Monday, August 29, 2011
Technology companies have growth cycles, with the attendant valuation cycles. As we've written before, Apple has become a cult stock. The recent explosion of revenue, returns, and valuation metrics was generated, in our opinion, from the ability of Steve Jobs to cut through the thicket of product development projects to identify the iTunes and iPhone projects as the "must haves" for the company's success. The troops at Apple all rallied to his call, and for such a large organization to focus with great energy and deliver is a testament to executive management, leadership and organizational depth.
The Wall Street Journal asks, "How can ordinary companies turn themselves into Apples?" The answer is easy, "They can't." As framed, it's a vacuous question.
Apple's adolescence, was exemplified by lousy products and a failed strategy, as discussed above. These describe an ordinary company. However, it grew out of adolescence into the young adulthood of the digital era with ideas that revitalized music publishing and enjoyment, as well as giving consumers the iPhone which converged entertainment, information, music, video, and computing in a great package. This is not an ordinary company by any stretch.
As Chairman of the Board, Mr. Jobs has the chance to interact with his hand-picked CEO Tim Cook and form a partnership which will guide Apple through another decade of adding value, but probably not at the rate of the recent past.
Friday, August 26, 2011
I''m still struggling to see how this makes the case for the common equity. There is definitely a case for investing higher up the food chain, particularly in Bank of America's bonds. Looking at the June 30th, report for Dodge & Cox Income Fund (DODIX), they have long pursued the strategy of overweighting corporates relative to their BCAG index. As an owner of the fund, I liked this strategy and it has really driven their out performance relative their intermediate bond fund peers.
For the most recent period, the weighting of Corporates went to 44.5% of assets versus 19.8% of the BCAG benchmark. Bank of America's bonds are now the largest corporate issuer in the portfolio, at 2.6% of fund assets. Ally Financial weighs in at 2.4%, and Citigroup at 2.1% of assets. Both Bank of America and Citigroup are stocks that may look like values to the risk-loving investor.
Web commentators have suggested that deposits continue to stream into Bank of America, and bulls suggest that there is money to be made in the stock. It's extremely difficult to project what normalized earnings will be in 2-3 years. Without a reliable estimate, how can one project a reasonable target price?
Since the near-term discussion will be dominated by asset sales, additions to reserves, delinquencies, charge-offs and regulatory hurdles, it's impossible to make a fundamental, valuation driven case for the equity. The bonds clearly have been strong performers, and are senior in the capital structure. It seems as if Mr. Buffett's choice to be higher up the capital structure, i.e. above common equity, but with an equity kicker is another, lower risk way to play Bank of America.
Tuesday, August 23, 2011
I look at it a bit differently. It appears that the regime of a despotic leader who squandered "four decades of a nation's life," has been brought down through a NATO coordinated support mission, with the most important contributions coming from the U.S., and without the shedding of American blood. However it happened, this is a pretty sensible use of our resources to get a good outcome. It beats our usual, "Ready, fire, reconsider" strategies.
Going forward, probably driven by the desire to take credit for domestic political reasons, we still run the risk of putting out feet in our mouths, backing the wrong horse, and throwing money at problems which are not monetary. Let's wait and see, perhaps leading from the back again.
When Gadhafi is found and captured, let's hope that the rebels don't create an undignified and inhumane spectacle. After some photo opportunity, like pulling down a Gadhafi statue in a Tripoli square, the settlement of old scores and grudges will begin. Also, there will be a struggle for primacy among the segments of the rebels. Who will be the face and voice of the new leadership council?
We have to resist our usual tendency to select that person, perhaps because they studied at Harvard. The oil companies, none of which appear to be American, are already lining up to lead the restoration of production capacity. Our not being a leader in this effort is probably a good thing, as it frees us a bit from the accusation that we're all about the black gold.
Even though Gadhafi has robbed the national patrimony, that's now in the past and the nation has to look forward. It will need institution building, tribal power sharing, and assistance in financing and building infrastructure and supplying essential services. We should look, listen and learn as this situation unfolds, and share in the pride of Libya's setting itself free.
