Debt Control: Turn Off Costly Sprinklers When Raining
By living in Southern California, I am acutely aware of the water shortage issues we face in this region of the country. We all have our pet peeves, and one that eats at me repeatedly occurs when I drive by a neighbor’s house and notice they are blasting the sprinklers in the pouring rain. I get the same sensation when I read about out-of control government spending confronting our current and future generations in light of the massive debt loads we presently carry.
I, like most people, love free stuff, whether it comes in the form of tooth-pick skewered, teriyaki meatball samples at Costco Wholesale Corp. (COST), or free government education from our school systems. But in times of torrential downpours, at a minimum, we need to be a little more cost conscious of our surroundings and turn off the spending sprinklers.
Certainly, when it comes to government spending, there’s no getting around the entitlement elephant in the room, which accounts for the majority of our non-discretionary government spending (see D-E-B-T: New Four Letter Word article). Unfortunately, layering on new entitlements on top of already unsustainable promises is not aiding our cause. For example, showering our Americans with free drugs as part of Medicare Part D program, and paying for tens of millions into a fantasy-based universal healthcare package (purported to save money…good luck) only serves to fatten up the elephant squeezed into our room.
Reform is absolutely necessary and affordable healthcare should be made available to all, but it is important to cut spending first. Then, subsequently, we will be in a better position to serve the needy with the associated savings. Instead, what we chose appears to have been a jamming of a massive, complex, divisive bill through Congress.
Slome’s Spending Rules
In an effort to guide ourselves back onto a path of sensibility, I urge our government legislators to follow these basic rules as a first step:
Rule #1 – Don’t Pay Dead People: I know we have an innate maternal/paternal instinct to help out others, but perhaps our government could stop doling out taxpayer dollars to buried individuals underground or those people incarcerated in jail? Over the last three years the government sent $180 million in benefit checks to 20,000 corpses, and also delivered $230 million to 14,000 convicted felons (read more).
Rule #2 – Pay for Our Own First: Before we start spending money on others outside our borders, I propose we tend to our flock first. For starters, our immigration policies are a disaster. As I wrote earlier (read Our Nation’s Keys to Success), I am a big proponent of legal immigration for productive, higher-educated individuals – not elitist, just practical. If you don’t believe me, just count the jobs created by the braniac immigrant founders at the likes of Google Inc. (GOOG), Intel Corp. (INTC), and Yahoo! Inc. (YHOO). These are the people who will create jobs and out-battle scrappy, resourceful international competitors that want to steal our jobs and our economic leadership position in the world. What I don’t support is illegal immigration – paying for the healthcare and education of foreign criminals with our country’s maxed-out credit cards. This is the equivalent of someone breaking into my house, and me making their bed and feeding them breakfast…ridiculous. I do not support the immigration law passed in Arizona, but this unfortunate chain of events thankfully puts a spotlight on the issue.
Rule #2a. – Stop Being the Globe’s Free Police: If we are going to comb the caves of Tora Bora as part of funding two wars and chasing terrorists all over the world, then we not only should be spending our defense budget more efficiently (non-Cold War mentality), but also charging freeloaders for our services (directly or indirectly). We are spending a whopping 20 cents of each federal tax dollar on defense, so let’s spend it wisely and charge those outside our borders benefiting from our monetary and physical sacrifices. And, oh by the way, sending $400 million to the territory controlled by Hamas (read more) doesn’t sound like the brightest decision given our fiscal and human challenges at home. I sure hope there are some tangible, accountable benefits accruing to the right people when we have 25 million people here in the U.S. unemployed, underemployed, or discouraged from finding a job.
Rule #3: Put the Obese Elephant on a Diet – As I alluded to above, our government doesn’t need to serve our overweight, entitlement-fed elephant more chocolate, pizza, and ice cream in the form of more entitlements we are not capable of funding. Let’s cut our spending first before we buy off the voters with new spending.
There are obviously a wide ranging set of economic, political, and even religious perspectives on the best ways of managing our hefty debt and deficits. I do not pretend to have all the answers, but what I do know is it is not wise to blast the sprinklers when it is pouring rain outside.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, and GOOG, but at the time of publishing SCM had no direct positions in COST, YHOO, INTC, 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.
Marathon Investing: Genesis of Cheap Stocks
It was Mark Twain who famously stated, “The reports of my death have been greatly exaggerated.” So too has the death of equities been overstated. Long-term stock bulls don’t have a lot to point to since the market, as measured by the S&P 500 index, has done absolutely nothing over the last 12 years (see Lost Decade). Over the last 10 years, the market is actually down about -20% without dividends (and about flat if you account for reinvested dividends). So if equities belong at the morgue, why not just short the market, burn your dollars, and hang out in a cave with a pile of gold? Well, behind the scenes, and off the radar of nanosecond, high frequency, day-trading CNBC junkies, there has been a quiet but deliberate strengthening in the earnings foundation of the market. In the investing world it’s difficult to move forward through sand. Even without a sturdy running foundation, sprinters can race to the front of the pack, but those disciplined runners who systematically train for marathons are the ones who successfully make it to the finish line.
