Rating Agencies to Government: Go Back to College!
Remember those days as a young adult, when you were a starving student in college, doing everything you possible could in your power to not run out of money (OK, if you were born with a silver spoon in your mouth, just play along). You know what I’m talking about… Corn Flakes for breakfast, PB&J for lunch, and maybe splurge with a little Mac & Cheese or Top Ramen for dinner. Well, the rating agencies, especially Standard & Poor’s (S&P) with their long-term sovereign credit rating downgrade on the U.S. from AAA rated to AA+ rated, are signaling our U.S. government to cut back on the champagne and caviar spending and go back to living like a college student.
Rent-A-Cops Assert Power
The rating agencies may have been asleep at the switch during the tech bubble (Enron & WorldCom) and the financial crisis of 2008-2009 (i.e., ratings of toxic mortgage backed securities), but they are doing their best to reassert themselves as credible security rating entities. By the way, as long as S&P has some wise critical advice for the U.S. government regarding fiscal responsibility, I have a suggestion for S&P: When providing a fresh ratings downgrade, please limit error estimations to less than $2,000,000,000,000.00 – this is exactly what S&P did in its ratings downgrade. Time will tell whether S&P can maintain its role as credit market policeman or will be mocked like those unarmed, overweight rent-a-cops you see at the shopping mall.
In reality, S&P’s moves represent little fundamental change, especially since these moves have been signaled for months (S&P initially lowered its outlook on the U.S. to negative on 4/18/11). I know there will be some that panic at this announcement (won’t be the first or last time), but should anyone really be shocked by an independent entity telling the U.S. government they are spending too much money and hold too much debt? If my memory serves me correctly, Americans have been screaming S&P’s same message for years – I think the rise of the Tea-Party, the results of the mid-term elections, and the tone of the debt ceiling debate may indicate a few people have caught onto this unsustainable fiscal disaster.
Two Simple Choices
As I have said for some time, these horrendously difficult issues will get resolved. The only question is who will resolve this negligent fiscal behavior? There are only two simple answers: 1) Politicians can proactively chip away at the problem with solutions my first grader has already identified (spend less and/or increase revenue); or 2) Financial Market Vigilantes can rip apart financial markets and force borrowing costs to the stratosphere. Option number one is preferable for everyone, and for those that don’t understand option number two, I refer you to Greece, Iceland, Ireland, Portugal, Italy and Spain.
If you’re getting sick of listening to debt and spending issues now, I will gently remind you this is an election year, so the nauseating debates are only going to get worse from here. I encourage everyone to make a game of this fiscal discussion, and do enough homework to the point you have informed, convicted opinions about our country’s fiscal situation. Unlike in periods past, when Americans could take a nap and ride the U.S. gravy train to prosperity, the ultra-competitive globalized game no longer allows us to rest on our laurels of being the world’s strongest superpower. There are a lot more people playing in our game outside our borders, and many of them are stronger, faster, smarter, and more efficient. Decisions being made today, tomorrow, and over the next year will have profound effects on millions of Americans, myself included. So as the government prioritizes spending programs and debates methods of raising revenue, I advise you to go back to your college days and decide whether you prefer Corn Flakes, PB&J, and Mac & Cheese. If voters don’t pressure politicians into doing the right thing, then we’ll all be collecting food stamps from the Financial Market Vigilantes.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: 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 MHP, 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.
Plumbers & Cops: Can the Debt Ceiling be Fixed?
The ceiling is leaking, but it’s unclear whether it will be repaired? Rather than fix the seeping fiscal problem, Democrats and Republicans have stared at the leaky ceiling and periodically applied debt ceiling patches every year or two by raising the limit. Nanosecond debt ceiling coverage has reached a nauseating level, but this issue has been escalating for many months. Last fall, politicians feared their long-term disregard of fiscally responsible policies could lead to a massive collapse in the financial ceiling protecting us, so the President called in the bipartisan plumbers of Alan Simpson & Erskine Bowles to fix the leak. The commission swiftly identified the problems and came up with a deep, thoughtful plan of action. Unfortunately, their recommendations were abruptly dismissed and Washington fell back into neglect mode, choosing instead to bicker like immature teenagers. The result: poisonous name calling and finger pointing that has placed Washington politicians one notch above Cuba’s Fidel Castro, Venezuela’s Hugo Chavez, and Iran’s Mahmoud Ahmadinejad on the list of the world’s most hated leaders. Strategist Ed Yardeni captured the disappointment of American voters when he mockingly states, “The clowns in Washington are making people cry rather than laugh.”
