Meanwhile, Back at Corporate America

Much investor attention has been focused on government discussions in Washington and Brussels, and market movements this week have been largely driven by macro events.

However, now that we're probably two-thirds through earnings season, it is safe to say that Corporate America is doing just fine.

More than 80% of the S&P 500 companies that have reported have beaten earnings expectations this quarter, according to the Financial Times. Technology companies in particular are doing great: we've seen "blow out" earnings reports from companies like IBM, Apple and Google.

Bloomberg points out that return on equity for the stocks in the S&P 500 rose to 24%. When you compare this to the paltry yields found in the bond market:

Return on equity, a measure of profits relative to investments in plants and labor, rose to 24 percent last month, according to data compiled by Bloomberg. At the same time, a gauge of corporate bond yields fell to 3.61 percent, according to Barclays Plc. That’s the biggest difference in at least 13 years, the data show.

http://www.businessweek.com/news/2011-07-18/record-s-p-500-return-on-equity-over-bond-yields-spurs-bulls.html

The problem is what what is good for corporate America is not necessarily good for the populace as a whole. Record earnings have largely been achieved through efficiency gains using the internet, and outsourcing jobs to lower cost countries. The average American is not seeing the benefits of the resurgence in business.

What does seem likely is that we will continue to see more M&A activity. Corporations have huge stockpiles of cash - nearly $1 trillion, by some accounts. With top line revenue growth gains difficult, and short term interest rates near zero, there is strong incentives for mergers. Even an old corporate raiders like Carl Icahn is trying to force Clorox management to sell.

On a lighter note, the increase in M&A activity has extended to even the smallest companies, as the Boston Globe noted this morning:

Berkshire Hathaway CEO Warren Buffett is one of the world’s richest men... was in Boston this week for a meeting... Afterward, we’re told, Buffett, his burly bodyguard, and a few folks ...headed over to Boston Speed Dog, the food truck in Roxbury that sells the most scrumptious hot dogs. Not surprisingly, Buffett loved the dog and joked that he wanted to buy the truck. When we asked Speed Dog co-owner Greg Gale about his brush with fame, he was confused. “Really? He was here? I didn’t even know,’’ Gale said. “I love his music.’’ No, we explained, it was Warren Buffett, not Jimmy Buffett. He’s older with gray hair and glasses, we said. “Now that you mention it, I did talk to him,’’ replied Gale. “He said he wanted to buy the place, and I told him, ‘You don’t have enough money.’ ’’

http://www.boston.com/ae/celebrity/articles/2011/07/22/warren_buffett_sure_likes_boston_speed_dog/

Everyone's A Contrarian

A few years ago I took my son Michael on college visit to the University of Virginia.

UVA is one of the top universities in the United States, and admission is highly selective and competitive. The school receives thousands of visits every year from high school students from around the world, and the crowd was large on the day of our visit.

When we visited Charlottesville,we heard a talk given by Parke Muth, one of the deans of admission at UVA.

It was an excellent talk, but what I remember most was the beginning of the presentation.

Mr. Muth looked out the audience of parents and top-flight students and asked:

"How many of you think the college admissions process is fair?"

Virtually no hands were raised.

So, with a smile, Mr. Muth said,

"Well, then, if you all think it's an unfair process, doesn't that really mean the process is fair? Doesn't really mean that you're all being treated the same way?"

The audience broke out in laughter.

-------------

I'm competing against another firm for a new relationship.

My competition is a small money management outfit here in Boston whose whole investment approach seems to boil down to "we're contrarians".

In my opinion (remember I'm biased), "contrarian" is one of the most overused terms in investment management.

So many firms bill themselves as "contrarians" that being a contrarian is almost the majority. But how can you be contrarian if all of your thinking is mainstream?

Or, to echo Mr. Muth of UVA, if everyone thinks their thoughts and investments are away from the "herd", then by definition they really are part of the "crowd".

For example: my competition's website describes how, through their years of experience and education, they are able to find undiscovered gems in the investment world. However, the insights that they offer up largely seem to center around our broken political system, large amounts of debt, and apparent overvaluation of all markets.

Is this really contrarian thinking?

