q2/2014 vs. $3,071 million at Q1/2014
The figures did not surprise anyone but the press release today provided the latest financial statements. There are some interesting conclusion one can make based on them.

Q2 Income Statement:

The pre-announcement already warned everyone about terrible loss number for Q2. Nevertheless, there are some slight positive points about this bad quarter. I believe Prem Watsa understand these points as well when made his $9 offer.  
  • The 50% quarter-over-quarter (q/q) decrease in revenue is surprising. However, BB10 device sales are not recognized until they are sold to end-customers (the sell-through model vs. BlackBerry's old sell-in model). Deferred revenue had a big jump of $500 million  q/q on the balance sheet. If one assumes (this is a big assumption) that the $500 million reflected potential BB10 sales, then the  revenue decline would have been 33% q/q vs. the 50%. BB10 sales could have been greater than $500 million but I am using the $500 million jump in deferred revenue as a rough guide
  • Adjusted gross margin of 36.2% was 2.3% higher than last quarter's 33.9%, despite most of sales came from older BB7 devices. This implies that management was heavily discounting BB7 in previous quarter to drive BB10 sales. Now with BB10 sales slowing, removing those heavy BB7 discounts actually resulted in higher gross margin. Most corporations still order BB7 devices because BES 10 (the company's mobile device management service) lacks full backward integration to support BB7 devices. Removing BB7 discounts was actually a good idea
  • The Cost of Sales line contained a $934 million inventory charge. An inventory charge also reduces the carrying cost of inventory. If BlackBerry can sell those worthless inventory in the future, it will help boost revenue and cash flow. Taking a big bath this quarter is shifting future expenses up-front
  • The most interesting point I saw was if we adjust the one-time items and apply the guided 50% cut in operating expenses going forward, the company can money. i.e. take earnings before tax of -$1,438 million, add the $934 million inventory charge, add the $72 million restructuring charge and add the $450 million potential reduction in operating expense. The adjusted earnings before tax becomes $18 million. Therefore, BlackBerry can make money in the future if it downsizes significantly and become a niche player. The 13% reduction in operating expenses did little to offset the 50% decline in revenue this quarter. 
Given BlackBerry's financial performance, the company's ability to generate future earnings is questionable. Therefore, looking at the balance sheet is important because the valuation of the company is heavily dependent on what resources it owns. 

Q2 Balance Sheet:
  • Despite the $934 million charge, the ending inventory is $941 million, which is higher than last quarter's! Thus, most of the $934 million charge was related to the $5.3 billion off-balance sheet supply commitment. BlackBerry may have to take additional inventory charge in future quarters 
  • The increase in income tax receivable to $462 million from $33 million is positive given this will be a future cash-inflow once collected
  • Working capital management appears poor with cash conversion cycle at 94 days (highest in the past 8 quarters), but this number is likely to decrease based historical trend. The company's working capital position improved after it booked a $400 million charge relating to its PlayBook tablet
  • Book Value reduced to $16.06 and Tangible Book reduced to $9.38. Looks like Prem's offer is just slightly below Tangible Book
The current value of BlackBerry is balance sheet dependent. The balance sheet contains cash at $2,569 million, PP&E booked at $2,119 million and intangible assets (patents) at  $3,505 million. The market value of patents, a key valuation input for BlackBerry,  is quoted from $1-3 billion. 

As I stated in my prior post, I valued BlackBerry at $11.50 based on the Q1 balance sheet and gave no consideration for future earnings power (the ability to generate future earnings). After seeing the updated Q2 balance sheet, I will revised the figure down to ~$11. However, this valuation does not matter if no one wants to pay for it. Shareholders only have one offer at $9 on the table and it may be the best offer. 

Prem Watsa's $9 Conditional Offer:

The shares are trading almost $1 below the $9 offer price, implying the market is betting the deal may not go through. A 12.5% risk-arb spread looks too good to be true. Nonetheless, there was a 30% risk-arb spread on the Progress Energy deal and a 20% risk-arb spread on the Nexen deal because of uncertainty regarding government approval. Investors should remember that both deals were completed and risk arbitrageurs got their double digit returns.

