Archive for June, 2011
Boo! Was that a ghost, or was that just some soft patch talk scaring you during a nightmare? The economic data hasn’t been exactly rosy over the last month, and as a result, investors have gotten spooked and have chosen to chainsaw their equity positions. Since late April, nervous investors had already yanked more than $15 billion from U.S. equity mutual funds and shoved nearly $29 billion toward bond funds (Barron’s). Jittery emotions are evidenced by the recently released June Consumer Confidence numbers (Conference Board), which came in at a dismal 58.5 level – significantly above the low of 25.3 in 2009, but a mile away from the pre-crisis high of 111.9 in 2007.
Economic Monsters under the Bed
Why are investors having such scary dreams? Look no further than the latest terror-filled headlines du Jour referencing one (if not all) of the following issues:
• Inevitable economic collapse of Greece.
• End of QE2 (Quantitative Easing Part II) monetary stimulus program.
• Excessive state deficits, debt, and pension obligations.
• Housing market remains in shambles.
• Slowing in economic growth – lethargic +1.9% GDP growth in Q1.
• Accelerating inflation.
• Anemic auto sales in part caused by Japanese supply chain disruptions post the nuclear disaster.
Surely with all this horrible news, the equity markets must have suffered some severe bloodletting? Wait a second, my crack research team has just discovered the S&P 500 is up +5.0% this year and its sister index the Dow Jones Industrial Average is up +7.2%. How can bad news plus more bad news equal an up market?
OK, I know the sarcasm is oozing from the page, but the fact of the matter is investing based on economic headlines can be hazardous for your investment portfolio health. The flow of horrendous headlines was actually much worse over the last 24 months, yet equity markets have approximately doubled in price. On the flip-side, in 2007 there was an abundant amount of economic sunshine (excluding housing), right before the economy drove off a cliff.
Being purely Pollyannaish and ignoring objective soft patch data is certainly not advisable, but with the financial crisis of 2008-2009 close behind us in the rear-view mirror, it has become apparent to me that fair and balanced analysis of the facts by TV, newspaper, radio, and blogging venues is noticeably absent.
Given the fact that the stock market is up in 2011 in the face of dreadful news, are investors just whistling as they walk past the graveyard? Or are there some positive countervailing trends hidden amidst all the gloom?
I could probably provide some credible contrarian views to the current pessimistically accepted outlook, but rather than recreating the wheel, why not choose a more efficient method and leave it to a trusted voice of Scott Grannis at the Calafia Beach Report, where he resourcefully notes the market positives:
“Corporate profits are very strong; the economy has created over 2 million private sector jobs since the recession low; swap spreads are very low; the implied volatility of equity options is only moderately elevated; the yield curve is very steep (thus ruling out any monetary policy threat to growth); commodity prices are very strong (thus ruling out any material slowdown in global demand); the US Congress is debating how much to cut spending, rather than how much to increase spending; oil prices are down one-third from their 2008 recession-provoking highs; exports are growing at strong double-digit rates; the number of people collecting unemployment insurance has dropped by 5 million since early 2010; federal revenues are growing at a 10% annual rate; households’ net worth has risen by over $9 trillion in the past two years; and the level of swap and credit spreads shows no signs of being artificially depressed (thus virtually ruling out excessive optimism or Fed-induced asset price distortions). When you put the latest concerns about the potential fallout from a Greek default (which is virtually assured and has been known and expected for months) against the backdrop of these positive and powerful fundamentals, the world doesn’t look like a very scary place.”
Wow, that doesn’t sound half bad, but rock throwing Greek vandals, nude politicians Tweeting pictures, and anti-terrorist war campaigns happen to sell more newspapers.
It’s the Earnings Stupid
Grannis’s view on corporate profits supports what I recently wrote in It’s the Earnings, Stupid. What really drives stock prices over the long-term is earnings and cash flows (with a good dash of interest rates). Given the sour stock market sentiment, little attention has been placed on the record growth in corporate profits – up +47% in 2010 on an S&P 500 operating basis and estimated +17% growth in 2011. Few people realize that corporate profits have more than doubled over the last decade (see chart below) in light of the feeble stock market performance. Despite the much improved current profit outlook, cynical bears question the validity of this year’s profit forecasts as we approach the beginning of Q2 earnings reporting season. However, if recent results from the likes of Nike Inc. (NKE), FedEx Corp (FDX), Oracle Corp. (ORCL), Caterpillar Inc. (CAT), and Bed Bath & Beyond Inc. (BBBY) are indicators of what’s to come from the rest of corporate America, then profit estimates may actually get adjusted upwards…not downwards?
