Sunday, March 09, 2008

Bubble Backlash

We try to make our investment discipline as clear and concise as possible. If you are a client you’ve heard us say it many times over (Jack has a tendency to lecture at length during our meetings), but here are our two guiding principles again.

1. Only own companies that generate returns on capital that exceed the cost of capital.
2. Never overpay for an expected future stream of cash flows.

These principles can be adapted for particular circumstances, but are too often ignored or forgotten by business owners and managers, households, and financial market participants. Because of this, our country finds itself in a serious economic predicament, as we go through the second post-bubble backlash in seven years.

As the financial markets have declined due to fears of recession, foreclosures, deflation, inflation, etc., etc., it is important to look across the valley for a path to higher ground. In the meantime we can use our guiding principles to help us find better investment returns along the way. So let’s take a brief trip down into the valley and look at the “crisis” facing the US economy. First, a look at how the US Dollar Index illustrates, literally, the road map we have been on.

This decline in the dollar can be summed up easily: the demand for dollars is significantly less than the supply available. Many believe this reflects the relative direction of our global economic position.

At risk of oversimplifying, we all know that US consumers have an insatiable appetite for “stuff”, and their eagerness to borrow (often against their houses) to buy that “stuff”, has created a growing disparity between what we use and what we produce in this country. This was greatly enhanced in recent years by the Greenspan rate cuts to 1% after the fallout from the tech bubble, and by financial markets deploying creative and complex ways of aggregating global capital that was starving for return. The perfect marriage of a fiscally irresponsible consumer, and capital invested at a reduced, or most likely false, expectation of return, created the potential for widespread destruction of value. Our clients and those familiar with our investment discipline will recognize this as similar to the reason we invest only in companies that are fiscally responsible and respect the cost of the capital they are using.

For most of the last century, the US has enjoyed the position of being the global economic leader and producer of goods. The reality is that economies previously labeled emerging (a fairly non-threatening term) have now emerged and are competing globally. While competition is healthy in a free market system, it also requires efficiency and discipline with respect to capital investment. Our consumption patterns, lack of saving and willingness to over-leverage are all weaknesses that are being highlighted and exploited by our newfound competitors (think China, India, etc.). The resulting fallout from this behavior, seen specifically in the highly leveraged housing and financial markets, has lawmakers and the Federal Reserve ready to intervene.

Government has been mastering the art of the bailout since at least the early 1900s and, therefore, the markets have high expectations for a rescue. While our capitalist, market-driven economy benefits from regulation and occasional targeted intervention, the focus on a rescue when things go awry can distort the market mechanism of finding equilibrium asset prices and flushing out bad financial decision making. The headlines of a looming recession and realized losses on financial investments coupled with constant rhetoric from politicians and central bankers, stoke the uncertainty and volatility present in markets today. Given that we are unwinding possibly the greatest credit bubble this country has ever seen, the proportionate response from the Federal Reserve and lawmakers may be quite large in absolute terms.

So, let’s look at what the geniuses at the Federal Reserve are up to. After several months of uncertainty, the Fed has clarified its position: Offset the deflationary and recessionary effects of deleveraging on the economy and worry about inflation later. To be clear, the greater risk in the very short run is deflation, as the rapid unwinding of credit and credit availability limit capital investment, consumption, and overall aggregate demand in the economy. Declining credit availability is similar to a decline in the money supply, which is exactly what the Fed is trying to offset.

The unwillingness (in some cases inability) for banks to lend, as well as the difficulty of credible borrowers to obtain capital, is at the forefront of the Fed’s concern as it continues to use the blunt force of lower short-term interest rates by injecting money into the banking system. As the Fed was apparently late in assessing the risks of the situation (or possibly ignorant as was much of Wall Street), the short end of the yield curve is currently indicating the need for substantially lower rates to induce capital flows. For much of the past two years, banks have faced weak net interest margins (interest received less interest paid) due to short-term rates equaling or exceeding long-term rates. In addition, some of the largest banking institutions and brokers (the best examples being Citigroup and Merrill) have sought massive capital infusions to bolster bloated balance sheets loaded with “toxic” loans that are subsequently being written down in value (in accordance with some debatable accounting standards). The Fed is attempting to allow banks to earn money at all maturities of the yield curve by lowering the Federal Funds Rate. As seen in past rate reductions, the target Federal Funds Rate may be somewhere below the two-year Treasury yield, a proxy for the short end of the yield curve. Currently that rate is close to 1.6%, but it can fluctuate greatly day to day.

