Tuesday, June 30, 2009

How Should Individual Investors Assess Political Risk?

The past 18 months have been particularly unsettling for individual investors, who have witnessed a crumbling of both their net worth and the underlying assumptions that drive their investment decisions. The US equity market, a benefactor of the “home field bias” that pervades the investment analysis conducted by many individual investors in the US, has corrected to levels seen a decade ago. Real Estate, previously considered the most reliable asset class by average Americans, has taken a well publicized beating, exposing the flaws in the two step investment strategy of lever an asset and hold. The bond market too, has not been kind to retail investors, a fact that the individuals who held $6B worth of GM debt can certainly attest to. To make matters worse, the Lehman bankruptcy triggered losses at a money market fund that caused it to “break the buck”, calling into question (at least at the time) the safety of any investment vehicle. Thankfully, the period of time during which the financial system literally seemed on the precipice of collapse has passed. Unfortunately however, in the wake of the post-Lehman turbulence, a new sort of risk has emerged in the investment landscape: political risk.

Although formal assessments of political risk have been conducted for many years- spawning an entire subset of professional consultancy-its relevancy has largely been confined to corporations and institutions. In the context of present day investment decisions however, we would argue that an individual investor’s ability to properly identify and assess the relevant political risks to his/her wealth preservation/creation is more important now than at any time in recent history. To achieve this task, individuals will need to develop a cogent framework with which to approach an issue of political risk; they will also need to perform some minor revisions to the way they view the world. Although we certainly don’t have all the answers, we have sketched an outline, organized along subcategories of what we perceive to be the top three facets of political risk as they exist today. For the sake of this discussion, political risk will encompass all risks stemming from official Government actions, regardless of whether the action is overtly “political” in nature.

Capital Structure Risk

Until recently, investors thought they knew the rules governing relative positions of priority in the event of a bankruptcy. Then came the Chrysler and GM bankruptcies. Without spending time on the specific criticisms we have as to the handling of those bankruptcies, we would emphasize the fact that “too big to fail” should no longer be misconstrued as “too big for you to lose your investment”. Government rescues have certainly not boded well for both equity and unsecured debt investors-the two areas of the capital structure most accessible to retail investors. If you intend to invest in these two intervention-prone areas, it is more important now than ever to fully educate yourself as to which stakeholders are in front of-and behind-you in the event of a bankruptcy proceeding. Some would conclude that a prudent course of action may be to avoid investing alongside union interests; a group that wields considerable influence in the upper echelons of government (especially during a Democratic Administration). As a personal recommendation, we’ve found it never hurts to follow the money - www.opensecrets.org is a great place to do this.

Reserve Currency Risk

With the United State’s influence in a period of relative decline, albeit at an arguable pace, individuals need to consider whether it is prudent to hold assets denominated entirely in dollars. The US Government’s agglomeration of debt has provoked a series of reactions from the Chinese and other major holders of dollar based reserves. Once again, there is no way to predict the future of the dollar-or anything else for that matter-however , it is important that retail investors begin paying closer attention to the words and actions of foreign governments and central banks. Press releases and other news relating to major foreign governments/central banks can, for the most part, be monitored via RSS feed. As the actions of foreign governments become increasingly relevant to the performance of “US based” assets, retail investors should adjust their awareness and exposure to emerging markets in commensurate fashion.

Market Distortion Risk

The United States Government, currently the largest investor on the block, has the ability to severely distort any market which it enters. For individual investors, this dynamic is currently most pertinent to investments in US Treasury debt; the market for which is currently the site of heavy Fed purchases. All investors must now be astutely aware of all current and planned Government securities purchases. News from both Treasury and the Federal Reserve can easily be tracked via RSS feed. The best thing an individual investor can do is to educate him/her as to every major Government rescue program, and in the event that he/she is invested alongside Uncle Sam, simply apply some common sense to the situation.

The current state of the global economy has produced a set of political risks that we will readily admit, are more complex than an article of this length has the ability to convey. It is likely that entire academic departments will be formed around this concept in the future, and will of course produce insights that put ours to shame. Ultimately though, we think that the best course of action for individual investors is to simply position themselves in front of the news that is most relevant to the three areas described above, and apply what is truly the only necessary ingredient to a sound investment strategy: common sense.

*no positions

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S&P Continues It's Commercial RE Downgrade Rampage

The news looks good on the commercial real estate front, as S&P has just announced the downgrade of 384 classes of commercial real estate collateralized debt obligations and re-REMIC(you don't need to know what this stands for). This action alone will affect $17.1B worth of commercial mortgage securities. These and other ratings actions are important because, at this time at least, the Government has said it will limit those assets which can be pledged as collateral in it's balance sheet cleansing programs to AAA securities. No AAA=No program

We commend S&P for at least appearing to possess a modicum of independence in it's ratings decisions, especially as the AAA-needing Treasury Department alphabet programs are struggling to get off the ground. It's actually surprising that the Treasury/Fed has not tried to punish S&P yet for it's rebellious ways. As soon as the Administration starts bandying the term "ratings reform" about, we will at least know what prompted it.
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Supreme Court Decision Will Enable Political Attacks

The Supreme Court yesterday issued an opinion that will likely pave the way for further political grandstanding and investigations conducted for the benefit of prosecutor's career stepping-stones. To summarize the ruling (full text below for those freshly dosed with "performance enhancers"), the Court distinguished what role State Attorneys General may play with regards to the supervision and/or (depending upon your perspective) regulation of federally chartered/regulated financial institutions. Basically, Andrew Cuomo demanded documents from a bank, threatened to acquire subpoenas if his demands were not met, and proceeded to investigate the bank for violations of a NY state predatory lending law. The bank sued because they are already subjected to OCC oversight, and besides, producing documents is a pain in the ass. The Court disagreed, as it reached back to 1864 and attempted to glean the original intent of the writers of a now antiquated bank regulation law. This exact modus operandi, pioneered by the Spritzers of the world and emulated by the Cuomos of the world, was given the thumbs up yesterday by the SCOTUS.

We are disturbed at the potential effect this ruling could have on the office of State Attorney General across the country. Condoning this sort of behavior will only encourage the most litigious and aggressive individuals to seek out the AG post, as the Supreme Court has now turned the AG's office into the ultimate political stepping-stone, and empowered it to conduct publicized yet baseless investigations into any corporation that it pleases.

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Monday, June 29, 2009

Bank of International Settlements: Politics Greatest Threat to Sustained Recovery

The Bank for International Settlements released it's annual report today, largely providing us all with the familiar narrative concerning the economic imbalances and other events which ultimately led us to the sad state of today. The BIS report did however include some rather useful statements(this is the only section we've included below) about what it perceives to be the major risks going forward, namely:

"Fiscal policy is at serious risk of overshooting even in the economies with the most room for debt expansion. A fundamental reason is that, while the programmes most likely to be highly effective and low risk are timely, targeted and temporary, those attributes of fiscal action are notoriously rare in representative democracies."

and yet again:

"And once the recovery materialises, how can central banks begin to tighten policy interest rates and unwind their vast monetary interventions? The technical issues are much less challenging than the political ones."