Some analysts predict Prem may lower his $9 offer to squeeze existing shareholders. That could definitely happen, but there are some negative implications for him as well. If he does lower his offer, his reputation and credibility will be damaged. Prem and Fairfax need that good reputation and credibility for future deal making so trading a good reputation for money is foolish. As Buffett famously said: "Lose money, I'll be understanding. Lose a shred of reputation, I will be ruthless." I think Prem understand what Buffett meant  and put his reputation on the line when he announced that the takeover would be led by Fairfax (his firm).  

Therefore,I think the $9 is creditable despite the uncertainty. Looking at the balance sheet, it is less healthier than I expected so a higher offer is unlikely at this point, although a higher bid could emerge.

Source: BlackBerry 6-K filing 

Monday, September 23, 2013

BlackBerry's Deal with Fairfax Financial

One has to wonder why BlackBerry pre-announced its fiscal Q2 results last Friday when its scheduled quarterly announcement is less than a week away. Shareholders got an answer in today's press release when BlackBerry signed a letter of intent with a consortium led by Fairfax Financial. The letter of intent contemplates a transaction in which BlackBerry shareholders would receive US$9.00 in cash for shares not owned by Fairfax (Fairfax owns 10% of the company). This transaction would value the company at US$4.7 billion, a fraction of the value the market gave it back in 2008 when it was worth US$80 billion. 

The parties will try to reach a definitive transaction agreement by end of November 4,2013. BlackBerry is allowed to enter into "alternative transactions" with another party during the due diligence period (now till November 4,2013). 

My Opinion:

It shouldn't be surprising that Fairfax, being the buyer, would offer a low price of US$9. Being a shareholder, I believe this undervalues the company, but I acknowledge the company is facing more headwinds than I anticipated. The low offer price for BlackBerry almost reminds me of Bear Stearns  when it was first offered $2 per share on March 14, 2008. Jamie Dimon stated that "buying a house and buying a house on fire is not the same". Ultimately, Dimon had to concede to shareholders by offering $10 per share. In case of BlackBerry, I don't expect the final transaction price to be significantly higher than the current pre-announced US$9 offer price. Nonetheless, it is more likely than not that the final transaction price will be higher than the current US$9. Therefore, I am holding my shares for now especially given the shares are trading below US$9 (BBRY) preliminary offer price. The final transaction may be slightly higher at $9.50-$10.50.  The announcement today does buy time for the company to find another buyer as it temporarily puts a floor to the stock price and will limit additional negative rumors on the company. The key point is that Fairfax has provided confidence to BlackBerry 's customers that the company will survive. 

Because of today's announcement, the stock has become a special situation and a pure risk arbitrage play. Taking the playbook from Buffett's 1988 annual letter on how to evaluate this situation:

To evaluate arbitrage situations you must answer the four questions: 
(1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up?  (3) What chance is there that something still better will transpire - a  competing takeover bid, for example? (4) What will happen if  the event does not take place because of anti-trust action, financing glitches, etc.?

The probability of (1) happening is high given Prem's track record of closing deals. Looking at criteria (2), the timing on this arbitrage trade appears to be 6 weeks. As for criteria (3), there is a chance of a better offer from another bidder or another a group of buyers teaming up to buy BlackBerry and carve out the operations. I think there is definitely a chance for a higher offer price than $9.50-10.50 but investors should keep their expectation low for now. Getting a better outcome than expected is never a bad thing! Finally, I think the chances for criteria (4) is less likely given I feel BlackBerry's management has already took the big bath in order to help Prem Watsa. A possible glitch is the financing because the Fairfax group has not finalized the financing yet.  Nonetheless, chances are low that Prem cannot find the necessary financing for a $2.1 billion ($4.7 billion less $2.6 cash) bid. 

With cash of $2.6 billion, patent value estimated at roughly $2 billion (could be high as $3-4 billion), and value of services/other infrastructure at $1.5 billion, BlackBerry should be worth ~$11.60 conservatively valued. Of course, Fairfax, being the buyer, will not pay that price even if the $11.60/share is a conservative value. However, Fairfax may raise the price slightly to $9.50 or $10 to appease shareholders just like JP Morgan did in its deal with Bear Stearns. There is still value in the company even if they flop the hardware side. The delay in its global BBM launch was disappointing but BBM will still ultimately attract millions of users, which the company can monetize through advertising etc.