There is plenty to worry about and there is never a shortage of scary headlines (see Back to the Future magazine covers), but reacting to news with impulsive emotional trades will produce fewer sweet dreams and more investment nightmares.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Performance data from Morningstar.com. Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and FDX, but at the time of publishing SCM had no direct position in NKE, CAT, ORCL, BBY or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
There are a few similarities between dieting and investing. There are no shortcuts or panaceas to achieving success in either endeavor – they both require plain old hard work. Any winning investment process will have some sort of mechanism(s) to generate new stock ideas, whether done quantitatively through a screening process or more subjectively through other avenues (e.g., conferences, journals, investor contacts, field research, or Investing Caffeine – ha). As many investors would agree, discovering remarkable stock picks is no effortless undertaking. A lot of meaningless rocks need to be turned before a gem can be found, especially in an age of information overload. I believe investing guru Peter Lynch said it best:
“I always thought if you looked at ten companies, you’d find one that’s interesting, if you’d look at 20, you’d find two, or if you look at hundred you’ll find ten. The person that turns over the most rocks wins the game.”
Depending on the duration of your investment time horizon, stock gems can be more abundant in certain time periods relative to others. The shorter the timeframe, the more important timing becomes. Looking at a few major turning points illustrates my point. Although hindsight is 20/20, it is clear now (and for a minority of investors 11 years ago) that the pickings were slim in March 2000 and virtually endless in March 2009 –practically anything purchased then went up in price.
Investing is not a game of certainty, because if it was certain, everyone would be sipping umbrella drinks on their personal islands. Since investing involves a great deal of uncertainty, the name of the game is stacking probabilities in your favor. If you have a repeatable process, you should be able to outperform the markets in the long-run. In the short-run, a good process can have a bad outcome, and a bad process can have a good outcome.
Macro vs. Bottom-Up
Gaining a rough sense of the macro picture can increase the probabilities of success, but more importantly I believe a bottom-up approach (i.e., flipping over lots of stock rocks) is a better approach to raising odds in your favor. The recent volatility and pullback in the market has left a sour taste in investors’ mouths, but great opportunities still abound. That’s the thing about great stocks, they never disappear in bear markets and they eventually flourish – more often when a bull market returns.
Characterizing the macro game as difficult is stating the obvious. Although there are only about two recessions every decade, if you watch CNBC or read the paper, there are probably about 20 or 30 recessions predicted every 10 years. Very few, if any, can profitably time the scarce number of actual recessions, but many lose tons of money from the dozens of false alarms. You’re much better off by following Lynch’s credo: “Assume the market is going nowhere and invest accordingly.”
Land Mine or Gold Mine?
Not everyone believes in the painstaking process of fundamental analysis, but I in fact come from the COFC (Church of Fundamental Research), which firmly believes fundamental research is absolutely necessary in determining whether an investment is a land mine or a gold mine. Others believe that a quantitative black box (see Butter in Bangladesh), or technical analysis (see Astrology or Lob Wedge) can do the trick as a substitute. These strategies may be easier to implement, but as well-known money manager Bill Miller indicated, “This is not a business where ignorance is an asset; the more you work at it, the better you ought to be, other things equal.”
By doing your investment homework on companies, not only will you gain better knowledge of your investment, but you will better understanding of the company. Regardless of your process, I’m convinced any worthwhile strategy requires conviction. If you have loose roots of interest in a stock, the wind will blow you all over the place, and ultimately rip the roots of your flimsy thesis out of the foundation. I contend that most lazy and simplistic processes, such as buying off tips, chasing winners, or letting computers buy stocks might create short-term profits, but these methods do not engender conviction and will eventually lead speculators to the poor house. If simple short-cuts worked so well, I think the secret would have gotten out to the masses by now. Rather than trading off of tips or questionable technical indicators, Peter Lynch advises investors to do their homework and “buy what you know.”