The message seems to be clear, and it is one that we have furthered on numerous occasions: Politically motivated actions, whether emanating from Washington or the various other global political power centers, pose the greatest risk to a recovery at the present time.

Bank for International Settlements 2009 Annual Report Sphere: Related Content

Markit Launches Industrialized Nation CDS Indices

In a press release today, data provider extraordinaire Markit announced the creation of several new CDS indices, including our favorite, the Markit iTraxx Sovx G7, which purports to track the "credit risk of the most industrialised countries in the world". Highlights from the press release include the following:

"Historically, the trading of sovereign CDS was limited to emerging markets, reflecting the credit risk associated with the government debt of these countries. However, an actively traded CDS market in industrialised sovereigns has now emerged as a result of the financial crisis and growing investor concerns relating to the solvency of developed economies."

The best thing about this index is the fact that developed nations will be forced to acknowledge the structural deficiencies of their customary fiscal behavior. Ideally, this data would be streamed live into legislative body's voting chambers around the developed world, forcing these folks to at least recognize that profligacy has it's consequences.
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Sunday, June 28, 2009

Japan Auctions Itself Away, Fertilizing It's "Green Shoots"

Well, this title is not entirely accurate. Besides, we would only be embarrassing ourselves by using the term "green shoots" for any reason other than mocking the overuse of the term "green shoots". Anyways, there is actually a bit of good news on the Japanese front, although not of the "broad based economic stabilization" storyline that the US Government has been slinging around for the past two months. Today's fascinating piece of information comes from the Daily Yomiuri Online, which published a story about the increasingly lucrative nature of the tax delinquency auctions conducted by local Japanese governments. These auctions, conducted mostly online, were implemented in 2004 with the help of Yahoo Japan Corp. in an effort to assist local government's revenue raising efforts. In 2004, the total value of all government auction sales totaled 40 million yen - in 2008 that number reached 3.43 billion yen. The Daily Yomiuri even reports that one municipality was forced to sell an older firetruck in the auction.

Maybe online tax auctions are the bubble that we've all been waiting for to get the economy going again.

*No position in anything Yahoo!

InfoNgen was used to research the content of this article Sphere: Related Content

Saturday, June 27, 2009

Amazon Poised to Benefit From Sales of Michael Jackson's Music

Today's WSJ featured an editorial that tipped it's hat to Tarheel basketball, yet criticized (our home State of) North Carolina's pending legislation that would impose an onerous set of tax compliance measures upon online retailers like Amazon.com(AMZN). The article also reports that Amazon has cancelled it's affiliate relationships within North Carolina - an act of defiance against the State and it's legislature. We're admittedly sad that NC has been made to look foolish by one of the few Companies that can boast earnings growth in the current recession. However, with the recent passing of Michael Jackson, the reality is that Amazon likely can afford to lose it's NC affiliate revenue.

Amazon is likely to have an exceptionally strong quarter, based largely on the fact that copies of virtually every Michael Jackson album are selling at a torrid pace. The French website Net-Actuality reported today that Michael Jackson's albums are currently holding the top 15 bestseller slots on both the French and American versions of Amazon. After visiting the online retailer's bestseller page, it appears that prior to two days ago, none of Jackson's albums were even in the top 100. It is highly unlikely that these albums were catapulted to the top positions by shoppers who had already planned on purchasing something from Amazon, and merely chose to buy a MJ album in the place of another item. Rather, we would argue that the lion's share of those purchasing a Jackson album through Amazon represent new traffic to the site. According to Alexa.com, Amazon yesterday attracted 2.23% of global Internet users, compared to a 3-month average of 2.043% of global users. When you consider that there are an estimated 1.6B global Internet users, this relatively small change in percentage terms translates into a sizable traffic surge. Although the volume of MJ's album sales will ultimately decline from the recent peak, they will likely stabilize at a higher level than before the tragic passing. Regardless, the cumulative impact should translate into a sizable boost to Amazon's current quarter revenue and income. Investors shouldn't forget that "Thriller" is the best-selling album of all time, and that even in an era of anemic album sales, Michael Jackson clearly maintains the ability to excite consumers. While AMZN is an expensive stock, relative to earnings, investors who think that the market is underestimating the impact of the current quarter's album sales may be wise to initiate a long position.

*No position in AMZN

InfoNgen was used to research the content of this article. Sphere: Related Content

California Lawmaker's Salaries Should Be Paid With IOU's

California lawmakers have failed to reach a budget compromise with Governor Schwarzenegger, setting the stage for issuance of IOU's as soon as Thursday of this week. The AP reported that lawmakers have literally just "walked out" of the Governor's office - likely feeling ashamed about the fiscal catastrophe they have not only created, but subsequently failed to fix. We'd also like to note that if California is in fact forced to issue IOU's, the supposedly compassionate and liberal utopia of a State will be singling out it's most vulnerable and weak population segments to receive the worthless State Fiat Currency - students, low income individuals, the elderly and the disabled will soon be the proud owners of a sheet of paper that promises future payment from a bankrupt State.

Although this whole situation is an atrocity, we have come up with a solution that would not only dole punishment to those who have created this predicament, but also incentivize the folks in Sacramento to bring a speedy resolution to the budget crisis: Replace the cash salaries of every single lawmaker and the Governor with these bogus IOU's. We're quite aware that the salaries afforded to State legislators, even in a state as large as California, are a mere pittance when compared to the posh arrangements that the US Congress have set up for themselves. However, the folks in Sacramento deserve to feel some modicum of pain as retribution for the damage they have caused. Pass it on.

*InfoNgen was used to research the content of this article Sphere: Related Content

Friday, June 26, 2009

If FedEx Can Compete With the US Government, Why Can't Health Insurers?

The Obama Administration's announcement concerning it's vision of a reformed American health care system, a vision based upon a Government based option to private insurance, has provoked quite a debate-one that seems able to fill the op-ed pages of major newspapers on a daily basis. The arguments, both in favor of and against a government intervention into the health care realm, are for the most part legitimate, provocative, and varied. Opponents of the reform measures outlined by the President will generally put forth arguments that revolve around one or more of the following points:
  1. There is nothing wrong with America's current health care system.
  2. If there is something wrong with America's health care system, the Government should have no role in fixing it.
  3. The United States can not afford to implement meaningful health care reform, at least not at this time.
  4. The Government is not capable of effectively managing the nation's health care system.
  5. Doctors personally hate the thought of it.
  6. If subjected to drug price "negotiations" with the Government, pharmaceutical companies will be forced to allocate less money to the R&D that is necessary to solve a host of pressing medical issues.
  7. A Government health insurance option will "crowd out" private insurance companies, rendering them useless.
As we've already stated, these are all perfectly valid arguments that merit serious discussion. To counter #7 however, we would argue that a reasonably applicable precedent of public/private co-existence has been in place for over 30 years. The peaceful existence we speak of is between the United States Postal Service, Federal Express, and the United Parcel Service.