Wednesday, August 17, 2011
We've written before about a very sensible proposal from Bob Pozen which aims to equalize any profits being repatriated from low tax jurisdictions while raising funds for the Federal government through a 5% administrative fee. Effective tax rates paid by U.S. corporations really don't vary substantially from European rates, and so there's absolutely no need to use this infrequent event as a substitute for meaningful tax reform.
Let's hope that we don't have another unjustified handout to the largest corporations and their shareholders. I tend to hold large capitalization stocks, and I still think it's unwarranted, by the way. If these companies want to spend some money, they are already flush with cash, and yet they are not expanding employment or increasing capital spending. A shortage of cash is not the constraint, but a total aversion to employing risk capital for business expansion. Now, that's a real problem of a lack of "animal spirits," in Keynesian language.
Tuesday, August 16, 2011
The Android experience varies substantially on different phones, which is a natural outcome of having an open source OS. (my son has always liked his bargain HTC phone) Before the acquisition, each handset maker had some incentive to innovate and make their version of the OS superior, enriching the customer experience and gaining some transitory market share. Going forward, because of the incentive for Google to work closely with Motorola Mobility, these other manufacturers like Samsung and HTC have less incentive to spend money improving Android on their phones. The suggestion that these manufacturers would automatically start looking at Windows Mobile out of pique seems irrational. If Android continues to gain share, what incentive is there to move to the OS that is less flexible to work with?
Apple seems to be left out in the cold, on first blush. It seems to be able to provide the best customer experience overall on devices from the iPad to the iPhone and the iMac. This is truly a terrific accomplishment, and at the end of the day, providing the best customer experience with innovative products and providing the best service is the best explanation of the stock's valuation. Now, all of this may not be enough to sustain it.
Both Microsoft and Google are looking for a consumer device, which seems now to be the SmartPhone, to be the stalking horse (or Trojan Horse?) into the consumer's home to deliver a variety of technology services, from entertainment to home energy management. The stand alone profitability of the device is a red herring, if the device is a means of entry.
Motorola Mobility also makes set top boxes, along with Cisco/Scientific Atlanta, used by major cable television systems, and this is another device that may continue to be important as a platform for delivering services to the household.
Since Dr. Eric Schmidt's conflict of interest serving on Apple's board was known for several years, and since Steve Jobs got it the instant he saw an Android phone prototype, one would hope that Apple has a strategy to continue to be major player. Duopolies are not good for consumers, so I surely hope that Apple continues to thrive and that it not become a casualty of the "Clash of The Titans." I'm going to go out and purchase an iSomething to support them.
Sunday, August 14, 2011
I was truly flabbergasted by the response of CEO Brian Moynihan, who said that Merrill, to paraphrase, was fully integrated into the culture of Bank of America. No serious institutional investor would have tipped their hand by challenging this assertion, but it is totally implausible.
Ever since the Eighties, when commercial banks first bought asset managers to reduce their earnings cyclicality, the cultures have never meshed, particularly over compensation issues. Over time, the targets for commercial banks became the investment banks, which themselves had wealth management businesses, as well as proprietary trading desks and investment banking. Now, the cultural and compensation issues diverged more sharply from the commercial banks, although bank CEO compensation exploded sharply because they ran bigger balance sheets.
I once worked for Merrill Lynch when they were located in the old US Steel Building on Liberty Street. The idea of costs and internal controls were about as well understood as Mandarin Chinese. There was a complete disconnect between the huge retail brokerage network, "The Thundering Herd," and the institutional business, both of which were totally oblivious to the asset management business located in New Jersey. Fast forward to 2008, Merrill Lynch was being run by a distant, isolated CEO who wasn't excited by either the brokerage business or by the lackluster asset management business. Instead he led it into the world of creating Collateralized Debt Obligations, instruments that the board and the CEO didn't understand. As this out of control empire started to collapse, along came Bank of America to acquire Merrill Lynch.