The problem with true contrarian thinking is that it often is at odds with making a living in the investment world.

For example, Jeremy Grantham - one of the most respected investment strategists in my business - was bearish on technology stocks starting in the mid-1990's. His work was eventually vindicated, but as he said, his firm (GMO) lost three-quarters of their assets under management in the late 1990's due to poor investment performance versus their benchmarks.

More recently, hedge fund managers like John Paulson and Michael Burry made literally billions of dollars betting against the US housing markets during the last decade (and were profiled in books like The Big Short). However, both men suffered huge amount of investor outflows from their firms before ultimately being vindicated.

As John Maynard Keynes said long ago, "Markets can stay irrational longer than you can stay solvent".

In my experience, everyone likes a contrarian - as long as it works out quickly.

OMG: Zillow Trades at $60 a share

I wrote a post last week about Zillow, the on-line real estate information company that just went public today. The stock ticker is Z.

When I attended the road show for the deal, I was impressed with the company and its potential. So too were a number of other investors - the meeting room was packed, and the hotel had to set up tables in the hall accommodate the attendees.

At the luncheon, management indicated that it was expecting to price the deal between $12 to $14 a share. Here's what I thought about the offering at those levels:

Zillow has not made any money in its short history. In 2010 it had total revenues of approximately $30 million, and lost about $7 million. Still, traffic at the Zillow site has been soaring, and there is significant revenue potential through both on-line advertising as well as partnering with affiliates such as mortgage companies.

The IPO is offering roughly 10% of the company for $45 million, with the founders and initial investors holding the rest of the shares. Put another way, the company is being valued at around $450 million, or 15x sales, which puts it at a valuation that I will have to take a pass.

http://randomglenings.blogspot.com/2011/07/are-new-tech-ipos-overvalued.html

Well, shows what I know.

Z opened today at $53, and traded as high as $60 a share, or 500% higher than the price indications of last week (talk about performance!). The trading has been very erratic, however, which is not surprising given the relatively small size of the deal, so who knows where it will close today.

Meanwhile, back at "old tech", Apple reported outstanding results last night. They are barely able to keep up with the demand for iPads. Combined with strong results from other tech companies like IBM and Google, it might appear that techology - which has lagged the general market this year - might be poised for a stronger second half.

IBM Rolls On

One of the most remarkable stories in American business, in my opinion, has been the evolution of IBM over its 100 year history.

We're all pretty familiar with the story: started by Tom Watson to sell adding machines, the company was on the forefront of computer technology research. By the late 1960's, IBM was so dominant that the US government brought a monopoly suit against it in an effort to break up the company.

However, as is almost always the case in technology, new and more aggressive rivals sprang up, and IBM slowly began to slide towards what appeared to oblivion. The old way of selling "big iron" to corporate American through an army of men dressed in blue suits began losing badly to more nimble start-ups.

Enter Lou Gerstner. Named as IBM's CEO in 1993, Gerstner brought a whole new mind-set to the company that changed not only the course of IBM but also the way that many other large technology companies operate today.

Gerstner's insight was simple: most CEO's are less interested in technology than they are in simply using technology to deliver products and services.

For example, Gerstner recalled that when he was head of American Express he was really only interested in having customers use his company's service. Technology enabled Amex to deliver a service, but their main product was credit cards, not technology.

Gerstner wrote an excellent book about his time as head of IBM named Who Says Elephants Can't Dance.

I can truthfully say that Gerstner's book is one of the few business books that I have read twice, and think about often in my daily business life.

The idea of looking at one's business from the customer's point-of-view, rather than the other way around, should be central to every company, yet too often the customer is forgotten in strategy discussions.

Here's a quote about Gerstner from Widipedia:

{Gerster} describes his arrival at the company in April 1993, when an active plan was in place to dis-aggregate the company. The prevailing wisdom of the time held that IBM's core mainframe business was headed for obsolescence... Gerstner reversed this plan, realizing from his previous experiences at RJR and American Express that there remained a vital need for a broad-based information technology integrator. His decision to keep the company together was the defining decision of his tenure, as these gave IBM the capabilities to deliver complete IT solutions to customers...

Today a number of companies - including Oracle and Hewlett-Packard - often cite IBM as their role model for how they are trying to structure their companies.