Although an organized system of mail delivery has been in place in the United States ever since Benjamin Franklin was named the first Postmaster General in 1775, the United States Postal Service as we know it was not created until the Postal Reorganization Act of 1970. This Act essentially created a Government business that would be forced to fund it's operations through it's own revenue - not taxes. Although initially subsidized in part by the federal government, the USPS was able to become operationally independent in 1982. The Act also created the Postal Rates Commission, and empowered the Commission to regulate the USPS and force it to adopt "fair" postal rates. It was during this exact time period that Federal Express(FDX) was incorporated(1971) and began operations(1973). The United Parcel Service(UPS) in contrast, was already a mature company at this time, and by 1975 it provided service to every address in the continental US. So here we have three nationwide package delivery services: one that received Government subsidies throughout the 1970's, one private upstart, and one more mature private company. An individual who carefully observed the circumstances in 1970 likely would not have predicted the current circumstances of these three organizations today.

In 2008, the US Postal Service, FedEx, and UPS reported annual revenue of $74.9B, $37.9B, and $51.4B respectively. Not only was FedEx able to avoid being "crowded out" by an already established Government business, it has since surpassed the USPS in relevancy - not an earnings season goes by without FedEx being described as a "bellwether" company. At the same time however, the US Postal Service has been able to provide quality services at a low cost to Americans. If a company needs an important contract delivered to a client before 10AM the next morning, it will use FedEx(or UPS), and it will pay a premium for this service. If the same company doesn't mind waiting 2-3 days however, it may choose to save money(especially these days) and go with the US Postal Service option. We would argue that the same dynamic can exist in the health care industry, given the proper implementation by the Government of course.

In order to address in preemptive fashion an obvious criticism that could be lobbed towards our argument, we will state that there are obvious differences between the health care and shipping industries. Some people might think that these differences are profound enough to negate any argument that attempts to compare the two. However, the rise of FedEx should be evidence enough that the existence of a Government option within an industry does not, by default, lead to the "crowding out" of other private participants. The emergence of a government option might have the potential to put some health insurers out of business, however, the strongest and most efficient companies in the private sector should live on and remain profitable - an outcome that would be to the benefit of everyone.

*No position in any of the securities mentioned in this article

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Investment Instrument Idea: Celebrity Net Worth ETF's

These days, an ETF either exists or is in the works for most every imaginable investment strategy. In the old days (at least so we are told) folks would stand around the water cooler at work and brag about their AT&T stock. Now however, we wouldn't be surprised to hear something along the lines of "I just went long on rainfall for the 2nd half of '09, and I shorted Washington State's apple harvest". That being said, we've decided it is our turn to pioneer a cutting-edge investment concept: the Net Worth ETF.

The Net Worth ETF will allow investors to make directional wagers as to the future net worth of an individual, or in special cases, a group of individuals. Celebrities, musicians, professional athletes, reality TV "stars" and other popular figures having a generally recognizable household name will be targeted for participation in the program. Here's how it would work: The celeb's assets would be pored over by forensic accountants, who would subsequently create a standardized set of financial statements. The celeb would then determine a certain percentage, say 20%, of his assets that would be deposited into a trust account. Depending on the celeb's preferences, he or she may also choose to designate a certain portion of his or her gross earnings to be deposited into the trust account on an annual basis. Next up are the lawyers, who descend upon the situation to write up a contract that will set limits, as well as enforcement mechanisms, upon the celeb's ability to touch the assets that have been placed in trust. Preferably, the celeb will be able to access the trust funds Only in the event that he or she has exhausted, wasted, squandered, been fooled out of, or just plain lost all other assets to his or her name. Even at this point however, there will be limits, both absolute and in percentage terms, as to what extent the celeb may "draw down" from his or her trust. Once the lawyers are finished, the trust is now ready to issue shares of itself. Prospective buyers will have the ability to peruse a set of legitimate financial statements, allowing them to essentially compare P/E ratios, price to book value, as well as a multitude of other neat metrics used to evaluate traditional stocks. While characters such as Gorilla Zoe or Bret Michaels might initially draw a large amount of short interest, the Market would be kept in check by the looming possibility that a celebrity could secretly possess a Sean "Puffy" Combs-like business acumen. The celebs would be incentivized via a cut of the trust's management fees, investment banks would profit from underwriting the IPO. Additionally, the celebrity aspect might lure an entirely new set of retail investors into the trading world - a potential boon for online discount brokers. At the very least however, it would be funny.
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Thursday, June 25, 2009

Moody's Report Shows Continued Decimation of Commercial RE

The chart above, courtesy of MIT's Center for Real Estate, illustrates the data contained in Moody's most recent report on the state of commercial real estate. For those of you who are unaware, there is a two month delay in the actual data, i.e June's report presents data that is current only as of the end of April. We've been wanting to do an old fashioned parsing of the Moody's/REAL Commercial Property Price Index and its underlying methodology, but we haven't found the motivation to do so yet. Regardless, the chart is not pretty. CRE prices appear to be in a literal free-fall, with the index posting a Month-to-Month decline of 8.6%. That's correct, meaning that between March and April of 2009, the value of CRE properties nationwide fell at an annualized rate of 33.9%. With the April year-to-year loss reported at 25.3%, it would appear that the pace of the decline in the commercial market is accelerating. The most despair inspiring corners of the market, listed in descending order based upon the sheer level of despair caused by the annual rate of decline, was South-Industrial(-28.8%) , East-Office(-27.2%), South-Office(-25%) and South-Retail(-23.3%).

The most popular explanation for the severe price declines is that we are just beginning to see closings of deals that were negotiated towards the end of 2008 - a time when the peddling of "Depression survival kits" likely reached its peak. While we will sign onto the validity of that assumption, we will not conclude from it that stabilization of this Market is just around the corner. The financial crisis portion of this recession may have abated, but CRE will still have to deal with economic contraction that has ensued as a result of said financial crisis. The de-leveraging process is continuing, and although Fed/Government actions will reduce the acuteness of the pain at any one given point in time, the inescapable truth is that even the Fed can not grant amnesty to multi-decades long debt agglomeration binge.
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Wednesday, June 24, 2009

Boeing's Misstep Indicative of Broader Misconceptions of Risk

In an announcement made to the chagrin of it's credibility, Boeing Co(BA) revealed that the 787 Dreamliner's maiden flight would once again be delayed, due primarily to issues surrounding the proper attachment of the aircraft's wing to it's body. This revelation prompted a round of excoriating commentary, accompanied by the necessary downward revisions to earnings estimates, from several equity analysts. Although management will bear the brunt of the fallout from the Dreamliner misstep, we would not characterize the embarrassing event as being indicative of Boeing's inability to manage a new product from conception to delivery, but rather as an over reliance on computer driven models - a condition that parallels many aspects of the current US economic predicament.