US Bancorp bought Piper Jaffray in 1997, and dividended it back to shareholders in 2003. USB bought it at the high point of the cycle and divested at the low point, just before the market turn. In the interim, ownership added no value, and Piper subsequently thrived as an independent public company. Citicorp's acquisition of Smith Barney was described as follows by the Wall Street Journal in 2009, "Ever since Smith Barney became part of Citigroup 10 years ago, the brokerage has been whipsawed by integration problems and troubled deals." Smith Barney was eventually disgorged by Citi.
Citi couldn't integrate Smith Barney after ten years, and yet we are to believe that Bank of America has integrated the bigger and more sprawling Merrill Lynch in less than two years? Not likely. I had the misfortune to have some dealings with Merrill Lynch recently, trying to transfer an old account. I ran full tilt into a total lack of communication, record keeping, and computer system issues between Bank of America's systems and those of Merrill Lynch.
Integration in the best possible case might involve computer systems. The cultures can never be integrated. Institutional traders, salespeople, analysts, and capital markets executives are masters of the universe, and brokers are not part of the club. Retail banks can't sell brokerage services effectively. Why did Charles Schwab return to the business he founded? My point is that the Bank of America CEO's assertion about Merrill Lynch's complete integration would represent the first such successful integration in corporate history.
Beyond this point, which is not small, there is the issue of Countrywide Financial. Nothing on the call added any more clarity to the risks associated with this disastrous acquisition. The "see you in court" challenge to AIG was false bravado and would not give me comfort as a shareholder. Bank of America's asking Secretary Geithner for relief against mortgage fraud issues being brought by State Attorneys General has not worked, and this will be a protracted, multi-front battle which probably won't end cheaply.
After all is said and done, Bruce Berkowitz's Fairholme Fund's investment in Bank of America is very hard to understand. In 2009, Forbes Magazine asked Berkowitz why he was avoiding financials. He is quoted as saying, "Well, we don't know how to value them...It's impossible to know what they own...Five years ago, you could read AIG's report on derivatives. Maybe it was a paragraph. It didn't tell you anything. You had to just assume that these people knew what they were doing. Today you can read ten pages on it and still not know what's going on unless you go through the underlying collaterals. Almost impossible."
Fairholme should have followed its own advice, and this conference call shouldn't have made them any more comfortable with their investment.
Friday, August 12, 2011
A 2009 paper by Glenn Hubbard and Chris Mayer of the Columbia Business School shows that the normalized spread is 160 basis points. Although the spread has come down from the intra-crisis peaks, it is still above the normalized level. In their paper, the excess spread raised the cost of owning versus renting by 10-17%.
We've noted before that banks have gone from drunken sailors to Scrooges, and mortgages are being denied to even a bank's good customers. Appraisers were complicit in the U.S. housing debacle, and in my state of Minnesota, the ability to fog a mirror can get you an appraiser's license. That industry is still out of whack, and it is complicated by the appearance of Web sites like Zillow which purport to show estimates of residential value which are based on their proprietary models. What I've seen of Zillow has been nonsensical though it has been improving. Their database on individual properties has gaps, inconsistencies and errors.
We have not come up with a solution for the tens of thousands of homeowners with negative equity in their homes. The worst ones are in the mill but the homeowners are staying put, not making payments, while it's unclear who holds the mortgage and who can dictate the new terms. The Obama administration seeking ideas to turn these homeowners into renters seems to be a blunt instrument which leaves lots of implementation questions unanswered.
The Government is still insuring more than $6 trillion in mortgages, and we can't expect anything from this sector for a long, long time unless it gets a pretty big fix, which should involve shared pain for the banks, investors, homeowners, and the taxpayers, unfortunately.
Wednesday, August 10, 2011
Wall Street takes that language and processes it, and the markets incorporate the information content into the shape of the yield curve, for example. The Fed is not committed to any specific date and retains flexibility, as it must and should. Putting a specific date on the period of low rates is an unprecedented break with central bank practice. This is another boon to Wall Street to have at it, and does nothing about the problem of all the excess liquidity on bank balance sheets and the lack of traditional lending.