I thought of IBM's history, and how far it is come, when I read the company's most recent earnings release. Big Blue continues to produce strong results:

IBM, which turned 100 last month, delivered better-than-expected quarterly results Monday that showed the old company had a lot of life in it.

The company got a lift from robust sales of new models of mainframes — I.B.M.’s heritage — while its biggest current businesses, software and services, generated healthy growth as well.

The company reported an 8 percent increase in net income, to $3.7 billion. Its operating profits per share rose 18 percent, to $3.09 a share, reflecting fewer shares outstanding because of I.B.M. stock buyback programs. Bolstered by the strong performance, I.B.M. raised its guidance for earnings for the full year, to “at least $13.25 a share” from the previous level of “at least $13.15 a share.”

I.B.M. Beats Analysts’ Forecasts - NYTimes.com

A World of Contrasts

"Before I go on with this short history, let me make a general observation– the test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function.
One should, for example, be able to see that things are hopeless and yet be determined to make them otherwise. This philosophy fitted on to my early adult life, when I saw the improbable, the implausible, often the "impossible," come true."
— F. Scott Fitzgerald

Perhaps Fitzgerald would have understood the world that we are facing today, since there seem to be so many contrasting trends.

In the U.S., for example, no one doubts that we have the financial capability to pay our debts, yet we can't agree on how we should go about it.

Meanwhile, in Europe, several countries would very much like to pay their debts, but don't have the financial capability to do so.

Regardless of how the various budget crisises are resolved - and I remain optimistic that at least here in the U.S. we will avoid a major policy blunder - it could be that what we are really seeing is a world struggling with deeper changes.

At least that's the argument of the Economist blog Democracy in America. Published last Friday, the author cites a recent research piece published by Michael Spence, a Nobel-laureate professor of economics at NYU.

Here's a quote from Professor Spence:

"[A]s recently as July 8, after the latest disappointing employment report in the United States, President Barack Obama expressed the widely held view that an agreement on the debt ceiling and deficit reduction would remove the uncertainty that is holding back business investment, growth, and employment. In other words, America’s fiscal problems explain its extremely weak economic recovery. Once a fiscal deal is done, government can step aside and let the private sector drive the structural changes that are needed to restore a pattern of inclusive growth."

However, Professor Spence argues that fiscal policy is not the fundamental problem for our economy. The rise of the emerging markets - in particular China - combined with our huge debt burdens means that America is facing a period of economic readjustment that will involve significant dislocations.

In Professor Spence's view, for example, our high rate of unemployment does not reflect poor government policies, but rather that American industries, and American workers, are having trouble competing in the global market place.

In other words, even if the recent fiscal crisis is resolved, it could very well be that our problems are deeper, and more intractable, that we are recognizing.

Or, on the other hand, we can hope that Fitzgerald was right: that what today seems like a hopeless stalemate in Washington will, in fact, hasten our collective wisdom to recognize that the world has fundamentally changed, and that our policy responses in both the public and private sectors will be made accordingly.

"The US Is Holding the Whole World Hostage"

This was the headline this morning in Der Spiegel, the German news magazine.

It is an illustration that an irresponsible act driven by American politicians could have wide-reaching effects beyond our federal government.

Judging from what I have read, the rest of the world is incredulous that there is even the possibility that the U.S. would deliberately default on its debt obligations.

Here's an excerpt from the Der Spiegel piece (which is quoting another German publication called Bild):

"Irrespective of what the correct fiscal and economic policy should be for the most powerful country on earth, it's simply not possible to stop taking on new debt overnight. Most importantly, the Republicans have turned a dispute over a technicality into a religious war, which no longer has any relation to a reasonable dispute between the elected government and the opposition."

"If it continues like this, the US will be bankrupt within a few days. It would cause a global shockwave like the one which followed the Lehman bankruptcy in 2008, which triggered the worst economic crisis since the war. Except it would be much worse than the Lehman bankruptcy. The political climate in the US has been poisoned to a degree that is hard for us (Germans) to imagine. But we should all fear the consequences."

http://www.spiegel.de/international/world/0,1518,774666,00.html#ref=nlint

Then there's the municipal market.