The specifics of Boeing's troubles were outlined in a WSJ article from today's paper, which cited the difficulties associated with certain carbon-fiber composite parts as the Company's primary stumbling block. The composite parts, desirable partly because of their light weight, pose an interesting problem for airline manufacturers: Advanced computer models display an inability to accurately predict the behavior of these composites under actual flight conditions. While the laws of physics and the elemental composition of the metals lend themselves to calculable outcomes under laboratory conditions, there is something about the introduction of real wind, velocity, acceleration etc. that defies the computer's ability to conduct it's "stress tests". In his new book Shopclass as Soulcraft: An Inquiry Into the Value of Work , Matthew Crawford addresses this phenomenon by referencing some wisdom he once received from his mathematically inclined father. The gist of this wisdom was that a shoelace knot, by all mathematical accounts, could always be untied by tugging at a single end of the knot. Even at a young age, Crawford was able to identify the inherent shortfalls of his father's statement; namely that while the conclusion might be valid under perfect conditions, it largely ignored the possibility that a shoelace might be wet, or compromised in some other way as to negate it's "easy removal" property. Unfortunately, such blind reliance on mathematical assumptions is not limited to shoelaces. As evidenced by Boeing's costly delays, airline manufacturers have come to rely heavily on computer models whose predictions apparently fail to capture real world variables. Furthermore, there is an argument to be made that an over reliance on computer driven and mathematical models, in an attempt to capture the elusive concept of "risk", has contributed to the current state of financial markets and the economy.

We will first clarify our position on this matter by stating that we are not categorically opposed to the use of quantitative models as a risk measurement tool, provided that the user of said tool has sufficient respect for the model's fallibility. Additionally, we acknowledge the argument that, in the midst of pursuing financial gains, individuals or organizations will often choose to ignore sobering evidence, and in some cases manipulate the means by which said evidence is generated altogether. However, we would observe that the point at which computer based and statistical models are the most vulnerable, i.e. most susceptible to providing an incorrect prediction, is the point at which the model meets reality. Boeing's moment of realization arrived when it's composite parts were introduced to climatic and environmental variables that simply do not exist in the vacuum of computer models. For those involved in the securitization of sub prime mortgages, and in particular those who either constructed or trusted the models which purported to predict default/delinquency/foreclosure rates across a pool of mortgages, the fact that something went wrong has been apparent for some time now. The historical data that guided mortgage performance projections was collected during both economic expansions and recessions, but never during an expansion that was accompanied by a housing boom of such colossal proportions. As speculative purchases proliferated, human nature introduced a wild-card to the equation that the models had not foreseen: Many homes were purchased with the intent to make a quick profit, and many of those buyers were ready, willing and able to stop servicing their mortgages when it became apparent that those profits would not materialize. The widespread development of this mindset was the point at which the computer models were faced with a reality that did not conform to their view of the world. Models based upon the assumption that the risk and return of a financial time series is normally distributed are potentially best suited for markets dominated by professionals, having a predictable and uniform set of goals and responses. However far removed a mortgage may be from the original loan underwriting decision, it can never escape the fact that an individual must continue to remit payment on a monthly basis. Whether it be shoelaces, composite material used in airline construction, or the performance of speculative mortgages, the important thing to acknowledge, and respect, is that aspects of this world will continue to defy prediction via statistical and computer based assignments of probability.

*no position in any of the securities or books mentioned
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Tuesday, June 23, 2009

Treasury Auctions and Economic Cheerleaders

In the first of three rounds of money-raising scheduled for this week, the Treasury managed to sell $40B worth of full faith and credit debt instruments - of the two year variety to be specific. For those of you keeping track, today's auction leaves Geithner with only $64B more to raise..this week. The Treasury market reacted favorably to the auction, as the foreign central bank purchasers of this recent issue demanded less yield than expected. With two more auctions on the block this week alone, it might be a bit presumptuous for us to offer any sweeping generalizations as to what today's action may mean for the equity markets and overall economy. However, we will be quite interested to see how the economy's most loyal cheerleaders (the Obama administration, Wall St., and any others who stand to benefit politically or financially from economic optimism and/or public involvement in the US equity markets) react in the event that the week's remaining auctions are met with similiar enthusiasm.

The primary pattern of the past two months has been declining Treasury prices, rising Treasury yields, and rising stock prices. We have been told, constantly, that such price movements are to be expected in an environment where investor capital is rotating Out Of safe Government bonds, and Into riskier stock investments. Cheers have accompanied the confident assertion that we are "returning to normalcy". What then will be said once (if) the equity market begins to correct from it's overpriced peaks of this year, causing capital to re-enter the safer waters of the government bond market? With so many feet in so many mouths, something clever will have to be devised. The best one we can think of is something along the lines of inflation expectations having "moderated". Better yet, what about the following: Investors have grown increasingly confident that we have, more or less, seen the worst of the US economic recession. Rising Treasury prices reflect a positive outlook for the fiscal state of the US, and a recognition that the United States will be able to meet it's obligations with relative ease.

Although we find the usual patterns to be funny, we're not necessarily sure that they should be. Sphere: Related Content

Monday, June 22, 2009

Worthwhile Reading: Alan Blinder on Inflation v Deflation

In Sunday's edition of the New York Times, Alan Blinder penned what we believe to be a worthwhile assessment of the prevailing wisdom, which states that a potent bout of inflation looms inevitably in the near future. Blinder injected the article with a dose of contrarian sentiment that has largely been absent from the public discourse over inflation(that would be self-evident though right?). The bit we most appreciated though was Blinder's exposure of what appears to be a logical "blind spot" on the part of the public and investment community. Namely, commentators have focused on the inflation risk that would arise if the Fed were unable to withdraw the banking system's excess reserves quickly enough. This line of reasoning ignores the fact that an equally likely event - the Fed withdraws reserves too quickly - would have deflationary consequences. Of course, as we see it, that is but one of the many logical fallacies that abound in the investment world. Sphere: Related Content

Saturday, June 20, 2009

Research In Motion's Blackberry: Beneficiary of "Cool"

Research In Motion's (RIMM) most recent earnings report triggered an interesting reaction from analysts and the investment community in general, as the bulk of post-earnings discussion seemed to focus not on the numbers themselves, but on the fact that 80% of the quarter's new Blackberry subscriber growth came from the consumer. For the sake of perspective, RIMM added roughly 3.8M net new Blackberry subscribers in Q1 - ~3.04M of these new subscribers were consumers, as opposed to businesses. While there is some degree of obviousness to the fact that businesses are providing fewer cell phones to employees, our informal research into the consumer aspect of Blackberry growth indicates that RIMM is currently reaping the benefits of having happened to produce a "cool" product. While analysts have properly classified the recent consumer based growth as more fickle in nature than business based growth, we think that due to the nature of the newest wave of Blackberry subscribers, the growth may be more tenuous than most perceive.