There is no single way of making money in the stock market, but I’m convinced any worthwhile process incorporates a process of pulling weeds and watering new flowers. But to generate a continuous flow of new stock idea gems, which are necessary to win in the investment game, you will need to turn over a lot of stock rocks.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Performance data from Morningstar.com. Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
When it comes to investing, do you trade like Jim Cramer on Red Bull – grinding your teeth to every tick or news headline? With the advent of the internet, an unrelenting, real-time avalanche of news items spreads like a furious plague – just ask Anthony Weiner. As fear and greed incessantly permeate the web, and day-trading systems and software are increasingly peddled as profit elixirs, investors are getting itchier and itchier trading fingers. Just consider that investment holding periods have plummeted from approximately 10 years around the time of World War II to 8 months today (see GMO chart below). Certainly, the reduction in trading costs along with the ever-proliferating trend of technology advancements (see Buggy Whip Déjà Vu) is a contributor to the price of trading, but the ADHD-effect of information overload cannot be underestimated (see The Age of Information Overload).
But fear not, there is a prescription for those addicted, nail-biting day-traders who endlessly pound away on their keyboards with bloody hangnails. The remedy is a healthy dosage of long-term growth investing in quality companies and sustainably expanding trends. I know this is blasphemy in the era of “de-risking” (see It’s All Greek to Me), short-term “risk controls” (i.e. panicking at bottoms and chasing performance), and “benchmark hugging,” but I believe T. Rowe Price had it right:
“The growth stock theory of investing requires patience, but is less stressful than trading, generally has less risk, and reduces brokerage commissions and income taxes.”
This assessment makes intuitive sense to me, but how can one invest for the long-term when there are structural deficits, inflation, decelerating GDP growth, international nuclear catastrophes, escalated gasoline prices, and Greek debt concerns? There are always concerns, and if there none, then you should in fact be concerned (e.g., when investors piled into equities during the “New Economy” right before the bubble burst in 2000). In order to gain perspective, consider what happened at other points in history when our country was involved in war; came out of recession; faced high employment; experienced Middle East supply fears; battled banking problems; handled political scandals; and dealt with rising inflation trends. One comparably bleak period was the 1974 bear market.
Let’s take a look at how that bear market compared to the current environment:
Then (1974) Now (2011)
End of Vietnam War End of Iraq War (battles in Afghanistan and Libya)
Exiting recession Exiting recession
9% Unemployment 9% Unemployment
Arab Oil Embargo Arab Spring and Israeli-Palestinian tensions
Watergate political scandal Anthony Weiner political scandal
Franklin National Bank failure Banking system bailout
Rising inflation trends Rising inflation trends
We can debate the comparability of events and degree of pessimism, but suffice it to say the outlook was not very rosy 37 years ago, nor is it today. History never repeats itself, but it does tend to rhyme. Although attitudes were dour four decades ago, the Dow Jones exploded from 627 in late 1974 to 12,004 today. I’m not calling for another near 20-fold increase in prices over the next 37 years, but a small fraction of that improvement would put a smile on equity investors’ faces. Jim Fullerton, the former chairman of the Capital Group of the American Funds understood pundits’ skepticism during times of opportunity when he wrote the following in November 1974:
“Today there are thoughtful, experienced, respected economists, bankers, investors and businessmen who can give you well-reasoned, logical, documented arguments why this bear market is different; why this time the economic problems are different; why this time things are going to get worse — and hence, why this is not a good time to invest in common stocks, even though they may appear low.”
Rather than getting glued to the TV horror story headline du jour, perhaps investors should take some of the sage advice provided by investment Hall of Famer, Peter Lynch (Lynch averaged a +29% annual return from 1977-1990 while at Fidelity Investments). Rather than try to time the market, he told investors to “assume the market is going nowhere and invest accordingly.” And Lynch offered these additional words of wisdom to the many anxious investors who fret about macroeconomics and timing corrections:
• “It’s lovely to know when there’s recession. I don’t remember anybody predicting 1982 we’re going to have 14 percent inflation, 12 percent unemployment, a 20 percent prime rate, you know, the worst recession since the Depression. I don’t remember any of that being predicted. It just happened. It was there. It was ugly. And I don’t remember anybody telling me about it. So I don’t worry about any of that stuff. I’ve always said if you spend 13 minutes a year on economics, you’ve wasted 10 minutes.”
• “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
• “Whatever method you use to pick stocks or stock mutual funds, your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed.”