Prices Chopped in Half
What many pundits and media mavens fail to recognize is S&P corporate profits have virtually doubled since 1998 (a historically elevated base), despite market prices stuck in quicksand for a dozen years. What does this say about the valuation of the market when prices go nowhere and profits double? Simple math tells us that all stock market inventory is selling for -50% off (the market multiple has been chopped in half). That’s exactly what we have seen – the June 1998 market multiple (valuation) stood around 27x’s earnings and today’s 2010 earnings estimates imply a multiple of about 13.5 x’s projected profits. With the rear-view mirror assisting us, it’s easy to understand why pre-2000 (tech bubble) valuations were expensive. By coupling more reasonable valuations with a 10-Year Treasury Note trading at 3.19% and lofty bond prices, I would expect stocks to be poised for a much better decade of relative performance versus bonds. The case becomes even stronger if you believe 2011 S&P 500 estimates are achievable (12x’s earnings).
In order to make the decade long valuation contraction more apparent, I wanted include a random group of stocks (mixture of healthcare, media, retailer, consumer non-discretionary, and financial services) to liven up my argument:
Data sources: S&P, ADVFN & Yahoo! Finance
What Next?
From a stock market standpoint, there are certainly plenty of believable “double dip” scenarios out there along with thoughtful observers who question the attainability of next year’s earnings forecasts. With that said, I do have problems with those bears like John Mauldin (read The Man Who Cries Wolf) who just last year pointed to a market trading at a “(negative) -467” P/E ratio, only to subsequently watch stocks advance some 80%+ over the following months.
Regardless of disparate economic views, I contend objective market observers (even bearish ones) have trouble indicating the market is ridiculously expensive with a straight face – based on current corporate profit expectations. At the end of the day, sustainable earnings and cash flow growth are what ultimately drive durable, long-term price appreciation. As Peter Lynch stated with technical precision, “People may bet on hourly wiggles of the market but it’s the earnings that waggle the wiggle long term.”
Running a marathon is always challenging, but with a sturdy foundation in which prices have been chopped in half (see also Market Dipstick article), reaching the goal and finish line for long-term investors will be much more achievable.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, WMT, and PAYX, but at the time of publishing SCM had no direct positions in ABT, CI, DIS, FRX, KO, KSS, MDT 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.
Private Equity Sitting on Stuffed Wallet
The clock is ticking and private equity (PE) firms need to put some $445 billion in their wallets to work. Otherwise, the dreams of outsized returns and hefty fees will have to wait for another Golden Era of deal making. Why such a hurry to use the cash? According to Andrea Auerbach, a Managing Director at Cambridge Associates, “Most funds legally have five or six years to invest that capital…it’s use it or lose it.”
Shop ‘til Wallet Drops
As easy as it sounds, spending half a trillion dollars can be difficult. Here’s how IBD’s Norm Alster characterizes the challenge:
“To realize the outsize profits investors expect, private equity firms would have to borrow two or three times that amount. But for the most part, credit spigots for such deals are still dry. At the same time, pinning down buyout targets is not that easy. Many potential sellers are balking at parting with corporate assets in the midst of a serious downturn.”
The 2010 private equity environment is quite a bit different than the LBO boom era from a handful of years ago, as you can see from the chart below. Thanks to cheap, free-flowing funding from the banks, $1.4 trillion worth of deals were consummated in 2006 and 2007, including large deals like First Data Corp. ($27 billion deal – KKR); Alltel ($28 billion – Goldman Sachs/ Texas Pacific Group); and Harrah’s ($30 billion – Apollo Management/Texas Pacific Group). Unfortunately, deals done during this period were done when valuations and leverage were at extremely high historical levels.
Chart source: Thomson Reuters via IBD
Deal Timeout
What’s causing the current dearth of deals? In many instances, business owners have not calibrated valuation expectations downward enough to account for the bruising financial crisis. Given the 77 leveraged buyout defaults in 2009, investors have become more reticent in committing capital as well. Refinancing the mountains of debt associated with the troubled 2006-07 vintage of deals will require patience and creative financing skills from the banks.
Because of the logjam of deals created by the financial crisis, PE firms are actively looking for exit strategies relating to their portfolio companies. Since private equity inherently involves illiquid investments, typically the industry creates liquidity through initial public offerings (IPOs), merger & acquisitions, and/or recapitalization structures that partially or fully return investor capital.