Although despair is in the air and the outlook is dour, our government can redeem itself with the simple passage of a debt ceiling increase, coupled with credible spending reduction legislation (and possibly “revenue enhancers” – you gotta love the tax euphimism).
The Elephant in the Room
Our country’s spending problems is nothing new, but the 2008-2009 financial crisis merely amplified and highlighted the severity of the problem. The evidence is indisputable – we are spending beyond our means:
Source: scottgrannis.blogspot.com
If the federal spending to GDP chart is not convincing enough, then review the following graph:
- Source: blog.yardeni.com – A graph a first grader could understand.
You don’t need to be a brain surgeon or rocket scientist to realize government expenditures are massively outpacing revenues (tax receipts). Expenditures need to be dramatically reduced, revenues increased, and/or a combination thereof. Applying for a new credit card with a limit to spend more isn’t going to work anymore – the lenders reviewing those upcoming credit applications will straightforwardly deny the applications or laugh at us as they gouge us with prohibitively high borrowing costs. The end result will be the evaporation of entitlement programs as we know them today (including Medicare and Social Security). For reference of exploding borrowing costs, please see Greek interest rate chart below. The mathematical equation for the Greek financial crisis (and potentially the U.S.) is amazingly straightforward…Loony Spending + Looney Politicians = Loony Interest Rates.
Source: Bloomberg.com via Wikipedia.com
To illustrate my point further, imagine the government owning a home with a mortgage payment tied to a 2.5% interest rate (a tremendously low, average borrowing cost for the U.S. today). Now visualize the U.S. going bankrupt, which would then force foreign and domestic lenders to double or triple the rates charged on the mortgage payment (in order to compensate the lenders for heightened U.S. default risk). Global investors, including the Chinese, are pointing a gun at our head, and if a political blind eye on spending continues, our foreign brethren who have provided us with extremely generous low priced loans will not be bashful about pulling the high borrowing cost trigger. The ballooning mortgage payments resulting from a default would then break an already unsustainably crippling budget, and the government would therefore be placed in a position of painfully slashing spending. Too extreme a shift towards austerity could spin a presently wobbling economy into chaos. That’s precisely the situation we face under a no-action Congressional default (i.e., no fix by August 2nd or shortly thereafter). To date, the Chinese have collected their payments from us with a nervous smile, but if the U.S. can’t make some fiscally responsible choices, our Asian Pacific pals will be back soon with a baseball bat to collect.
The Cops to the Rescue
Any parent knows disciplining teenagers doesn’t always work out as planned. With fiscally irresponsible spending habits and debt load piling up to the ceiling, politicians are stealing the prospects of a brighter future from upcoming generations. The good news is that if the politicians do not listen to the parental voter cries for fiscal sanity, the capital market cops will enforce justice for the criminal negligence and financial thievery going on in Washington. Ed Yardeni calls these capital market enforcers the “bond vigilantes.” If you want proof of lackadaisical and stubborn politicians responding expeditiously to capital market cops, please hearken back to September 2008 when Congress caved into the $700 billion TARP legislation, right after the Dow Jones Industrial average plummeted 777 points in a single day.
Who exactly are these cops? These cops come in the shape of hedge funds, sovereign wealth funds, pension funds, endowments, mutual funds, and other institutional investors that shift their dollars to the geographies where their money is treated best. If there is a perceived, heightened risk of the United States defaulting on promised debt payments, then global investors will simply take their dollar-denominated investments, sell them, and then convert them into currencies/investments of more conscientious countries like Australia or Switzerland.
Assisting the capital market cops in disciplining the unruly teenagers are the credit rating agencies. S&P (Standard and Poor’s) and Moody’s (MCO) have been watching the slow-motion train wreck develop and they are threatening to downgrade the U.S.’ AAA credit rating. Republicans and Democrats may not speak the same language, but the common word in both of their vocabularies is “reelection,” which at some point will effect a reaction due to voter and investor anxiety.