The next 6 weeks will be interesting. The earnings report on Friday September 26 will offer more colour on the financial health and future of BlackBerry. 


Wednesday, September 18, 2013

No Tapering...For Now

Market participants were quite surprised at the FOMC's decision to not taper its asset purchase program today. The consensus among many analysts and economists was for the FOMC to taper or reduce the size of its asset purchase program in the range of $10-$15 billion. The reaction to the announcement was quite volatile. The S&P500 rallied to an all time high of 1725, the 10-year treasury yield decrease 15 basis points (bps) to 2.70%,  precious metals rallied and the U.S. Dollar depreciated against the majors. 

Why Not Taper?

During Bernanke's press conference, there was a question phased as "Why not taper now given that the Fed has already signaled to the market that it will taper in September?". The Fed Chairman's answer was simple: the reduction of QE is heavily data dependent and financial conditions have tighten considerably to pose a risk to the economic recovery. Bernanke reiterated his stance that there is no "pre-set course" on ending the asset purchase program (QE3) and market participants were wrong to bet on a September taper. The Fed will consider reducing QE in the "coming meetings" depending on incoming data. Nonetheless, Bernanke's tone in the press conference was more cautious and suggest that the Fed may wait longer before tapering QE; the following statement from the FOMC illustrates this point: "...the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases"

Bernanke clearly explained that the labour market must improve "substantially" and the outlook for the labour market must be equally solid to justify a reduction of QE. The labour market improved since last September, but the improvement was not  "substantial".
  • The 6 month average non-farm payrolls did improve from 140K last August to the 155K currently. Many FOMC members stated in their public speeches that a run-rate of 200K or above defines a solid labour market. Because the rolling 6-month average payroll number is still below the 200K level, a September taper does make sense especially due to the Fed's mandate of maximum employment
  • The unemployment rate decreased from 8.1% in August 2012 to 7.3% currently. Although the 0.8% reduction in unemployment rate is encouraging, part of the decrease is attributable to the 0.3% decrease in the labour participation rate during the same period, which is definitely not positive. As Bernanke stated in the press conference, the 0.8% decrease should be partially discounted because it ignores decline in the participation rate 
There are also other reasons, as outlined below, that explain why the Fed did not taper:
  • The recent spike in interest rates was a major concern as outlined in today's FOMC statement "the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market". It was obvious that FOMC members realize that market participants perceived tapering as tightening. Given that interest rates have increased significantly since June, FOMC members wanted to let interest rates fall slightly in order to stimulate economic activity, especially in the housing sector. i.e. recent weekly mortgage applications have been decreasing at double digit percentage rates. This is attributable to the 120 bps rise in the 30-year mortgage rate from 3.5% to 4.7% in less than 3 months
  • The recent run-up in rates has partially alleviated the Fed's concern about financial stability. Higher interest rates and speculation regarding a September taper helped to reduce the excessive levered positions taken by speculators. With less concerns regarding financial stability, the Fed decided to continue QE as risks to the recovery still remains
  • Fiscal problems, such as the potential debt ceiling debate later this month and a possibility of a government shutdown, may slow the recovery. A repeat of 2011 would be disastrous for the financial markets and the Fed is just being cautious ahead of the negotiations 

In the final analysis, all of the points above explain why the Fed decided to keep the size of its asset purchase program at $85 billion and did not taper QE. Also, it is interesting to note that FOMC members lowered their GDP forecast for 2013 to 2.0-2.3% from 2.3%-2.6%. 

When Will the Fed Taper?

Don't count on the 7.0% and 6.5% thresholds:

Many analysts thought Bernanke was giving specific guidance when he indicated that the QE program will end by the time the unemployment rate hit 7.0% and a first hike will occur when the unemployment rate hit 6.5%. Because the Fed chairman uses words like "depends", "subject to", and "data dependent" when explaining Fed policy, investors should rely less on the numbers provided and more on the chairman's qualitative descriptions. He made it clear in today's press conference that the numbers provided were used as illustrations to describe potential exit strategies. Also, the 7.0% and 6.5% are used as thresholds, not as triggers. QE does not necessarily end when the unemployment rate drops below 7.0%. By the same token, a rate hike is not automatically considered if the unemployment rate drops below 6.5%. Investors must remember that the Fed has a dual mandate of maximum employment and price stability. Whether QE is a good policy tool or not is debatable, but FOMC members are simply doing their job by promoting maximum employment when they decided to not taper today. 