If the economic malaise lingers and valuations remain depressed, I have no doubt owners will eventually return to the negotiating table while waving a white towel in hand. Until then, private equity firms will continue begging for capital from the banks (i.e., using “other peoples’ money”) and beating down sellers into submission with regards to price expectations. If PE firms are not successful in using that wad of cash by the end of the fund’s term, then investors will be free to walk away with their money without paying lucrative fees to the PE firms.
Don’t Forget Benefits
The PE field is facing its fair share of trials and tribulations, but PE’s diversification benefits should not be forgotten. The success of the “Yale Model,” implemented by David Swensen, has come under attack with the recent bursting of the credit bubble, but with the ever-swinging performance pendulum of various asset classes/styles moving in and out of favor, I am confident a consistent strategy integrating PE as a portion of a diversified portfolio will yield respectable risk-adjusted returns over the long-run. Like other areas in the financial services industry, fees are being scrutinized and transparency requests by investors (limited partners) have been on the rise. But first things first – before attractive PE profits can be made as part of a diversified portfolio, the wad of cash in the wallets of PE firms must find a home in portfolio companies.
Read Norm Alster’s full IBD article originally referenced on TRB
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including S&P 500-like positions), but at the time of publishing SCM had no direct positions in GS, Harrah’s 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.
Ray Allen, the VIX, and the Rule of 16
Photo Source: Babble.com
Ray Allen gets paid a lot of money for running into people and bouncing an orange ball around a wooden floor, but even his game can appreciate the importance volatility can play in a high stakes game. First, Allen set an NBA Final’s basketball record of eight three-pointers made (including seven in a row) in Game 2, and then followed up in the next game with an astonishingly dismal “O” for thirteen performance – the second worst shooting performance during a Final’s game in 32 years. The emotional rollercoaster ride for the Celtics fans resembles a volatility chart of the VIX (Volatility Index) in recent weeks.
Chart Source: Yahoo! Finance
In the last 40 trading days the VIX has moved more than +/- 5% on 30 different trading sessions (75% of the time), including seventeen +/- 10% trading days. The +32% spike in the VIX on the day of the “Flash Crash” (May 6, 2010) would have even generated a smirk on the face of Ray Allen, not to mention the face changing impact of the other three +/- 30% move days that occurred within a month of the Flash Crash trading debacle. Even though the VIX has settled down from a short-term peak last month (48.20 on May 21st) to a lower level (28.79), the fear gauge still stands at almost double the rate of the multi-year low just a few months ago (15.23 on April 12th).
The VIX and the Rule of 16
No, this VIX is not the same as the Vicks vapor rub medication placed on your chest to relieve cough symptoms, rather this VIX indicator calculates inputs from various call and put options to create an approximation of the S&P 500 index implied volatility for the next 30 days. Put simply, when fear is high, the price of insurance catapults upwards as measured by the VIX – just like we saw when the VIX spiked above 80 during the 2008 financial crisis and above 40 during the more fresh Greek debt disaster. I’m not in the position to bust out some differential calculus to explain the nuances of a complex VIX formula, but what I can do is regurgitate a helpful formula relating to the VIX, called the Rule of 16. What the Rule of 16 allows laymans to do is understand the relationship between the VIX and daily volatility.
This is how Jeff Luby of Green Faucet describes the Rule of 16:
• VIX of 16 – 1/3 of the time the SPX will have a daily change of at least 1%
• VIX of 32 – 1/3 of the time the SPX will have a daily change of at least 2%
• VIX of 48 – 1/3 of the time the SPX will have a daily change of at least 3%
To put these VIX numbers in perspective, industry citations put the long-term VIX average around a level of 20. With a VIX hovering around 30 now, we are approaching the 2nd bucket of expectations (2%+ moves in the market 1/3 of the time). The price moves don’t correlate directly with the Dow Jones Industrial Average index, but I think about the current VIX levels equating to about a +/- 200 point move in the Dow one or two times per week…uggh.
Generally, I would prefer lower volatility, but I continually remind myself volatility is not necessarily a bad thing – volatility creates opportunities. I’m not sure if I can apply the Rule of 16 to Ray Allen’s scoring output, however based on last night’s 5-10 shooting performance, perhaps volatility in the market and Ray Allen’s shooting game will begin to normalize toward historical ranges.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including S&P 500-like positions), but at the time of publishing SCM had no direct positions in SPX, VIX-related securities, 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.
Margin Surplus Retake
Like a B-rated horror movie using the same old cliques (i.e., girl home alone with serial killer on the loose or a concealed intruder hidden in the back seat of a car), one of the financial cliques that persists today is the belief that the United States trade deficit will result in financial ruin for our economy. The recent widening of the trade deficit to $40.3 billion makes this economic issue a topical discussion. Enter Andy Kessler, former hedge fund manager and author of Running Money. He believes the stale, exploding trade deficit arguments are hogwash, primarily due to his “margin surplus” theory articulated in his book and Wall Street Journal article entitled, We Think, They Sweat.