I understand that inflation could surprise, but unless something unusual happens on the global economic growth front, apart from a supply shock or natural disaster, there appears to be no fundamental underpinning for an inflationary spike.
The oil price decline is a combination of growing inventories, sharply declining demand, and a reduction in speculative focus on this market. The speculation will move elsewhere, with a Fed guarantee that it won't surpise speculators with higher rates. Gold has been levitating for a long time, but let's leave that market aside.
Turning to the ECB, it has relatively few options that will provide meaningful support to a dismal outlook in Europe. The Wall Street Journal naively suggests that the Germans, French and stronger European countries will withdraw from the European currency union and create their own "strong euro."
This is extremely unrealistic and would not solve the fundamental problem of economic imbalances within the European Union. Germany is really in the driver's seat, but it too will be reluctant to detonate the charge that destroys the empire of the Brussels bureaucrats, of which many senior ones are French. A slow, economically inefficient unwinding is probably what's in store.
What about the former Eastern Europe? There is a lot of underexploited dynamism in countries like Poland, but they never really had a primary seat at the table of the European Union. If the euro disappears and the Union falters, do they turn East or West for economic growth?
There is occasional blather about the need for European countries to increase fiscal harmonization to get out of the current mess. That was never acceptable to any EU member, and the notion of giving up some degree of national sovereignty remains anathema. Forget about this option.
Finally, in Britian we have again echoes of London Calling by the Clash. Paul Simonon sang an ominous "Guns of Brixton," and that's one of the neighborhoods being torn apart by violence and thuggery. In addition to any issues with newer immigrant groups, Londoners are finally having to acknowledge that with all the economic gains in the City of London financial district, the educational and employment situation of a few generations is dire and has been ignored.
Fiscal stimulus anyone?
Tuesday, August 9, 2011
Let's leave aside the whole issue of comprehensive tax reform, because we came up with a great blueprint in 1986 and seem incapable as a body politic of dealing with this kind of complexity.
Now, we have the problem of U.S. corporations holding more than $2 trillion abroad in non-repatriated cash income from foreign subsidiaries. GE alone is said to have over $14 billion in eligible earnings that could be repatriated. GE had the moxie to suggest companies being able to bring in the cash free of tax, in exchange for creating an infrastructure bank, among other things!
Bob Pozen, Chairman Emeritus of MFS Investments, has a wonderful idea, implementable without a comprehensive reform. His idea, reported on Bloomberg, is to exempt from U.S. corporate taxes income earned in foreign jurisdictions with an effective tax rate of 20% or higher. "Such earnings could be repatriated to the U.S., subject to payment of a 5 percent administrative fee." This fee, which Pozen says is applied in France and other countries, would account for prior deductions from U.S. taxes, primarily for salaries of U.S. executives who helped start and run the foreign operations. Some fraction of 5 percent of $2 trillion. Now that would show the Chinese that we're serious about putting our house in order.
There would have to be a transitional regime, which is relatively simple, as Pozen points out. However, for a variety of reasons, a lot of cash would be brought to the safety of U.S. shores and financial system.
Pozen points out that academic studies show that the average effective U.S. corporate tax rate is around 22.5 % compared to 19.8-21.5% in larger European countries. So, let's turn off the corporate PR machines and make some win-win policy here.
If the Federal government wants to fund an infrastructure bank itself, it will have ample funding to do so under this kind of plan.
Monday, August 8, 2011
S&P, we can all agree, has imprudently overplayed their marketing hand and revealed, through their $2 trillion arithmetic error, that they don't deserve to be taken seriously on the U.S credit rating downgrade.
It was discouraging to read that the Justice Department has concluded its investigation into actions taken by Countrywide Financial and its officers during the run up to the financial crisis. Nobody has gone to jail yet, and it sounds as if that will continue to be the case. The Fairholme Fund's self-interested conference call with Bank of America management might be interesting, although it seems quite bizarre that the BofA management has agreed to this unique format for a 1% shareholder. It's a funny way to do business, in our opinion.