Real money is not made by following the crowd. Real money is made by buying quality companies and securities at attractive prices. The prescription to generating above-average profits is finding those quality market leaders (or sustainable trends) that can compound earnings growth for multiple years, not chasing every up-tick and panicking out of every down-tick. Following these doctor’s orders will lead to a strong assured mind and a healthy financial portfolio – key factors allowing you to peacefully snooze to investment prosperity.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Performance data from Morningstar.com. Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in TROW, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Apple Inc. (AAPL) is considered the quintessential innovation company. After all, if you flip over an iPad or an iPhone it will clearly state, “Designed by Apple in California. Assembled in China.” Apple is just too busy innovating to worry about dirtying their hands by assembling products – they can simply outsource that work. Many people have a problem with the millions of manufacturing jobs moving offshore, but if I am the self anointed “Innovation Czar” for the United States, I definitely favor keeping the $120,000 Apple engineering jobs over the low-cost $2 per hour jobs being lost to China (or cheaper developing country). Oh sure, I would prefer keeping both workers, but if push comes to shove, I much rather keep the six-figure job. The bad news is the displaced American iPhone/iPad assembler must find an alternative lower-skilled employment opportunity. The good news is there are plenty of service-based jobs that will NOT get outsourced to the Chinese. If displaced workers are unhappy serving lattes at Starbucks or changing bedpans at the local hospital (or other unglamorous service-based job), then they can choose to retool their skills through education, in order to land higher-paying jobs not getting outsourced.
Bass Ackwards Job Assessment
While I may agree with many points made by Time Magazine’s Fareed Zakaria in his article, The Future of Innovation: Can America Keep Pace?, I think Zakaria is looking at the job trade-off a little backwards. Here is what says about Apple-created job losses in a CNN blog post:
“Apple has about $70 billion in revenues. The company that makes Apple’s products called Foxconn is in China. They have about the same revenue – $70 billion dollars. Apple employees 50,000 people. Foxconn employs 1,000,000 people. So you can have all the innovation you want and tens of thousands of engineers in California benefit, but hundreds of thousands of people benefit in China because the manufacturing has gone there. What does that mean? America needs to innovate even more to keep pace.”
Wow, that’s very altruistic of Apple to create thousands of jobs for Foxconn in Asia, but that $70 billion in Apple revenues likely generates close to 10 times the profits that Foxconn creates (Apple had 24% net profit margins last quarter versus probably a few percent at Foxconn). As Innovation Czar, I’ll gladly take the $20 billion in Apple profits added to the U.S. economy over the last 12 months versus the $2-3 billion profits at Foxconn (my estimate). Let’s be clear, profitable companies add jobs (Apple added over 12,000 employees in fiscal 2010, up +35%) – not weak or uncompetitive companies losing money.
Although the U.S. is losing low-skilled jobs to the likes of Foxconn, guess what those $120k engineering jobs at Apple are creating? Those positions are also generating lots of $12/hour service jobs. When you are paying your workers billions of dollars, like Apple, a lot of those dollars have a way of recirculating through our economy. For instance, if I am a six-figure employee at Apple, I am likely funding leisure jobs in Tahoe for family vacations; supporting jobs at Cheesecake Factory (CAKE) and Chipotle Mexican Grill (CMG) because my demanding schedule at Apple means more take-out meals; and creating jobs for auto workers at Ford (F) thanks to my new SUV purchase.
Margin Surplus Redux
The same arguments I make in the Apple vs. Foxconn comparison are very similar to the case I wrote about in Margin Surplus Retake, which compares the profit and trade deficit dynamics occurring in a $1,000 Toshiba laptop sale. Although Toshiba and its foreign component counterparts may recognize twice the revenues in a common laptop sale as American suppliers (contributing to our country’s massive trade deficit), Intel Corp. (INTC) and Microsoft Corp. (MSFT) generate six times the profits as Toshiba and company. The end result is a massive profit or margin surplus for the Americans – a better barometer to financial reality than stale government trade deficit statistics.
There are obviously no silver bullets or easy answers to resolve these ever-growing economic issues, but as political gridlock grinds innovation to a halt, globalization is accelerating. The rest of the world is racing to narrow the gap of our innovative supremacy, but our sense of entitlement will get us nowhere. Zakaria points out that by 2013, China is expected to overtake the U.S. as the leading scientific research publisher and after we held a three-fold increase in advanced engineering and technology masters degrees in 1995, China surpassed us in 2005 (63,514 in China vs. 53,349 in the U.S.). China may not be home to Facebook or Google Inc. (GOOG), but Baidu Inc. (BIDU) is headquartered in China with a market capitalization of $43 billion and Tencent Holdings is valued at more than $50 billion (not to mention Tencent has roughly the same number of users as Facebook – more than 600 million).