Profiting from Trade Deficits
The absolute numbers used by Kessler in his Toshiba laptop example might have changed since his book was first published in 2004, but this margin surplus theory example is just as relevant today as it was back then. Here is an excerpt from his book:
“Let’s open up that Toshiba laptop. With a $300 Intel chip (which has at least $250 in profit for Intel) and a $50 Windows license ($49.95 margin to Microsoft), the laptop is then sold by Toshiba back into the U.S. for $1,000. Toshiba and every other supplier are lucky if they make $50 profit, combined, on the deal.”
In this illustration, government statistics would recognize a $1,000 contribution to our bloating trade deficit figures, even though nearly 90% of the laptop profits would be flowing (“surplus-ing”) back to the U.S. Hmmm, maybe this trade deficit thing isn’t as evil as it is portrayed in the popular media, or perhaps we are measuring it incorrectly? Kessler makes the case that Gross Domestic Product (GDP) is not the most important economic gauge, but rather the real crucial GDP metric is actually Gross Domestic PROFIT. He adds the best indicator for economic profits is the stock market, and as foreigners seek more productive returns on their cash beyond the 3% Treasury yields, they will eventually filter back their dollar currency reserves into stocks and other more productive asset classes.
Brain Driven Economy
You don’t have to be a brain surgeon to realize our roots as an industrial economy have shifted to an intellectual property economy. So while we may be exporting low-skilled labor jobs to China and other low-cost regions, our country is also creating higher-skilled, higher-paying jobs at innovative growing companies such as Google Inc. (GOOG) and Apple Inc. (AAPL). Case in point, flip an Apple iPod over and read the fine print on the back – it reads, “Assembled in China…Designed by Apple in California.” Once again, the commoditized aspects of slapping together a widget have been outsourced to workers in far-off lands for a small fraction of what American workers earn. If improving the standard of living is our goal, then transferring low paying jobs to foreigners should not be a concern. According to Kessler, $70 in iPod profits (versus $4 for the Chinese assemblers) from this unique, differentiated device has generated millions in profits, which in turn can be used for the creation of desirable, high-paying jobs here in the U.S.
Selling the Farm
Warren Buffets has a different view about our trade deficits and the directional value of the U.S. dollar. He perceives our economy as a fixed size farm that is selling $2 billion pieces of the farm to foreigners on a daily basis. Buffet adds:
“We’re like a very rich family; we own a farm the size of Texas but want to consume more. If you force-feed $2 billion a day to the rest of the world, they get somewhat less enthusiastic over time – and the dollar is worth less.”
Over time, Buffett believes future generations will resent paying for the gluttony of consumption by prior generations and foreigners will demand a higher interest rate for their loans. What I believe Buffet fails to consider is that the farm is not static. As we sell off $2 billion chunks of the farm, portions of those proceeds are being used to adjoin additions, buy new farms, build adjacent wind turbines, and/or incorporate other productive uses. Now if the proceeds were used to solely purchase bon-bons and doughnuts, then indeed we would be in trouble. Ultimately, the financial markets will be the true arbiter of how efficiently the foreign capital is being invested and will dictate the level of rates paid on the loans. From a pure cash management standpoint, stretching out payables (net imports) is a sound practice (i.e., it’s desirable to collect early and pay late).
The flip side of the argument explains how the farm sale proceeds from our asset sales to foreigners (such as our real estate, our Treasuries, and our stocks) can be employed in a productive manner. The Buffett argument states that our farm will eventually be completely sold to foreigners or they will hold a gun to our head asking for higher interest rates to fund our deficits. The problem with that argument is that the money received from the farm sales (Treasuries, stocks, real estate, etc.) can be (and is) used to build new farms. And that is the key question…are all these deficit building dollars being used to create new, innovative, job creating companies like Google and Apple, or are these dollars being redeployed into unproductive uses (e.g., worthless t-shirts and lead-filled toys from China, or funding of bailouts and cash-for-clunkers waste) ?
At the end of the day, money goes where it is treated best – meaning global capital seeks the royal treatment in markets where profits reign supreme. So rather than relying on rusty, obsolete statistics measuring the balance of trade (i.e., trade deficits and GDP), investors would be better served by taking a page from Andy Kessler’s book. Following the principles of “margin surplus” will increase the probabilities of profiting from global capital flows.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, Treasury securities, GOOG, and AAPL, but at the time of publishing SCM had no direct positions in Toshiba, INTC, BRKA/B 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.
Microchip: Selling Electronic Cake Mix to the World
Microchip Technology Inc. (MCHP) is not in the business of selling cakes. Rather, Microchip is more akin to a chef selling cake mix in the form of microcontrollers to hungry designers with a sweet tooth. All that the customers need to do is add some water to the mix, and voila they have all the ingredients necessary to make a cake.