Nobody wants to see our nation’s pipes burst from excessive debt and spending, and if the political plumbers can repair the very obvious and fixable fiscal problems, we can move on to more important challenges. It’s best we fix our problems by ourselves…before the cops arrive and arrest the culprits for gross negligence.
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 MCO, 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.
No Respect: The Rodney Dangerfield of the Investment World
Source: Photobucket
Ask any average Joe off the street what investment category is at or near record all-time highs, and a good number of them will confidently answer “gold,” as prices recently eclipsed $1,600 per ounce. But of course this makes perfect sense, right? The Fed is printing money like it’s going out of style, the dollar is collapsing like a drunken sailor, inflation is about to sky-rocket to the moon, and China is on the verge of becoming the world’s new reserve currency. Never mind that Greece, Portugal and Ireland are in shambles with the Euro on its death bed. Or Japan has achieved a debt to GDP ratio that would even make U.S. vote grubbing politicians blush. A sub-3% 10-Year Treasury Note doesn’t appear to discourage fervent gold-bugs either.
No Respect
While gold has experienced an incredible sextupling in prices over the last decade and hit new-all time highs, believe it or not, there is an unlikely asset class that is reaching new historic highs and has outperformed gold for almost 2.5 years. Can you guess what asset class star I am talking about? If I said U.S. “stocks,” would you believe me? OK, well maybe I’m not referring to large capitalization stocks like Johnson & Johnson (JNJ), Microsoft Corp. (MSFT), Wal-Mart Stores (WMT), Intel Corp. (INTC), and AT&T Inc. (T), all of which have effectively gone nowhere in the 21st Century. However, the story is quite different if you look at small and mid capitalization stocks, which have received about as much respect as Rodney Dangerfield.
As a matter of fact, the S&P 400 (MidCap Index) and S&P 600 Index (SmallCap Index) have more than doubled gold’s performance since the lows of March 2009 (SmallCap +149.0%; MidCap +145.1%; Gold/GLD +71.0%). Given the spectacular performance of small and mid-sized companies, I’m still waiting with bated breath for a telemarketer call asking me if I have considered selling my small and mid cap stock certificates for cash – since everyone has melted their gold chains and fillings, a new hobby is needed.
S&P 400 MidCap and S&P 600 SmallCap (Source: Yahoo! Finance)
What Next?
Has the fear trade ended? Perhaps not, if you consider European sovereign debt and U.S. debt ceiling concerns, but what happens if the half empty glass becomes half full. The early 1980s may be a historical benchmark period for comparison purposes. An interesting thing happened from 1980-1982 when Federal Reserve Chairman Paul Volcker began raising interest rates to fight inflation – gold prices dropped -65% (~$800/oz. to under $300/oz.) from 1980-1982 and the shiny metal lived through approximately a 25 year period with ZERO price appreciation. Since there is only one direction for the Fed’s zero interest rate policy (ZIRP) to go, conceivably history will repeat itself once again?
In hindsight gold was a beautiful safe haven vehicle during the panic-filled, nail-biting period during late-2007 throughout 2008. Since then, small and mid cap stocks have trounced gold. Like stocks, Rodney Dangerfield may have gotten no respect, but once fear has subsided and rates start increasing, maybe stocks will steal the show and get the respect they deserve.
See also Rodney Dangerfield’s perspective on Doug Kass and the Triple Lindy
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 (including small cap and mid cap ETFs), and WMT, but at the time of publishing SCM had no direct position in JNJ, MSFT, INTC, T, 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.
Stretching Rubber Band Creating More Value
Concerns over debt ceiling negotiations, European financial challenges, and overall economic malaise has reached a feverish pitch in the U.S., yet in the background, a valuation rubber band has quietly been stretching to ever more attractive levels. Regardless of whether seniors might not receive Social Security checks, troops not obtain ammunition, and investors not collect credit rating agency love, corporations keep churning profits out like they are going out of style (17%+ growth in 2011 estimated earnings). We have barely scratched the surface on earnings season, and I’m sure better than expected earnings from the likes of Google Inc. (GOOG), JPMorgan Chase & Co. (JPM), FedEx Corp. (FDX), Nike Inc. (NKE), and Bed Bath & Beyond Inc. (BBBY) will not sway the bears, but in the meantime profits keep chugging along. Although profits have more than doubled in the last 12 years, not to mention a halving in interest rates (10-year Treasury yield cut from 6% to about 3%), yet the S&P 500 is still down approximately -4% (June 1999 – June 2011).