The jobless recovery has been painful for the 14 million unemployed, but there is hope for all, if innovation and education (see Keys to Success) can create more six-figure Apple jobs to offset less valuable jobs lost to outsourcing. In order to narrow the chasm between rich and poor in our country, Americans need to climb the labor ladder of innovation. Contrary to Fareed Zakaria’s assertion, swapping quality job gains with crappy job losses, is an economic trade I would make every day and twice on Sunday. If the country wants to return to the path of economic greatness and sustainable job creation, the country needs to embrace this idea of outsourced creative destruction.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Performance data from Morningstar.com. Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, AAPL, and GOOG, but at the time of publishing SCM had no direct position in Foxconn, Facebook, MSFT, INTC, CAKE, CMG, F, BIDU, Tencent, Toshiba, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Is the market making you feel a little lost, down, or disconnected? Then perhaps what you need is a prescription of adrenaline in the form of some CGM Focus Fund shares (CGMFX). Ken Heebner has captained the CGM Focus Fund since its 1997 inception. This hyper-volatile fund is not for the faint of heart. The concentrated fund holds a narrow portfolio (often 20-30 positions), which is managed with a very itchy trigger-finger. The eye-popping 363% turnover last year is proof of Heebner’s rapid fire approach, which equates to an average stock holding period of around three months. Although “Dr. Adrenaline” has earned the top Morningstar ranking for his Focus Fund on a 10-year basis (annualized +11.8% vs. +2.1% S&P 500 – Morningstar 6/9/11), Heebner is dead last on a 3-year basis (annualized -19.9% vs. +.4% S&P 500).
The Journey from First to Worst
How does a manager go from first to worst? Well, given the fund’s “go anywhere” mandate, Heebner became a hero when he shorted technology and internet stocks in 2000 and 2001during the bubble burst (yes, that’s correct, the Focus Fund has the ability to short securities as well). Simultaneously, Heebner went long the homebuilders and watched the massive appreciation transpire as the real estate bubble inflated. This clever maneuvering earned the fund a whopping +54% return in 2000 and an encore +47% advance in 2001, while the S&P 500 index plummeted -9% and -12%, respectively.
While Heebner captured the inflection of the tech bubble bursting, he has fared less well through the financial crisis and recovery of 2008-2011. After riding the commodities boom in 2007, on the way to an +80% killing, Heebner overstayed his welcome at the trough. Not only did his commodity stocks tank, he prematurely piled into financials and insurance companies (e.g., BAC, C, WFC, HIG). Like many other managers, Heebner underestimated the severity and scope of the financial crisis and he and his investors suffered the consequences (underperformed the S&P 500 by -11% in 2008 and -16% in 2009).
This is what Heebner had to say about the housing market in late 2007:
“It’s a narrow sector. Globally the US housing market is not that important. I think it may flatten out our retail sales and our economy may go sidewise, but I don’t think that’s going to derail this global economy.”
That forecast didn’t really pan out as expected and this year hasn’t exactly gotten off to a rosy start either. The fund is already down -12% in 2011, trailing the S&P 500 by an overwhelming -15% margin.
Behind the Brains
The grey-haired, 70-year-old Heebner has accumulated a lot of real world schooling before starting CGM (Capital Growth Management) in 1990. Heebner started his career as an economist with A & H Kroeger in 1965, before he decided to get his feet wet in money management as a portfolio manager at Scudder, Stevens & Clark, as well as Loomis Sayles & Co.
Heebner does not follow your ordinary run of the mill investment strategy. As the antithesis of a traditional value investor, Heebner typically buys stocks that have already appreciated in price. He is looking for stocks with a “pattern of earnings development in excess of consensus.” Or as Heebner clarifies, “I try and find a situation where the development of the fundamentals is going to be more positive than other investors are experiencing.” When investing in the fund, Heebner combines fundamental analysis with an overlay of a top-down macroeconomic assessment.
At last check in April, Heebner was still optimistic about the prospects for equities, despite the outlook for inflation:
“I ran money from 1976 to 1980. The inflation rate went from 6 to 15. There was a lot of money to be made.”
In inflationary environments, Heebner advocates finding companies with earnings growth profiles that will expand faster than the compression in price-earnings ratios.