Endless Opportunities
Making a cake may sound simple, but the real magic comes as a result of the baking chef exploring the endless possibilities across colors, flavors, sizes, frostings, and accessories. The microcontroller business is similar in many respects. Microchip provides the essential tools (ingredients) to efficiently and cost-effectively build solutions for an almost infinite number of applications. Microcontrollers can be found in a diverse mix of products and gizmos, ranging in size from an iPod Nano (AAPL) and Tickle Me Elmo toy to a Whirlpool (WHR) washing machine and a butt-warming car seat in a Porsche 911 Turbo. From a verticals standpoint, Microchip services more than 60,000 customers globally (75% of revenues internationally) in the automotive, aerospace, communications, computing, consumer, and industrial control markets, among others.
What the Heck is a Microcontroller?
You can think of a microcontroller as a computer-on-a-chip, and these mini-computers, which are embedded into all types of applications, allow designers to create all types of products. The low-cost computer chips handle simple functions such as turning products on and off and setting speeds in consumer products, cars, telecommunications and office equipment. More specifically, these microcontrollers provide designers with the ability to introduce or expand functionality, reduce power consumption, and create further efficient designs, thereby potentially leading to lower costs and higher profits. Even though talking about the digital world of 1’s and 0’s sounds sexy, in the real world we are surrounded by analog factors like time, temperature, sound, music, and video – analog functions that require the heavy lifting of a microcontroller to process digital data after it has been converted from analog.
These microcontrollers aren’t multi-hundred dollar microprocessors manufactured in multi-billion fabrication facilities at Intel Corp. (INTC) – rather these more mundane (although essential) components sell often for a few bucks each. What’s more, the pricing in microcontroller and analog land is more stable at Microchip relative to the annual -20-30% price cuts common in the microprocessor world.
On top of performance (speed, power, heat, etc.) and cost, ease of design is a way Microchip gains market share away from competitors through its PIC architecture – the software platform that designers program Microchip’s microcontrollers. The company devotes extensive resources to spreading the PIC gospel to designers around the world and Microchip engineers are constantly upgrading the programming software. To date, Microchip has almost shipped 1,000,000 development tools to designers and developers. The software and design kits add to the company’s revenues, but the real profitability kicks in when the customers reorder chips related to multiyear product life cycles. For example, you can think of a television company that must order a microcontroller for a five-year old, broken TV remote control that a child stepped on…hmm, sounds familiar.
Expanding Pie (or Cake)
This is no puny market; the overall microcontroller segment of the semiconductor market is estimated to have generated $10.7 billion in sales during 2009. Microchip has managed to not only become the 800 pound gorilla in the 8-bit microcontroller space, but in recent years they have also made significant headroom in the higher functionality/performance markets of 16-bit and 32-bit microcontrollers. In total, Microchip offers its customers more than 650 flavors of its microcontroller products.
One would think the company is busy enough with its core microcontroller business, but Microchip is not sitting on its hands. They are employing a Velcro strategy by attaching other embedded features on its “computer-on-a-chip,” including analog, memory, DSP (digital signal processing), and other capabilities. Already, Microchip’s analog business has grown to more than 10% of the company’s revenues (about 600 analog products and > 14,000 customers), and Microchip’s foray into the digital signal controller sector (dsPIC product family) is expanding the company’s total addressable market as well. Consistent with this Velcro strategy, Microchip recently purchased Silicon Storage Technology Inc. (SST) for $354 million, focusing on SST’s high margin flash memory licensing business. Thanks to shrewd negotiating and jettisoning of non-core SST segments, the deal will solidify Microchip’s embedded solution positioning and is expected to add $.14 – $.18 cents to Microchip’s 2011 earnings per share (EPS).
The Head Chef
The head chef of the technology kitchen is Steve Sanghi, and in 1990 (after 10 years of employment at Intel Corp.), when he took over as President of Microchip, the kitchen was a complete mess. Not only was the company losing money, but they were spread too thin across disparate technologies. His accomplishments were recognized immediately and Sanghi became CEO shortly thereafter in 1991. Microchip, which was originally founded in 1989 as a spinoff from General Instrument, eventually went public in 1993. Despite a tough technology market post the technology crash of 2000, Microchip has managed to gain market share from struggling competitors like Atmel Corp. (ATML). Under Sanghi’s leadership, Microchip has more than doubled profits over the last decade and sales have almost multiplied 12-fold to $950 million since the company went public 17 years ago.