What Gives?
Could the valuation stretching continue as earnings continue to grind higher? Absolutely. Just because prices have been chopped in half, doesn’t mean they can’t go lower. From 1966 – 1982 the Dow Jones Industrial index traded at around 800 and P/E multiples contracted to single digits. That rubber band eventually snapped and the index catapulted 17-fold from 800 to almost 14,000 in 25 years. Even though equities have struggled in the 21st century, a few things have changed from the low-point reached about 30 years ago. For starters, we have not hit an inflation rate of 15% or a Federal Funds rate of 20% (4% and 0% today, respectively), so we have a tad bit more headroom before the single digit P/E apocalypse descends upon us. If you listen to Peter Lynch, investor extraordinaire, his “Rule of 20” states a market equilibrium P/E ratio should equal 20 minus the inflation rate. This rule would imply an equilibrium P/E ratio of 16-17 when the current 2011 P/E multiple implies a value slightly above 13 times earnings. The bears may claim victory if the earnings denominator collapses, but if earnings, on the contrary, continue coming in better than expected, then the sun might break through the clouds in the form of significant price appreciation.
Another change that has occurred since the days of Cabbage Patch dolls has been the opening floodgates of globalization. The technology revolution has accelerated the flattening of the globe, which has created numerous new opportunities and threats. Creating a company like Facebook with about 750 million users and an estimated value of $80 billion to $100 billion couldn’t happen 30 years ago, but on the flip side, our country is also competing with billions of motivated brains lurking in the far reaches of the world with a singular focus of sucking away our jobs, resources, and dollars. Winners recognize this threat and are currently adapting. Losers blind to this trend remain busy digging their own graves.
Future is Uncertain
As famous Jedi Master Yoda aptly identified, “Always in motion is the future.” The future is always uncertain, and if it wasn’t, I would be on my private island drinking umbrella drinks all day. With undecided debt ceiling negotiations occurring over the next few weeks, political rhetoric will be blaring and traders will be hyperventilating with defibrillator paddles close at hand. If history is a guide, stupid decisions may be made, but the almighty financial markets (and maybe a few Molotov cocktails at a local protest rally) will eventually slap politicians in the face to wake up to reality. Perhaps you recall the attention the markets earned from legislators when the Dow fell 777 points in a single September 2008 trading session. Blood on the streets forced Congress to approve the Troubled Asset Relief Program hot potato four days after the initial vote failed. And if that wasn’t a gentle enough reminder for Democrats and Republicans, then a few lessons can be learned from the interest rate sledgehammer that capital markets vigilantes have slammed on the Greeks (10-year Greek yields are hovering above 17%+).
Down but Not Out
The stories of debt collapse, hyperinflation, double-dip recessions, plunging dollar, secular bear markets, and government shutdowns are all plausible but remote scenarios. As Winston Churchill so eloquently stated, “You can always count on Americans to do the right thing – after they’ve tried everything else.” Voter moods are so venomous that if fiscal irresponsibility is not changed, politicians will be voted straight out of office – even hardcore, extremist elected officials understand this self-serving point.
Suffice it to say, as the political noise reaches a deafening pitch in the coming weeks and months, a quiet rubber band in the background keeps stretching. When the political noise dies down, you may just hear a noise snapping stock prices higher.
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, GOOG, and FDX, but at the time of publishing SCM had no direct position in JPM, NKE, BBBY, Facebook, 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.
