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  Stewart's investment strategy cremates wealth

BENJ GALLANDER and BEN STADELMANN

Tuesday, April 6, 2010

It's that time of year when the mail slot clangs with the sound of big, fat annual reports. Reading these missives is hardly the most exciting part of being an investor, but it's a great time for shareholders to take a step back and get a big-picture view of what is happening with their companies.

Going through the annual report of Contra holding Stewart Enterprises has been a study in contrasts. Operationally, 2009 was very encouraging, with excellent cash flow generation, a substantial chunk of debt paid off and a 20 percent hike in the dividend. Given the backdrop of lower death rates and the trend towards cheaper cremations, the company has carefully managed expenses and used its strong market position to enhance profitability.

But there is another aspect of the funeral business that has nothing to do with undertakers and providing families with a needed service in sad circumstances. Money gets collected today for services that will only be rendered at some point in the future. These funds are put into three kinds of trusts, for pre-need funeral services, for pre-need cemetery plots, and for interment rights and perpetual care of cemeteries. Bring on the cookie jars!

In theory, the opportunity to grow these assets until withdrawals are required is a huge advantage. For example, one of the reasons the insurer Geico is so successful is that premiums collected are brilliantly invested by parent Berkshire Hathaway. So how does Stewart stack up?

At first glance, the historical returns don't look too bad, albeit somewhat less than would be expected even from investing in a balanced, conservative portfolio. From page 31 of the report, "The following table presents the overall annual realized return in our domestic trusts for the years 1991 to 2009."

1991–998–9%
20005.8%
20016.3%
20024.3%
20034.8%
20042.6%
20054.3%
20065.1%
20074.8%
2008−3.3%
2009−0.4%

Ah, but these "overall returns" are not what we would call returns at all. They include interest, dividends and realized capital gains or losses, but not unrealized capital gains or losses. Throw those in, and these returns would look, shall we say, six feet under. As of October 31, 2009, unrealized gains were $11.9 million, unrealized losses came to $261.5 million, for a net unrealized loss of $249.5 million. Incredibly, despite a historic rally, the net unrealized loss is actually worse than the tally for a year earlier.

The explanation would appear to be that, late in 2008, Stewart retained a new consultant who told them to reallocate more money to fixed-income securities. That would have been fine advice in 2007, but to do so after the market meltdown is very much a case of shutting the barn door when the horse is long gone.

In its defence, management points out that its bets in the U.S. financial sector were with corporations in the S&P 500 that were rated at least "A" by S&P, Moody's or Fitch. Well, we all know that those ratings weren't worth the electrons used in their dissemination. But just a sec, if Stewart managed to thoroughly participate in the market's downfall, how come it didn't hitch a ride upwards during the go-go years from 2003 to 2007?

There's a hint of an explanation in management's depiction of its "actively managed covered call program." This program is characterized as a "hedge" and an opportunity for income. That is a fallacy. Writing calls on stocks that you own is, in fact, an option strategy that assumes you are smart enough to select companies whose stock price will stay within a narrow range for a specific period of time. Indeed, there is a chance to profit when this works out, but it provides no protection during unanticipated declines. It also forces you to sell your big winners, or buy back the calls at a higher price. Over time, poorly executed covered calls will cull a portfolio of the heavy hitters, while retaining all of the duds.

The care of Stewart's trust funds is under the auspices of Investors Trust Inc., an in-house corporation that provides exclusive financial advisory services to Stewart. This cozy arrangement allows Stewart to earn income from the fees collected to manage these trusts. Here's a memo to management: A herd of drunken baboons throwing darts would probably have a better record than the folks running this show. Stewart should stick to the business it knows and performs well, providing funeral services, and leave investing decisions to quality professionals.


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