Cash Machine
Besides pumping out microcontrollers, Microchip pumps out a lot of cash as well. In their recently completed fiscal year (ending in March), the company generated close to $400 million in free cash flow (cash from operations minus capital expenditures), by my definition. With a market capitalization of around $5 billion this relationship implies an almost 8% free cash flow yield – a bit nicer than the 3.17% yield recently offered on the federal government’s 10-year Treasury Note. Microchip’s cash metrics look even that much more impressive when you consider the company has more than $1.1 billion in net cash piled up on the balance sheet. Since the capital intensity of the microcontroller and analog businesses is so much less demanding than the microprocessor world, Microchip has plenty of flexibility in paying a nice, big fat, 5%+ dividend (about $1.37 per share annually), which has increased modestly in each of the last three quarters. On a Price-Earnings basis (P/E), Microchip’s share price is currently trading at an attractive 13 x’s the company’s $2.11 consensus Earnings-Per-Share (EPS) estimate.
Risks
Microchip is not a risk-free Treasury investment and the company faces significant cyclical sensitivity to global macroeconomic trends, as we saw in fiscal 2009 (ending March). The pace of global design activity will generally be responsive to overall business confidence. In spite of Microchip’s dominance in the 8-bit market, some skeptics also question Microchip’s ability to gain market share in the 16-bit and 32-bit markets.
In addition to those concerns, another hazard relates to the company overpaying for future, potential acquisitions. Traditionally Microchip has focused on internal growth, however in recent years the company’s appetite for acquisitions has increased – most notably the failed merger of Atmel Corporation for roughly $2.3 billion in early 2009. If history serves as a guide, Microchip has been prudent in acquisitions – for example, the timely $183 million purchase of Gresham, Oregon manufacturing plant in 2002 for cents on the dollar or the recent opportunistic and accretive SST deal.
Momentum and Visibility Improving
With the global upturn occurring, Microchip has seen a +189% increase in its backlog (orders in hand for future delivery) to $528 million. Having these orders in hand allows Microchip to plan and invest more appropriately for growth in the coming year. Fourth quarter sales (without SST’s contribution) increased by more than +60% from last year and Non-GAAP earnings mushroomed by more than +200% on a year-over-year basis.
The ease and affordability of new product design will be an accelerating trend of new product proliferation. As I wrote in an earlier article (Revenge of David), the simplicity of design has become dramatically easier. A laptop and internet connection affords any designer the ability of downloading free design software, building a prototype with a 3-D printer, ordering Chinese manufacturing services through Taobao.com (parent Alibaba Group), and waiting for UPS to deliver the product to their doorstep in fairly short order. This design tailwind only serves to increase demand for Microchip’s microcontroller solutions over time.
Ever since the company’s IPO (Initial Public Offering), Microchip has had a phenomenal track record of success led by Steve Sanghi’s direction. Microchip is a much more mature company since going public in 1993 at a stock price of $0.57 per share (split-adjusted), but if the stock price can appreciate a fraction of the +4,623% already achieved, then my clients and I should be able to purchase a lot of cake mix.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, MCHP, AAPL, and Treasury securities, but at the time of publishing SCM had no direct positions in WHR, Porsche, Volkswagen, INTC, ATML, SST, UPS, General Instrument, 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.
The Annuity Trap
Like the infamous Roach Motel, annuities allow investors to check-in while making it very difficult to check out. In many instances, getting out of annuities can be cost prohibitive (fees, charges, commissions, expenses, etc.), even if escaping these fee-laden products is in the investors’ best financial interest.
In an article dated April 13th, 2010, Jay Peroni warned others by outlining a typical annuity fee structure as follows:
- Mortality and Expense Charge 1.50%
- Sub Account Management Fees 1.00%
- Unreported trading costs 0.78%
- Annual Administrative Expenses 0.15%
TOTAL ANNUAL EXPENSES 3.43%
What aren’t included in these numbers above are the surrender charges, which effectively can lock you into the annuity if you are averse to paying hefty surrender charges. Normally, the surrender charges vary from up to a 10% charge for large withdrawals in year one, decreasing to something like 1% in year 10. Worth noting, steep sales commissions can be layered on top of the previous charges or mysteriously embedded in the fee structure categories above.
The Big Sell
Driving the push for these 3%+ annual fees are lucrative financial institutions hiring aggressive salespeople. Typically annuities are sold under the guise of safe tax shelter investments. What the broker won’t tell you is that only a fraction (“exclusion ratio”) of the annuity payments is shielded from taxes, and the rest of the payments are taxed at the higher, unfavorable ordinary income tax rate (relative to qualified dividends and capital gains from other securities). Much of the time, many of the salespeople, who call themselves “financial advisors,” know little about these complex annuity products (see Financial Sharks article). What these brokers do understand are the big, fat commissions they stand to collect upon fleecing unsuspecting investors.