Innovative Bird Keeps All the Worms
Source: Photobucket
As the old saying goes, “The early bird gets the worm,” but in the business world this principle doesn’t always apply. In many cases, the early bird ends up opening a can of worms while the innovative, patient bird is left with all the spoils. This concept has come to light with the recent announcement that social networking site MySpace is being sold for a pittance by News Corp. (NWS) to Specific Media Inc., an advertising network company. Although Myspace may have beat Facebook to the punch in establishing a social network footprint, Facebook steamrolled Myspace into irrelevance with a broader more novel approach. Rather than hitting a home run and converting a sleepy media company into something hip, Rupert Murdoch, CEO of News Corp. struck out and received crumbs for the Myspace sale (News Corp. sold it for $35 million after purchasing for $540 million in 2005, a -94% loss).
Other examples of “winner takes all” economics include:
Kindle vs. Book Stores: Why are Borders and Waldenbooks (BGPIQ.PK) bankrupt, and why is Barnes and Noble Inc. (BKS) hemorrhaging in losses? One explanation may be people are reading fewer books and reading more blogs (like Investing Caffeine), but the more credible explanation is that Amazon.com Inc. (AMZN) built an affordable, superior digital mousetrap than traditional books. I’ll go out on a limb and say it is no accident that Amazon is the largest bookseller in the world. Within three years of Kindle’s introduction, Amazon is incredibly selling more digital books than they are selling physical hard copies of books.
iPod vs. Walkman/MP3 Players: The digital revolution has shaped our lives in so many ways, and no more so than in the music world. It’s hard to forget how unbelievably difficult it was to fast-forward or rewind to a particular song on a Sony Walkman 30 years ago (or the hassle of switching cassette sides), but within a matter of a handful of years, mass adoption of Apple Inc.’s (AAPL) iPod overwhelmed the dinosaur Walkman player. Microsoft Corp.’s (MSFT) foray into the MP3 market with Zune, along with countless other failures, have still not been able to crack Apple’s overpowering music market positioning.
Google vs. Yahoo/Microsoft Search: Google Inc. (GOOG) is another company that wasn’t the early bird when it came to dominating a new growth industry, like search engines. As a matter of fact, Yahoo! Inc (YHOO) was an earlier search engine entrant that had the chance to purchase Google before its meteoric rise to $175 billion in value. Too bad the Yahoo management team chose to walk away…oooph. Some competitive headway has been made by the likes of Microsoft’s Bing, but Google still enjoys an enviable two-thirds share of the global search market.
Dominance Not Guaranteed
Dominant market share may result in hefty short-term profits (see Apple’s cash mountain), but early success does not guarantee long-term supremacy. Or in other words, obsolescence is a tangible risk in many technology and consumer related industries. Switching costs can make market shares sticky, but a little innovation mixed with a healthy dose of differentiation can always create new market leaders.
Consider the number one position American Online (AOL) held in internet access/web portal business during the late nineties before its walled gardens came tumbling down to competition from Yahoo, Google, and an explosion of other free, advertisement sponsored content. EBay Inc. (EBAY) is another competition casualty to the fixed price business model of Amazon and other online retailers, which has resulted in six and a half years of underperformance and a -44% decline in its stock price since the 2004 peak. Despite questionable execution, and an overpriced acquisition of Skype, eBay hasn’t been left for complete death, thanks to a defensible growth business in PayPal. More recently, Research in Motion Ltd. (RIMM) and its former gargantuan army of “CrackBerry” disciples have felt the squeeze from new smart phone clashes with Apple’s iPhone and Google’s Android operating system.
With the help of technology, globalization, and the internet, never in the history of the world have multi-billion industries been created at warp speed. Being first is not a prerequisite to become an industry winner, but evolutionary innovation, and persistently differentiated products and services are what lead to expanding market shares. So while the early bird might get the worm, don’t forget the patient and innovative second mouse gets all the cheese.
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, AMZN, and GOOG, but at the time of publishing SCM had no direct position in BGPIQ.PK, NWS, YHOO, MSFT, SNE, AOL, EBAY, RIMM, Facebook, Skype, 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.
Soft Patch Creating Hard-Landing Nightmares
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.
Balanced Viewpoints
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?
Source: Scott Grannis - Calafia Report
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.
Winning the Stock Rock Turning Game
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.
Snoozing Your Way to Investment Prosperity
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).
Source: GMO (James Montier)
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.
Job Losses = Job Creation
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.
Ken Heebner: Dr. Adrenaline
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.
Vodpod videos no longer available.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.
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