It is fairly well documented that the Blackberry is the smart phone market's most dominant player: The most recent survey by ChangeWave credits Blackberry with 41% of the consumer market for smart phones. Additionally, the survey found that 11.2% of consumers plan to purchase a smart phone in the next 90 days, up from a figure of 6.8% when the survey began in June of 2005. So, we've established RIMM as the market share leader in a consumer market that has been steadily growing since 2005. With these facts established, there is a tendency to characterize the strong recent Blackberry consumer growth as the simple continuation of a trend that appears to have some degree of staying power. However, our anecdotal and unscientific investigation into the unscientific yet powerful concept of "cool" has led us to the conclusion that Blackberry's are in the midst of a sharp popularity increase amongst the teenage population - a segment of the population that does not adhere to brand loyalty.

Interestingly, the most common smart phone purchase denominator, at least amongst the teenage consumers we spoke with, is the ability to check social networking sites like Twitter, and particularly Facebook. The situation in Iran has called attention to the political and organizational powers of these sites. We would assert however, that Facebook and Twitter have also become an increasingly significant factor in teenager's purchasing decisions, most specifically with regards to cell/smart phones. As they are often obligated to participate in the same cell service provider as their parents, it isn't surprising that more teenagers would purchase the Blackberry, with its wider network availability, than the exclusively AT&T iPhone. The two risks to future Blackberry growth, considered within the framework of the existing reality, are that Apple manages to strike deals with additional wireless providers(think Verizon) or that a widely available "upstart" device(think Palm's latest) manages to gain traction with teenage consumers. With the teenage predisposition towards fads/trends, we would argue that a shift away from the Blackberry has the potential to occur quickly, in erratic fashion, and for intangible reasons (such as "cool"). In our opinion, this is not an ideal situation for a company like RIMM, whose shares trade on assumptions of healthy growth going forward.

Disclosure: No position in any of the companies mentioned. Sphere: Related Content

Friday, June 19, 2009

Commercial Real Estate's Problem: Down and Dirty

With all of the talk about commercial real estate, a.k.a the next shoe to drop, we thought we'd share some actual revenue projections that are used to assess the financial viability of a deal at its infancy. The blue line above represents actual base rental revenue projections for a large, well known office building. These figures are typically projected out ten years into the future. As is evident by the slope of the blue line, the assumption is that, generally, rental revenue will always go up. The red line represents what we would call a "mild recession scenario", where rental revenue drops 5%/year for three years, at which point it stops declining and begins increasing, at the rate of 5%/year for the remainder of the 10 year projection. As you can see, the red line is unable to surpass the blue line - despite the fact that the growth of the blue line slows significantly around the 7th year. Based on these numbers, a building that follows the path of the red line will collect rental revenues that total $31.6M or ~11% less than a building following the blue line's path. While this isn't necessarily a good thing, it probably doesn't mean the project will fail outright. Don't forget however, that the red line corresponds to a recession much milder than we are experiencing, and the blue line projections (forecast circa 2000) are not nearly as optimistic as the CRE projections going on in 2007. At a certain point, a building is simply unable to service its debt and operational costs with a dwindling revenue stream. That reality is certain to transpire for many of the commercial mortgages written on buildings at or near the peak of the CRE cycle. Sphere: Related Content

California Can Not Print Money

Well, technically the State of California does have the ability to print money. To do so however, would seem to directly contradict Article 1, Section 10 of the United States Constitution. The most inconvenient paragraph of Section 10, at least insofar as California is concerned, states the following:
"Section 10. No state shall enter into any treaty, alliance, or confederation; grant letters of marque and reprisal; coin money; emit bills of credit; make anything but gold and silver coin a tender in payment of debts; pass any bill of attainder, ex post facto law, or law impairing the obligation of contracts, or grant any title of nobility."

Sure, we understand that certain bits of this paragraph appear slightly outmoded. For instance, the stipulations regarding payments in gold and silver have been ignored for some time now. However, we think there is a pretty strong consensus that a State is forbidden from issuing its own currency, in an official capacity, and replacing the dollar as the chosen means by which commerce is to be conducted. Surprisingly, this is a path that California appears on the brink of heading down. Some readers may ask "Who said anything about California coining its own money?". Well, clearly the State has chosen an alternate set of terminology by which to describe it's actions.

That California is in a state of fiscal disarray shouldn't be news to anyone by now - short sighted tax policy (property tax freeze), profligate spending, serving as one of the epicenters of the housing collapse and a gridlocked State legislature have all but assured an inevitable day of reckoning for the State. Also well publicized is the fact that California may run out of cash by the end of July, at which point the State will proceed to issue IOU's to those it does business with. (S&P eloquently referred to the IOU's as "registered warrants" in its justification for placing California's general obligation debt on CreditWatch negative.) We would argue that these IOU's are tantamount to coining money; after all, a dollar bill itself is no more than an IOU from the federal government. We doubt however that this distinction will ever be brought to light, as recent events (think Chrysler) would seem to suggest that financial distress is ample justification for a government to trample across years of legal precedent.
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Thursday, June 18, 2009

Senate Committee Quietly Approves Military Purchases of Canadian Tar Sand

The Senate Energy & Natural Resources Committee approved several interesting measures yesterday, by a vote of 15-8. We found the following approved items, which represent only a portion of the overall package, to be particularly interesting:
  • Oil and gas – opens portions of the Eastern Gulf of Mexico, including Destin Dome, to oil and gas leasing, and establishes a one-stop permitting office in Alaska for offshore leasing in the Chukchi and Beaufort seas;
  • Alaska natural gas pipeline – increases federal loan guarantee for the developers of a gas pipeline project from $18 billion to $30 billion, and allows access to the Federal Financing Bank;
  • Modification of Section 526 – allows the government, and in particularly the military, to purchase Canadian tar sand oil.
As recently as one year ago, with oil prices cresting above $140/bbl, the debate over whether to expand Gulf drilling was particularly fracticious in nature, and appeared unlikely to be championed in bi-partisan fashion by a Senate Committee. Introduce an exponentially rising budget deficit and an expensive health care proposal into the mix however, and all of a sudden the idea of Gulf Drilling - and its associated tax revenues - becomes a bit more appealling to the folks in Washington.

The modification of Section 526, and in particular the emphasis on military purchases, is a most interesting twist to the story. Although we haven't researched the Senate's justification for this measure, we are prepared to lob our provocative thoughts on the subject into the world: With the situation in Iran escalating on a daily basis, we have to assume that there have been discussions, at the highest levels of US Government, over the possibility of a disruption of the oil tanker traffic that passes daily through the Straits of Hormuz. Despite the fact that world oil supplies are currently at record highs, a disruption at Hormuz could cause those stockpiles to deplete in rapid fashion, and would launch world oil markets into a panic not seen since the oil embargoes of the 1970's. The modifications to Section 526 would allow for the fueling of the US military, and facilitate a forced re-opening of the Straits. We sure think it makes sense.

InfoNgen was used to research the content of this article

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Wednesday, June 17, 2009

Why Shouldn't GM Be Allowed to Lobby?