Scores of these so-called advisors are actually “registered representatives” who do not carry a fiduciary duty (meaning they are NOT required to make investment decisions in the best interest of their clients). Certainly, there are some situations where annuities might be appropriate, but from my experience there are very few cases where the egregious charges and expenses outweigh the benefits. I believe the vast majority of brokers/registered reps/salespeople are more concerned about padding their wallets than building and protecting client portfolios.
The Alternatives
If safety and tax advantages are features you are looking for then I encourage you to look at more efficient options such as the following:
- 401k Defined Contribution Retirement Plan (or other “Qualified Plan”): Allows you to achieve tax deferral often with free money given to you in the form of a match to your contributions.
- IRA (Individual Retirement Account): Whether you consider a traditional or Roth IRA, there are tax deferral advantages with lower fees.
- Low Turnover, High Dividend Portfolios: Using a tax efficient management strategy with better tax treatment of income is another approach that I firmly believe will outperform most annuities.
- Tax-Exempt Muni Bonds or Corporates: The tax-exempt status of municipal bonds affords investors a tax advantaged status. The after-tax yield on corporate bonds can be compared to the returns promised on annuities (AFTER all fees, charges, and commissions). Holding individual bonds until maturity can help avoid interest rate risk.
- Ladder Zero Coupon Bonds: If safe fixed payments are what you are looking for, then staggered purchases of zero coupon bonds can be purchased as well.
These are only a few options that could and should be considered when reviewing your personal objectives and circumstances. With regard to the insurance component of an annuity contract, there are more cost effective ways of paying for insurance – most notably, term insurance.
At the end of the day, no matter the financial product, it is important you understand the underlying fees charged on any strategy, along with how the person selling you stuff is compensated. If you don’t do your homework on these extremely complex products (many not regulated by the NASD or SEC), then you may find yourself checking into the annuity hotel, but unable to check out.
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 positions in 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.
Blowing the Perfect Investment Game
Photo source: Boston.com
Armando Galarraga, pitcher from the Detroit Tigers baseball team, became a victim of a blown call by umpire Jim Joyce, resulting in a lifetime opportunity being ripped from his clutches. Not only did the error in judgment cost Galarraga a perfect game – a feat only achieved by 20 pitchers over the last 130 years – but the blunder also cost him a no-hitter. Perfect games are difficult to come by in the investment world too, but for those ambitious investors reaching for the finance Hall of Fame, I strongly believe a healthy dosage of international and emerging markets is required to achieve perfection (or significant outperformance).
The Fab Five
The oft quoted view that the U.S. was the dominant economic powerhouse in the 20th century (after Britain controlled the 19th century) led me to analyze five emerging growth markets outside of the U.S. There are some clear leaders in pursuit of 21st century economic supremacy, however nothing in the global pecking order is guaranteed. What I do know is that me and my clients will be relying on the financial tailwinds of growth coming from these international markets to provide excess return potential to my portfolios (albeit at the cost of shorter-term volatility). Even retired individuals, or those with shorter time horizons, should consider small bite sizes of these emerging markets in their portfolios, if merely for some of the diversification benefits (see diversification article).
Pundits and media types endlessly write and talk about the “lost decade,” the demise of “buy and hold,” and/or the “death of equities.” Well, as you can see, the lost decade through the first half of 2010 turned out to be a significantly lucrative period for investors with the stomach and courage to invest outside the familiar comfort zone of the United States (see chart below).
Specifically, here is the international outperformance achieved in the sample of international markets as compared to the United States (S&P 500 Index):
- Brazil +266.22% (EWZ tracking Bovespa Index)
- India +266.16% (Bombay Stock Exchange – BSE)
- Australia +68.16% (ASX 200 Index)
- China +68.06% (Shanghai Index)
- Hong Kong +39.74% (Hang Seng Index)
- United States -128.19% Average Underperformance versus five other geographic indexes.
An added kicker for investment consideration is valuation. According to The Financial Times market data section, all these international markets, with the exception of India, trade at a discount to the S&P 500 on a Price/Earnings ratio basis (P/E).
Victim of Our Own Success
Graph source: The New York Times
In many respects, our country has continued to thrive in spite of some of our political and economic shortcomings. As you can see from the chart below (NY Times article) our country’s market share of the world’s Gross Domestic Product (GDP) has been steadily been declining since World War II (and we’ve still done OK). With U.S. GDP exceeding $14 trillion, our sheer size makes it much more difficult to grow relative to our smaller, more nimble international brethren. Given our top economic position in the world, Warren Buffett succinctly identified the force working against size when he said, “Gravity always wins.” I would expect gravitational influences to continue to weigh us down in the future, but our declining share should not be considered a detrimental trend. Globalization needs to be embraced by policymakers so we can take advantage of these faster growing countries as opportunistic export markets. We Americans can improve our standard of living while riding the coattails of our speedy neighbors. Do yourself a favor and include a healthy chunk of higher growth markets into your portfolio – it’s important you do not blow your own investment game.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including BKF, FXI, EWZ), but at the time of publishing SCM had no direct positions in 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.