The Fed will taper when the labour market has improved "substantially":

As discussed above, the Fed will taper QE when the labour market improve substantially. A substantial improvement can be defined when all the conditions below are satisfied:
  • When the 6 month average payrolls number is near or above the 200K level 
  • Unemployment is below 7% AND the labour participation rate shows some improvement from current levels
  • Wage growth is at or above the current 2% level
  • Improvement in other labour market statistics: lower longer term unemployment, lower number of discouraged workers and higher private payrolls

The actual timing is difficult to ascertain but the Fed will eventually taper: 

In my opinion, predicting when the Fed will taper is a pure gamble. Because the FOMC hinted at the possibility of tapering in the "coming meetings" in today's statement, investors should expect a taper announcement either in the October or December meeting depending on the incoming economic data. Investors are making a mistake if they think the Fed will continue its easy monetary policy. Generally, the economy is on a better footing compared to last year, so less monetary stimulus is justified. The Fed needs to communicate clearly to the market on how it will reduce QE over time when it begins to taper QE. Overreactions in the financial markets, such as the rate shock in June, can spill over to the real economy and damage the underlying recovery. 

Implication for Investments:

Today's Fed announcement did not change my long term investment outlook. Investors are facing a rising interest rate environment in the long run and chasing after yields is a bad strategy. Short to intermediate term bonds are better choices than long term bonds, although the long-end of the curve may outperform in the short term. As for equities, valuations are no longer attractive and caution is warranted given that lower interest rate (the driver of lower discount rates) won't be around forever. However, equities are not terribly overpriced either, so betting against stocks is also not a good strategy. I am maintaining all my long equity positions, although I may sell into large rallies in the upcoming months. 

The energy and materials sectors will benefit from today's Fed announcement and will outperform in the short term. Because these two sectors were the laggard this year, investors may benefit from overweight energy and materials stocks relatively to other sectors. Nonetheless, individual stock selection is important given that not all stocks in the energy or materials sectors are attractive.  

There will always be opportunities to take advantage of one-sided expectations. As described in my prior posts, the 10-year treasury with a 3% yield is too high because higher rates will eventually cripple the recovery. After today's rate announcement, the yield decreased to 2.7%. If the yield drops below 2.3% in the upcoming month, a short rates trade may look attractive. The 2.3% was the yield before Bernanke laid out the framework for tapering QE in the June 19th FOMC press conference. The Fed will taper eventually so any large drop in rates, especially within a short time period, provides a good opportunity to short rates.

All in all, investors should remember this: financial assets (stocks or rates) don't grow to the sky, nor do they fall to the floor. 

Appendix: FOMC policy statement [1], bolded sentences are important.

Information received since the Federal Open Market Committee met in July suggests that economic activity has been expanding at a moderate pace. Some indicators of labor market conditions have shown further improvement in recent months, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has been strengthening, but mortgage rates have risen further and fiscal policy is restraining economic growth. Apart from fluctuations due to changes in energy prices, inflation has been running below the Committee's longer-run objective, but longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic growth will pick up from its recent pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate. The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished, on net, since last fall, but the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market. The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, but it anticipates that inflation will move back toward its objective over the medium term.

Taking into account the extent of federal fiscal retrenchment, the Committee sees the improvement in economic activity and labor market conditions since it began its asset purchase program a year ago as consistent with growing underlying strength in the broader economy. However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases. Accordingly, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. Taken together, these actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee's dual mandate.

The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. In judging when to moderate the pace of asset purchases, the Committee will, at its coming meetings, assess whether incoming information continues to support the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective. Asset purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on the Committee's economic outlook as well as its assessment of the likely efficacy and costs of such purchases.

To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Charles L. Evans; Jerome H. Powell; Eric S. Rosengren; Jeremy C. Stein; Daniel K. Tarullo; and Janet L. Yellen. Voting against the action was Esther L. George, who was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations

[1] FOMC Statement
[2] FOMC Projects
[3] FOMC Press Conference