The latest illogical attack that is running rampant through Washington and the media has to do with the lobbying activities of General Motors. The argument goes that, as a recipient of extraordinary aid from the federal government, GM is essentially lobbying itself when it pays a consultant to have dinner with a member of Congress. We believe that this sort of argument ignores the true interests of taxpayers, and succumbs to the misplaced reasoning that generally pervades every form of public discourse concerning federal-aid-receiving corporations these days.

As a taxpayer, the number one priority should be the safe return of all principal that you have effectively loaned to any number of American corporations. In order for this to be achieved in a timely fashion, recipients of aid, including GM, must be allowed to make prudent decisions that are in the best interest of the business. In other words, in all bailout scenarios, taxpayer interests are most closely aligned with the ability of the various corporations to make the most profitable decision at a particular point in time, every time. Lobbyists, disliked as they are in general, are held in such contempt because of a perceived unfair advantage they afford to the corporations on whose behalf they act. In the case of GM, the taxpayer should be cheering for the lobbyist, who will presumably be advocating for measures that will maximize the profitability of the auto-maker. Who wouldn't want GM to conduct lobbying activities? Why, politicians of course. The reason: the introduction of lobbyists into the current power structure would weaken their ability to influence GM's business decisions in favor of a particular Congressional district, but to the detriment of the Company as a whole. In a recent op-ed in the Wall Street Journal, we learned that, upon hearing the news of a pending plant closure in his district, Barney Frank proceeded to dial-up GM's newly appointed CEO and "persuade" him that, perhaps another plant should selected for closure (we presume he was leaning towards the "not one in my district" direction). According to the same article, this abdication by GM opened up a Pandora's Box, filled exclusively with members of Congress eager to avoid further job losses in their precious district.

So we pose the question(s): As part of its ongoing restructuring, would it be reasonable to assume that, when GM decides to close a manufacturing facility, it has made the decision based upon economic/supply chain/productivity/needs based analysis that has as its ultimate goal the profitability of the company? We hope for the sake of your intelligence that you answered "yes", and that, based upon the immutable rules of logic, Barney Frank chose to act against the economic best interest of GM. Therefore, Barney Frank chose to act against the economic interests of the taxpayer, for the purpose of securing his seat in Congress for another go-round.

Could lobbyists have stymied such an intervention? Maybe not. What we do know however, is that for the sake of the taxpayer, there needs to be someone allowed onto Capitol Hill who can advocate for the proper operation of GM. The alternative, we fear, is another Amtrak.

InfoNgen was used to research the content of this article.
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Reaction to FedEx Indicative of Market's Excessive Optimism

Shortly after FedEx, the global shipping company, released its results for the recently concluded quarter and provided guidance for the current quarter, a spate of explanatory headlines were generated and distributed across the usual media outlets. According to the reports, Wall Street was most focused on the current quarter's guidance (forward looking bunch they are), and what said guidance from the "bellwhether" company means for stocks and the economy going forward. We noted that "cautious" and "downbeat" seem to be the adjectives most commonly deployed in the overrall attempt to characterize the Company's current quarter forecast, which estimates earnings of between 30 and 45 cents per share v. analyst estimates of 71 cents per share. Earnings within the estimated range would correspond to a quarter to quarter decline of at best 19.6%, and at worst 53.1% based upon last quarter's 64 cents per share (ex items) of reported earnings. The fact that Wall Street is disappointed at this guidance is, we believe, indicative of the excessive Market optimism that has contributed to the current over-pricing of US equity markets.

The Market, choosing only to remember recessions that follow a "V" shaped progression, is naturally forward looking and anticipatory of quarterly earnings Gains. The fact that the broader market is trading at a multiple of greater than 20X reported earnings is irrelevant to many. The logic of the "V" shaped recovery supports the conclusion that the Market is only expensive based on Current earnings, and that as earnings rise in the quarters ahead, prices will increasingly be supported by the underlying earnings. The important distinction we see is that while the financial crisis has abated, there is still a considerable degree of weakness in the US economy as a whole. The United States continues to shed jobs at a rate that, while not indicative of a literal collapse in economic activity, would certainly be considered damaging. Furthermore, the rise in oil prices has rendered meaningless a substantial portion of the cost-cutting that nearly every company has been engaged in.

The primary lesson from today's "guidance disappointment", we think, is that there is no substitute for a common sense approach to investing, especially with regards to an individual investor's participation in the US equity markets.
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Tuesday, June 16, 2009

Lincoln's Outlook Revised to Stable

As we expected, Lincoln Financial agreed to accept roughly $1B from the federal government in the form of CPP proceeds. The Company was able to concomitantly raise $1.1B from the Market-$600M via a sale of common equity, and $500M from the sale of senior notes. S&P quickly revised it's outlook for Lincoln from Negative to Stable for essentially the same reasons that led us to characterize Lincoln as an adequately capitalized institution just last week. The only negative headline came via a downgrade of the Company's preferred stock to "BBB-" from "BBB". This action is the downside of, as we described it, "allowing Uncle Sam to insert himself into the...capital structure". The Federal Government has tended to make a loser out of at least one class of stakeholder in every business it has intervened in thus far. For Lincoln, assuming that no further Government aid is needed or sought, that investor class will be those holding the preferred stock. Sphere: Related Content

The Fed's Balance Sheet

For some reason, we never grow bored of looking at this chart. This is a chart of the Federal Reserve's balance sheet, over time, in a stacked and colorful format (for your viewing pleasure). Oh yes, those numbers on the left are in hundreds of thousands. We wanted to provide the full number, for effect, but the display of the full figures had the unfortunate consequence of crowding out the rest of the chart. One can only imagine the sort of filth that lies in the region above $1Trillion. In another sort of speculation that is so troublesome it borders upon humurous, we wonder how many new colors will need to be added to this chart by the time it is all said and done.
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Friday, June 12, 2009

Lincoln Financial: Well Capitalized Ahead of TARP/CPP Decision

The Treasury Department’s decision to expand the scope of the Capital Purchase Program (CPP) to include the nation’s largest insurance companies has created an understandable dilemma for the newly eligible insurers, raising the question of whether or not to accept Treasury’s offer.

On one hand, the global economic outlook, especially as it pertains to the near term direction of the world’s most advanced economies, remains shrouded in uncertainty. A prudent course of action would be to accept the CPP funds as an “insurance policy” against a potential deterioration of credit markets. However, the government’s unprecedented and often irrational intervention into the daily business activities of both commercial banks and auto makers has not gone unnoticed by insurance industry executives, who must now assess the risks of allowing Uncle Sam to insert himself into the insurance industry’s capital structure.

Furthermore, they are forced to estimate a highly unknown yet crucial variable: How will the label “TARP recipient” influence the perceptions and behaviors of potential policy purchasers? At the time of this writing, four of the six major insurers have declined to participate in the CPP program, leaving Hartford (HIG) and Lincoln (LNC) as the remaining undecided companies. Although we expect Lincoln to accept at least a portion of the $2.5B it was offered by Treasury, we do not believe that the decision, assuming that the choice is to accept the capital, is indicative of any weakness in the company’s current capital cushion, or the expected performance of its investment portfolio.