Happy Birthday Investing Caffeine!
Three hundred sixty-seven days ago Investing Caffeine launched an ambitious drive to share the important truths about investing, financial markets, and personal finances (among other subjects). After a year, some 225 articles, and over 50,000 hits, the site continues to gain momentum and I look forward to offering a unique perspective to thousands of more readers in 2010 and beyond.
Over the last twelve months, here are some of the most heavily trafficked postings along with a few of my favorites (CLICK AWAY!):
Investing Legends
- Peter Lynch: Inside the Brain of an Investing Genius
- Phil Fisher: Standing on the Shoulders of a Growth Giant
- Doug Kass: Kass Attempts the “Triple Lindy”
Dubious Declarers
- Peter Schiff: The Emperor Schiff Has No Clothes
- Meredith Whitney: Meredith Whitney’s Cloudy Crystal Ball
- Glenn Beck: Stewart Makes Skewered Beck-Kebabs
History Revisited
- Back to the Future Magazine Covers, Part II, Part III
- History Never Repeats Itself, But It Often Rhymes
- Can the Lost Decade Strike Twice?
Investment Trends/Themes
- Stock Market Nirvana: Butter in Bangladesh
- High Frequency Trading: Buggy Whip Déjà vu
- TMI: The Age of Information Overload
It’s Your Money…Invest Wisely
- Beating off the Financial Sharks
- Super Sizing May Be Hazardous to Your Portfolio’s Health
- The Hidden Train Wreck – Professional Athlete Portfolios
Investment Lessons
- Lessons Learned from Financial Crisis Management 101
- Getting off the Market Timing Treadmill
- Compounding: A Penny Saved is Billions Earned
Government Gossip
- Debt: The New Four-Letter Word
- Plucking the Feathers of Taxpaying Geese
- Healthcare Reform: The Brutal Reality of Aging Demographics
Investment Trends/Themes
- Jumping on the Globalization Train
- Technology Does Not Sleep in a Recession
- Social Media Revolution Taking Over World
Stock Talk
- NVEC: Profiting from Electronic Eyes, Nerves & Brains
- Amazon: Growing Up to be Wal-Mart
- From Pooches to Profits
The last year has been a complete blast and hopefully you’ve enjoyed parts of the ride. Stay tuned for more eclectic articles in the days, weeks, and months to come.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds. Read disclosures provided in article links provided in above posting. 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.
Gravity Takes Hold in May
Warner Bros. picture of Wile E. Coyote’s failed apprehension of Roadrunner
Wile E. Coyote, the bumbling, roadrunner-loving carnivore from Warner Bros.’ Looney Tunes series spends a lot of time in the air chasing his fine feathered prey. Unfortunately for Mr. Coyote his genetic make-up and Acme purchases could not cure the ills caused by gravity (although user error was the downfall of Wile E’s effective Bat-Man flying outfit purchase). Just as gravity hampered the coyote’s short-term objectives, so too has gravity hampered the equity markets’ performance this May.
So far the adage of “Sell in May and walk away” has been the correct course of action. Just one day prior to the end of the month, the Dow Jones Industrial and S&P 500 indexes were on pace of recording the worst May decline in almost 50 years. If the -6.8% monthly decline in the S&P and the -7.8% drop in the S&P remains in place through the end of the month, these declines would mark the worst performance in a May month since 1962.
Should we be surprised by the pace and degree of the recent correction? Flash crash and Greece worries aside, any time a market increases +70-80% within a year, investors should not be caught off guard by a subsequent 10%+ correction. In fact corrections are a healthy byproduct of rapid advances. Repeated boom-bust cycles are not market characteristics most investors crave.
It was a volatile, choppy month of trading for the month as measured by the Volatility Index (VIX). The fear gauge more than doubled to a short-run peak of around 46, up from a monthly low close of about a reading of 20, before settling into the high 20s at last close. Digesting Greek sovereign debt issues, an impending Chinese real estate bubble bursting, budget deficits, government debt, and financial regulatory reform will determine if elevated volatility will persist. Improving macroeconomic indicators coupled with reasonable valuations appear to be factoring in a great deal of these concerns, however I would not be surprised if this schizophrenic trading will persist until we gain certainty on the midterm elections. As Wile E. Coyote has learned from his roadrunner chasing days, gravity can be painful – just as investors realized gravity in the equity markets can hurt too. All the more reason to cushion the blow to your portfolio through the use of diversification in your portfolio (read Seesawing Through Chaos article).
Happy long weekend!
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 positions in TWX, VXX, 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.
Investing Caffeine 