Friday, August 5, 2011
Let's go back to the early days of the financial crisis when it was being described as a crisis of liquidity. Well, the U.S. Federal Reserve unleashed a historically unprecedented global tsunami of liquidity. It had to be reflected in the markets for financial assets, and yet this basic economic insight has been pooh-poohed repeatedly.
Joseph Carson, U.S. Director of Global Research for Alliance Bernstein, writing in his August 5th letter notes, "Looking back, the Federal Reserve's second quantitative easing program (QE2) is partly to blame for the surge in commodity prices that has weighed on growth this year. Although several factors contributed to the sharp rise in oil prices, ....a sharp increase in commodity prices began to develop almost immediately after the Fed started QE2 last November."
There's really no fundamental inflationary pressure worldwide because of deficient aggregate demand compared to worldwide excess capacity in key industries, such as steel, natural gas, and aluminum to name a few. Much of this excess capacity has been built in China.
As a mirror to U.S. fiscal profligacy, there is the totally inefficient allocation of capital in the Chinese model of state capitalism. In a drive to build capacity for its own projected GDP growth rates of 10% per annum and to become a global exporter of industrial goods and machinery, China has invested heavily in basic materials like steel and aluminum. All of this activity has fed back into their commercial real estate bubble. Skyscrapers bigger than the Empire State Building were to have been built already, but like our "shovel ready" infrastructure projects, these projects are vacant lots. The stimulus loans for the projects have already been disbursed, and these loans, wherever they reside, are bad and unrecognized on public and private financial statements.
So, again, from the point of view of the real economy, it's almost impossible to pick up a real sniff of rising inflation trends, apart from what's being driven by the continuing misguided monetary policy. Monetary policy will also do nothing for global employment.
Mary Ellen Stanek, CFA the Chief Investment Officer for Robert W. Baird's Fixed Income funds wrote recently for her clients, "We are not seeing signs of worrisome inflation...while there are visible signs of inflation in food and energy, these pockets of inflation have not....worked their way into longer term inflation expectations in a meaningful way." If the bond market imposes inflationary discipline on issuers, then this opinion from a big, savvy player carries a lot of weight.
The stock market may be waking up to the fact that lots of liquid assets on the books of public corporation are nice to have, but in the long run deficient global aggregate demand and a zombie consumer sector with over leveraged households mean low unit growth and lack of pricing flexibility. Not great for earnings.
Wednesday, August 3, 2011
When the Panel of Wise People meets to eventually decide on $1.2 trillion of "spending reductions," they are to fall on defense and social expenditures. Let's not cut defense spending on our troops, as we continue to ask fewer and fewer troops to do so much more. When they come home, we don't keep up our end of the bargain with them either. Everybody knows that there is tremendous waste and duplication in the services competing with each other for their own fighters or bombers. Over the decades, we've done precious little of substance on this front.
Pictured above is the Air Force's $12 billion Global Hawk program prototype, designed to replace the long-serving U2, in which Colonel Gary Powers was shot down way back in the Cold War era. It looks almost like a battle ship with wings. With all the progress in miniaturizing digital video technologies to virtual commodities, and progress in making lighter, stronger materials, it seems to me that the concept of this aircraft is a throwback to days gone by. Can't we have a lot more, smaller, dispersed, lower-cost-per unit drones spread over a network? Can't a network of satellites do more functions at a lower cost?
Again, as our military troops on the ground have fallen victim to expensive, failed technologies like Swiss cheese armored vehicles in Afghanistan, I hope that we take a good hard look at DoD procurement programs for some of our recently mandated defense cuts in the coming year.
Monday, August 1, 2011
Also, even though tabbed browsing is now commonplace, it seems to work a lot better in Google Chrome than it does in Explorer, which again seizes or freezes when too many tabs are open. Machine resources seem to get tied up faster in the Microsoft complex of Windows, IE, and Bing than they do without Internet Explorer in the mix.
It's probably way too costly and risky to expect that Microsoft would radically simplify the kernel of Explorer, but it should. It would require quite a paradigm shift in the way it deals with partner applications, but IE is still not an application worthy of a market leader.