A review of Lincoln’s most recent 10-Q reveals that, despite an intense recessionary environment, the Company was able to increase revenue in several areas during Q1 ‘09 as compared to Q1 ’08. Insurance premiums increased by 2% or $9M, Group Protection revenue was up 6% or $23M, and revenue for the Insurance Solutions business segment as a whole increased by 3% or $44M. Judging by the revenue picture as a whole, it is clear that the Company was able to weather the bout of consumer panic that ensued following the Lehman collapse quite well, and has not suffered from the collapse in revenue streams that has plagued many companies over the past year. In fact, the Company received 10% less revenue from surrender fees in Q1 ’09 than in Q1 ’08, indicating that clients did not feel the need to “cash out” of policies.

The Company has also taken several prudent and appropriate steps towards bolstering its financial condition. $500M in debt was recently paid down, the dividend has been reduced to 1 cent, and extensive cost-cutting has been deployed, which the Company projects will save up to $250M.

In terms of capital adequacy, Lincoln estimates that its risk based capital ratio currently stands at 380%. To put the figure in perspective, the NAIC considers a RBC ratio in excess of 200% to be indicative of a well-capitalized institution. With an RBC ratio nearly twice of what would be observed at a healthy institution, it appears that Lincoln is not in need of assistance under the CPP program. This reality supports our overall point, which is that for an already well capitalized institution, the receipt of CPP money should be viewed as a net positive. The fact that Lincoln does not require the money to continue operating its business will serve to weaken the government’s influence over business decisions in the event that the Company does opt to receive the funding.

Ultimately, if Lincoln does in fact enter the CPP program, we will view the decision as a testament to Lincoln’s executive team and their ability to act in accordance with the Company’s fiduciary duties to both its shareholders and policyholders. Should the economy take a turn for the worse, it is quite likely that the insurers who declined to participate in CPP will be faced with the embarrassing task of returning to Treasury and requesting entry into the program. Such an about -face would adversely affect the credibility of management and call into question the ability of those executives to navigate economic uncertainties.

We expect Lincoln to accept CPP funding, anticipate that it will be viewed in hindsight as the correct decision, and in the long term, believe the decision will reap rewards for Lincoln stockholders.

Disclosure: No position in HIG or LNC. The author is registered to sell products offered through Lincoln National Corp.

InfoNgen was used to research the content of this article.

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Tuesday, June 9, 2009

Chrysler Tests the Independence of the Supreme Court

We recall a certain first day of Consitutional Law class where the professor questioned us regarding the strength of the legislative, judicial, and executive branches of the federal government, relative to one another. We quickly reacted and, in idealistic fashion, proclaimed something along the lines of "The United States Constitution, in it's brilliance, created three separate yet equally powerful branches of Government. The wonderful document forced the implementation of a variety of checks and balances such that no one branch could act outside of it's legally proscribed bounds. Therefore, all three branches are of equal power!" That may technically be true, said our Professor, but in the end, the President commands every branch of federal law enforcement, in addition to the United States military. In contrast, he reminded us, each Justice of the Supreme Court is assigned a lone US Marshall, carrying a single handgun. If there ever erupted an actual struggle for power, he questioned, who do you all think would prevail?

Fortunately, branches of the federal government have never literally gone to arms against each other. However, based upon the example set during the Great Depression by Franklin Roosevelt, it is not impossible for politics to enter the decisions of the 9 Supreme Court Justices. As a refresher, Roosevelt was having trouble implementing every aspect of his New Deal. The trouble was, the Consitution only provided Congress the ability to pass laws based upon an explicit set of justifications. One of those justifications, the ability to regulate interstate commerce, was commonly cited as the basis for Roosevelt's New Deal measures. At the time however, the Supreme Court was a slightly conservative leaning body that in fact struck down several New Deal programs as being unconstitutional on the basis that they had nothing to do with interstate commerce. Roosevelt's plan: announce that he would like the Supreme Court to be a 12 person panel, with the additional three members arriving via Presidential appointment. The threat of vote dilution and embarassment was successful, as it prompted the current members of the Court to "behave" and not make things difficult for Mr.Roosevelt.

Today's "stay order" (below) is significant because it shows that the Supreme Court is at least considering whether it wants to behave as an independent body, as opposed to a rubber-stamping Kangaroo Court that would allow a sitting President to destroy decades of precedent regarding a creditor's rights in bankruptcy proceedings. The interesting thing about the stay order is the sheer indefiniteness of it; the Court has literally halted proceedings until further notice. With every day that passes however, the storyline gets increasingly compelling.

As we see it, the Court only has two choices: To follow the political will of a popular President, or to follow the law. To choose the former would be a complete repudiation of the Court's independence, in our most humble opinion.

In Police Pension v Chrysler Sphere: Related Content

Friday, June 5, 2009

Rate of Job Losses Slows, But For How Long?

This morning, the Department of Labor, Bureau of Labor Statistics, in a preliminary estimate, reported that US nonfarm payroll employment fell by 345,000 in the month of May. This report marked the most substantial departure from the rapidly accelerating decline in payrolls that has transpired in each month since the collapse of Lehman Brothers. Economists and analysts, understandably focused on the deciphering of trends, will be sure to note that while the US economy is still losing jobs, it is no longer losing jobs at an increasing rate. (Calculus geeks might note that while the second derivative "flatlined" several months ago, this month's data marks the first time that the anticipated change in the first derivative has occurred). Considering this positive development, we find it ironic that the major job loss inflection points have been marked by the bankruptcy of a major US corporation. We wonder then, to what degree will the collapse of GM continue to affect the labor markets?

There are numerous and obvious distinguishing factors between the Lehman Brothers and GM bankruptcies:
  • The Government is holding GM's hand through the bankruptcy process.
  • GM will restructure, and emerge as a leaner entity.
  • The Lehman collapse put the entire financial system at risk.
  • The Lehman collapse caused the failure of a multi-billion dollar Money Market Fund
  • and the list goes on (further than we care to take it)
Due to the obvious differentiating factors between these two embarassing chapters in US corporate history, it at least appears that the immediate and severe fallout witnessed in the Lehman debacle will not repeat itself in the wake of GM's failure.

We are sure that, somewhere, an economist has attempted to calculate the overral effect that the GM bankruptcy will have on the labor market. While such an analysis might be useful from an academic perspective, we are of the opinion that the downsizing of GM will bring with it a multitude of incalculable shock waves. The two that come to mind are 1) How will the bankruptcy affect the general attitudes of prospective car buyers? and 2) Will car dealers anticipate a subsequent round of dealership closings, and how will they respond to this perceived threat? These are both highly unknown variables that will largely determine the labor market fallout that results from the downsizing/bankruptcy of GM. We will not pretend to be able to calculate the impact.