Heebner Not Alone
Ken Heebner is certainly not the only hot-shot manager in history to suffer a cold-spell. After setting records and beating the S&P 500 index for 15 consecutive years, Bill Miller has found his fund (Legg Mason Capital Management Value Fund – LMVTX) firmly in the bottom decile of his peer group on a 1-year, 3-year, 5-year, and 10-year basis (see also Revenge of the Dunce). Moreover, Morningstar’s fund manager of the decade, Bruce Berkowitz of the Fairholme Fund (FAIRX), has also recently been hit by the performance ugly stick (see also The Invisible Giant), albeit less bad than Heebner and Miller.
When all is said and done, the flexibility afforded to Ken Heebner in managing the CGM Focus Fund has served long-term investors very well – if they were not prematurely spooked out the investments due to volatility. For those not invested in the CGM Focus Fund, or for those bored individuals looking for rollercoaster returns, Dr. Heebner may have just the adrenaline prescription you were looking for…a healthy dosage of CGM Focus Fund shares!
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Performance data from Morningstar.com. Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in CGMFX, LMVTX, FAIRX, BAC, C, WFC, HIG, MORN, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Fareed Zakaria thoughts have blanketed both traditional and internet media outlets, spanning everything from Newsweek to Time, and the New York Times to CNN. With an undergraduate diploma from Yale and his PhD from Harvard, Dr. Zakaria has built up quite a following, especially when it comes to foreign affairs.
In his latest Time magazine article, Can America Keep Pace?, Zakaria addresses the role of innovation in the U.S., “Innovation is as American as apple pie.” The innovation lead the U.S. maintains over the rest of the world will not evaporate over night because this cultural instinct is bred into our DNA – innovation is not something you one can learn directly from a textbook, Wikipedia, or Google (GOOG). With that said, the innovation gap is narrowing between developed and developing countries. New York Times columnist Tom Friedman captured this sentiment when he stated the following:
“French voters are trying to preserve a 35-hour work week in a world where Indian engineers are ready to work a 35-hour day.”
The fungibility of labor has pressured industries by transferring jobs abroad to much lower-cost regions like China and India, and that trend is only expanding further into countries with even lower labor cost advantages. Zakaria agrees:
“America’s future growth will have to come from new industries that create new products and processes. Older industries are under tremendous pressure.”
The good news is the United States maintains a significant lead in certain industries. For instance, we Yankees have a tremendous lead in fields such as biotechnology, entertainment, internet technologies, and consumer electronics.
The poster child for innovation is Apple Inc. (AAPL), which arose from the ashes of death ten years ago with its then ground-breaking new product, the iPod. Since then, Apple has introduced many innovative products and upgrades as a result of its research and development efforts, including the recently launched iPad.
The Education Engine
Where we are falling short is in education, which is the foundation to innovation. In a country with a high school system that Microsoft Corp.’s (MSFT) founder Bill Gates calls “obsolete,” society is left with one-third of the students not graduating and nearly half of the remaining graduates unprepared for college. In this instant gratification society we live in, the long-term critical education issue has been pushed to the backburner. Other emerging countries like China and India are churning out more college graduates by the millions, and also dominating us in the key strategic count of engineering degrees.
With the massive debt and deficits our country currently faces, an ongoing debate about the size and role of government persists. Zakaria makes the case that government must place a significant role when it comes to innovation. Unfortunately, the U.S. wastes billions on pork-barrel projects and suboptimal subsidies while dilly-dallying in political gridlock over critical investments in education, infrastructure spending, basic research, and energy policies. In the meantime, our fellow competing countries are catching up to us, and in certain cases passing us (e.g., alternative energy investments – see Electric Profits).
Zakaria makes this point on the subject:
“The fastest-growing economies are all busy using government policy to establish commanding leads in one industry after another. Google’s Eric Schmidt points out that ‘the fact of the matter is, other countries are putting a lot more money into nurturing new industries than we are, and we are not going to win unless we do something like what they’re doing.’”
As a matter of fact, an ITIF (Information Technology & Innovation Foundation) study measuring innovation improvement from 1999 to 2009, as it related to government funding for basic research, education and corporate-tax policies, ranked the U.S. dead last out of 40 countries.