Even though the banking system as a whole is well capitalized, restriction of the flow of capital is a real and destabilizing threat to the economy that the Fed needs to address. The risk here is being too aggressive for too long. By inflating our way out of this problem with an increasing supply of money, a substantial portion of those “extra” dollars unfortunately will be used to consume imported goods, which will expand the difference of what we use versus what we produce as a nation. By forcing dollars into the hands of our foreign competitors and essentially asking for them back as a loan to fuel further consumption and government spending, we give away ownership interest in our national assets, as well as the discretion over how those dollars are invested. For example, when we use dollars to buy toys with lead paint from China, they can use those dollars to invest in US Treasuries, which helps keep our long term interest rates low but also makes us dependent on them to finance our deficits. Or they can reallocate and buy other stores of value. If they choose to do the latter because the returns here are insufficient (i.e., practicing principle number one from above), it will raise our interest rates, exacerbate tight commodity markets (commodities are already expensive due to global demand and ethanol subsidies), and raise the cost of imported goods. These are all symptoms of inflation. Worse, it is inflation with very little real growth, or “stagflation”.

The key here is this: no pain, no gain. Deleveraging and the revaluation of asset prices (e.g. houses, mortgage backed securities, leveraged loans) is taking place right now. So far the Fed’s action can be seen as attempting to stabilize defunct credit markets. We should expect (or hope for) the Fed to take back anything extra that has been put on the table, as soon as markets have had time to heal. Healing might require going into a recession, but it is often the best remedy. Consider how the Fed inflated its way out of a surprisingly mild recession in 2002. Possibly the credit bubble we face today could have been avoided with less aggressive monetary policy and a deeper, more effective slowdown. As Stephen Roach, chairman of Morgan Stanley Asia, opined in the New York Times recently, “The greater imperative is to avoid toxic asset bubbles in the first place.” (click here to read his op-ed, after you finish this blog post of course)

Additionally, right or wrong, the government will bail out many people who made poor financial decisions (by the way there is some real evidence of fraud in mortgage lending being uncovered). At the very least, Congress and the Treasury will attempt to facilitate a workout of the mortgage problem to get people back on their feet. There are many pitfalls along the way, but the real challenge is to moderate assistance, so those that get help learn to stay on their feet. Some ideas that are being floated include reform (or possibly a bailout) of Government Sponsored Enterprises known by their chummy nicknames Fannie Mae and Freddie Mac, expansion of the FHA, and a public awareness campaign called The Hope Now Alliance, which is sponsored by the Treasury Department. In the end, free markets guided by the boundaries of sound laws and the efficient transfer of capital will eventually get it right and money will flow when returns are appropriate. Lessons will be learned (possibly to be forgotten as history suggests) and we will make progress.

There is a path that leads us to higher ground and there will continue to be opportunities to invest profitably. Since it is difficult to say it any better, here is a quote from Warren Buffett’s 2007 letter to shareholders: “Despite our country’s many imperfections and unrelenting problems of one sort or another, America’s rule of law, market-responsive economic system, and belief in meritocracy are almost certain to produce evergrowing prosperity for its citizens.” This is the belief in our country to get it right. The realities of a global economy have revealed our weaknesses and it will take time to adjust and correct our errors and imperfections. Now is the time to focus on fiscal discipline, sound capital management, sound free trade policy, and innovation to compete and export in a global marketplace.

It is very important to look across the valley at future growth and investment returns. The U.S. economy continues to increase productivity, more companies are focusing on return on capital (we see it most in working capital management), and many U.S. corporations are well positioned internationally to take advantage of the rapid growth of infrastructure and technology on a global level. Those opportunities are most prevalent today in China and India, which are voracious consumers of resources and goods, as they build out to accommodate a surging urban population.

No matter how long the duration of the credit crisis, we stick to our principles of investing, which are serving our clients well. Many well run businesses will feel minimal effects from a slowdown. Stock market values may go down, but as long as businesses continue to create value and preserve capital, intrinsic values will rise. While by no means the beginning of a long term bull market, current levels are presenting opportunities to invest. We continue to be conservative in our choices and maintain our current theme of preserving capital by maintaining some defensive positions. We will continue to add undervalued names that will benefit from global expansion and the general level (not just the rate of change) of commodity prices. We are closely watching some financial companies that have been significantly discounted in the market. Retail is not as interesting quite yet as consumer spending and employment will likely be under pressure through much of 2008. We will also take full advantage of opportunities to take profits when appropriate. Finally, as a reminder we will:

1. Only own companies that generate returns on capital that exceed the cost of capital.
2. Never overpay for an expected future stream of cash flows.

These should not simply be treated as truisms, but should be discussed and practiced in all matters of economic consequence.

We welcome your questions and opinions.

Peter Falker, CFA