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Thursday, June 4, 2009

Does the US Need More Wal-Mart Jobs?

Reuters reported this morning that Wal-Mart will hire an additional 22,000 individuals to staff its voluminous stores. Certainly, in this time of mounting job losses, a job at Wal-Mart is better than nothing as everyone has bills to pay. However, on a broader level, we are disturbed by what this announcement "means" for the country. Apparently, the deepest recession since the Great Depression has not been enough to derail Wal-Mart's growth. What then, could ever stop the discount retailer?

Obviously, those folks who view Wal-Mart as a net contributor to the US economy will cite the addition of 22,000 jobs as proof that the Company is a benevolent sort of Giant, offering regular Americans the chance to earn an honest living. The evidence however, suggests that Wal-Mart compensates it's associates so meagerly that they are forced to seek the refuge of Government assistance just to make ends meet. A Government inquiry into Wal-Mart's labor practices, the results of which are contained in the report below, concluded the following:
  • In 2001, Wal-Mart Sales Clerk's earned on average $13,861 per year.
  • In 2001, the federal poverty line for a family of three was $14,630.
  • A 200 employee Wal-Mart store costs taxpayers an average of $420,750 per year.
Assuming that Wal-Mart's announcement of 22,000 new jobs corresponds with an opening of roughly 100 new stores(this is generous, and assumes that 9% of the jobs created will be white collar, higher paying positions), we could confidently say that Wal-Mart today was really announcing a cost to the federal taxpayers of $42,075,000. This figure doesn't even include the state and county level tax incentives that are so often used to lure Wal-Mart into a particular area.

Does the US need more Wal-Mart jobs? We would say no.

Wal-Mart's Labor Record Wal-Mart's Labor Record Carneades Report by Representative George Miller Sphere: Related Content

Wednesday, June 3, 2009

Taleb's Hyperinflation Call: Proceed Carefully

As the inner workings of the global financial system deteriorated in unprecedented fashion following the collapse of Lehman Brothers, the natural inclination amongst investors and the media was to scan the universe of prominent voices, and identify a sage or two who had managed to "predict" the seemingly unpredictable. From this seer-seeking process emerged Nicolas Taleb, the author of Fooled By Randomness and The Black Swan. Taleb proved correct in his postulation that, despite the day's prevailing wisdom, the financial system was actually riskier and more prone to collapse than at any other point in history. He asserted that the advent of "mega-banks", and the proliferation of securitazation practices had produced a degree of financial interconnectivity such that the failure of one important player could trigger a global failure. While this assertion proved correct, we feel that it would be advantageous for investors to familiarize themselves with Taleb's stated investment strategy.

The impetus for the most recent media coverage of Taleb has been the news of his purported "bet" on hyperinflation. While Taleb is obviously in possession of admirable analytical abilities, we would caution against interpreting the "bet" as Taleb's prognosis that hyperinflation is More Likely to Occur than it is not i.e the probability of hyperinflation is greater than or equal to .5. Upon actually reading either of Taleb's books, it becomes clear that his investment approach is markedly different than the consensus approach taken by most money managers. Conceptually, Taleb advocates the use of a small portion of one's capital, distributed across numerous positions. The perceived probability of success for any given position is extremely low, however, a correctly selected position will result in an extremely high return. Taleb indicates that he has sometimes gone years without a correct call-it is the outsized gain that occurs Once which vaults him into profitability. For instance, Taleb was short the market for several years leading up to the Crash of 1987, probably losing money on expired put options the whole time. However, when the Crash finally did happen, the gains were far in excess of the losses that had been suffered in previous years.

A rational assessment concerning the liklihood of hyperinflation would lead one to the conclusion that the scenario fits nicely within Taleb's existing investment framework. While we will not pretend to know the exact probability associated with a looming bout of hyperinflation, we can say that a correct wager in favor of hyperinflation would lead to outsized gains in the event that it transpired. In addition, to not hedge against this possibility, albeit of questionable liklihood, would subject one's entire portfolio to great risk. For a similar, yet more grave analogy, simply peruse the web for an explanation of "Pascal's Wager". Furthermore, we know that Taleb has historically maintained a portfolio consisting of roughly 75% US Treasury Bonds - an asset class that would be sure to perform poorly in any hyperinflationary scenario. Ultimately, we consider it vital that individual investors be able to properly consume the many media accounts of Nicolas Taleb's latest "market prediction".
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Procter and Gamble: Can They Cope With Compensating Consumer Behavior?

The emergence of frugality as a popular trend amongst consumers should continue to affect consumer spending, which, as we recall, represents some ~70% of the US economy. Our venue of choice for gleaning insight into this trend is the earnings, statements, and behavior of Procter and Gamble (the company responsible for every brand of household necessity that you see on the store shelf). At an investor conference last week, the CEO of P&G, A.G. Lafley, made the following statement:

"In every recession there are hosts of compensating consumer behaviors as they manage a more modest budget. We have to expand our portfolios to serve the needs of those consumers. I think a lot of that is going to last"

P&G is one of the fortunate ones-their products are actually needed by consumers, and they have a broad enough product mix (Gain v Tide, Pampers v Luvs) to emphasize "trade down" products in a recessionary environment. Even they are not immune however, as the Company's most recent 10-Q indicates that Q1 earnings were bolstered largely through the combination of a one time gain from the divestiture of its Folgers coffee business, aggressive cost-cutting, and lower interest expense.

Based on the Company’s most recent 10-Q, Net Sales and Operating Income, when compared to the prior year's period, declined 8% and 7% respectively. However, these factors were offset by a 13% decline in the Company's Selling, General and Administrative Expense. Additionally, the Company indicated an 8% decline in interest expense for the quarter, "driven mainly by a reduction in US interest rates". Furthermore, $0.63/share or 19.6% of the $3.46/share earned by the Company in the nine months ending March 31st is attributable to the sale of Folgers.

We would tend to agree with Mr. Lafley’s assertion that a majority of consumer’s compensating behavior will remain in place, even as Washington and the media pronounce an end to the economic gloom. This trend is most exemplified by the average US savings rate which, after steadily climbing for all of 2009, has now eclipsed the 5% mark. This trend does not bode well for P&G, as it is our view that consumers will increasingly turn to the private label “store brand” products as part of attempt to squeeze extra savings out of strained grocery budgets. In fact, P&G will be fighting a two-front war on this issue, as grocery stores have begun aggressively negotiating costs downwards, in some instances threatening to or actually removing a particular company’s products from its shelves.

Ultimately, barring a substantial departure from the current trend, we predict a continued decline in P&G’s sales. Given that the company has already cut costs significantly, we doubt that further cost-cuts will be able to keep pace with sales declines. Additionally, US interest rates continued to rise throughout April and May, putting further pressure on the Company’s bottom line. We expect the Company’s Q2 earnings to reflect the above realities in disappointing fashion.

Disclosure: No position in PG, however I own SPY puts

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