Not All is Lost – Pie Slice Maintained
Although the outlook may sounds bleak, not all is lost. In a recent Wall Street Journal interview with Bob Doll Chief Equity Strategist at the world’s largest money management company (BlackRock has $3.6 trillion in assets under management), he makes the case that the U.S. remains the leading source of technological innovation and home to the greatest universities and the most creative businesses in the world. He sees this trend persisting in part because of our country’s relative demographic advantages:
“Over the next 20 years, the U.S. work force is going to grow by 11%, Europe’s going to fall by five, and Japan’s going to fall by 17. This alone tells me the U.S. has a huge advantage over Europe and a bigger one over Japan for growth.”
So while emerging markets, like those in Asia, continue to gain a larger slice of the global GDP pie, Mark Perry at Carpe Diem shows how the U.S has maintained its proportional slice of a growing global economic pie, over the last four decades.
Growth is driven by innovation, and innovation is driven by education. If America wants to maintain its greatness, the focus needs to be placed on innovation-led growth. The world is moving at warp speed, and our neighbors are moving swiftly, whether we come along for the ride or not. The current, sour conversations regarding deficits, debt ceilings, entitlements, wars, and unemployment are all essential discussions, but more importantly, if these debates can be refocused on accelerating innovation, the country will be well on its way to curing its ills.
See also Our Nation’s Keys to Success
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, GOOG, and AAPL, but at the time of publishing SCM had no direct position in MSFT, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Excerpt from No-Cost June 2011 Sidoxia Monthly Newsletter (Subscribe on right-side of page)
With the Rapture behind us, we can now focus less on the end of the world and more on the economic tug of war. As we approach the midpoint of 2011, equity markets were down -1.4% last month (S&P 500 index) and are virtually flat since February – trading within a narrow band of approximately +/- 5% over that period. Investors are filtering through data as we speak, reconciling record corporate profits and margins with decelerating economic and employment trends.
Here are some of the issues investors are digesting:
- International Expansion: A weaker dollar has made domestic goods and services more affordable to foreigners, resulting in stronger sales abroad. The expansion of middle classes in developing countries is leading to the broader purchasing power necessary to drive increasing American exports.
- Rising Productivity: Cheap labor, new equipment, and expanded technology adoption have resulted in annualized productivity increases of +2.9% and +1.6% in the 4th quarter and 1st quarter, respectively. Eventually, corporations will be forced to hire full-time employees in bulk, as bursting temporary worker staffs and stretched employee bases will hit output limitations.
- Deleveraging Helps Spending: As we enter the third year of the economic recovery, consumers, corporations, and financial institutions have become more responsible in curtailing their debt loads, which has led to more sustainable, albeit more moderate, spending levels. For instance, ever since mid-2008, when recessionary fundamentals worsened, consumer debt in the U.S. has fallen by more than $1 trillion.
Fed Running on Empty: The QE2 (Quantitative Easing Part II) government security purchase program, designed to stimulate the economy by driving interest rates lower, is concluding at the end of this month. If the economy continues to stagnate, there’s a possibility that the tank may need to be re-filled with some QE3? Maintaining the 30-year fixed rate mortgage currently around 4.25%, and the 10-year Treasury note yielding around 3.05% will be a challenge after the program expires. Time will tell…
Slogging Through Mud: Although corporate profits are expanding smartly, economic momentum, as measured by real Gross Domestic Product (GDP) growth, is struggling like a vehicle spinning its wheels in mud. Annualized first quarter GDP growth registered in at a meager +1.8% as the economy weans itself off of fiscal stimulus and adjusts to more normalized spending levels. An elevated 9% unemployment rate and continued weak housing market is also putting a lid on consumer spending. Offsetting the negative impacts of the stimulative spending declines have been the increasing tax receipts achieved as a consequence of seven consecutive quarters of GDP growth.
Mixed Bag – Euro Confusion: Germany reported eye-popping first quarter GDP growth of +5.2%, the steepest year-over-year rise since reunification in 1990, yet lingering fiscal concerns surrounding the likes of Greece, Portugal, and Italy have intensified. Fitch, for example, recently cut its rating on Greece’s long-term sovereign debt three notches, from BB+ to B+ plus, and placed the country on “rating watch negative” status. These fears have pushed up two-year Greek bond yields to over 26%. Regarding the other countries mentioned, Standard & Poor’s, another credit rating agency, cut Italy’s A+ rating, while the European Union and International Monetary Fund agreed on a $116 billion bailout program for Portugal.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
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