Remember Meredith Whitney, the analyst who famously predicted "hundreds of billions of municipal defaults" last December on the CBS television show 60 Minutes?

Well, so far Ms. Whitney has been woefully wrong: Not only have municipal defaults in 2011 been below historic averages, but the municipal market itself has had a solid performance. The 5 year Barclays muni index, for example, has returned +3.4% YTD (or nearly +7% annualized).

But if the unthinkable happens, and the US defaults, the muni market could suffer as well. Moody's warned yesterday that 7,000 municipalities could have their credit ratings downgraded if the US is taken down, which could lead to higher borrowing costs.

Here's an excerpt from an article on Bloomberg:

July 14 (Bloomberg) -- At least 7,000 top-rated municipal credits would have their ratings cut if the U.S. government loses its Aaa grade, Moody’s Investors Service said.

An “automatic” downgrade affecting $130 billion in municipal debt directly linked to the U.S. would occur if the federal level is reduced, Moody’s said yesterday in a report. Additionally, top-rated securities with no direct links to the national government will be reviewed for similar action.

Moody’s Will Cut 7,000 Municipal Ratings If U.S. Debt Downgraded - Businessweek

Somewhere Ms. Whitney awaits vindication.

More on the Budget Battles

According to several press reports, last night's budget meeting between the President and House Republicans ended on a sour note.

Here's the report from Ezra Klein in today's Washington Post's blog Wonkbook:

House Majority Leader Eric Cantor launched into a stemwinder before the teams had even had time to look at the options papers the staffs had developed. On three separate occasions, Cantor pushed for the sort of short-term increase the administration has explicitly ruled out. Cantor's final effort to push the new plan came as the meeting was breaking up and the president was giving instruction to staff on how to prepare for the next set of talks. "Eric, don't call my bluff," the president said. "I'm going to the American people on this." Then, as the story goes, he walked out.

As I wrote yesterday, I continue to be more optimistic than many of my clients that all of this will be resolved in short order. Still, the more acrimonious the debate becomes, the more worrisome the situation becomes.

Much of the debate seems to center around political calculations, and how any resolution will play to the constituents back home.

Problem is, we tend to forget that a huge amount of our debt is held by foreign creditors, who really don't care about American politics: They just want their money to be safe.

The Chinese, for example, own at least $1 trillion of our debt obligations, and as the New York Times notes this morning, they are less than thrilled about the tempest in Washington:

"We hope that the U.S. government adopts responsible policies and measures to guarantee the interests of investors," ministry spokesman Hong Lei said at a regular news briefing in Beijing, when asked about the Moody's report.

He did not elaborate.

China, the United States' biggest creditor with more than $1 trillion in Treasury debt as of March, fears even a small default could destabilize the global economy and sour political relations.

http://www.nytimes.com/reuters/2011/07/14/us/politics/politics-us-china-usa-debt.html?_r=1&partner=rss&emc=rss

Bill Gross, bond manager extraordinaire and head of the huge investment firm Pimco, wrote an editorial in today's Washington Post about the implications of a U.S. debt default from a bond investors perspective.

Besides the obvious tarnish that a refusal to meet our obligations would bring to our reputation, a credit default would also mean a serious increase in interest costs:

An actual default — or even the threat of one — might set off a chain reaction that would raise Treasury bond yields by 25 basis points (a quarter of a percentage point) or more, pushing up the cost of debt throughout American financial markets.... If an extra 25 basis points becomes the new benchmark, federal interest expenses might increase by $30 billion to $40 billion annually over the ensuing years as $1.5 trillion of new debt is issued each fiscal year...

Bond investors are a conservative lot. They earn only 1.6 percent on the average Treasury maturity these days, but they expect certainty on when, and whether, they will be repaid. Countries that keep them guessing or that are expected to default are punished severely, as reflected in 20 percent bond yields in Greece or even 5 to 6 percent in AA-rated Italy. Like it or not, James Carville, global investment managers have global choices these days, and a solvent Germany or Canada is just a wire transfer away for trillions of potential investment dollars looking for a safer haven.

http://www.washingtonpost.com/opinions/warning-to-washington-dont-mess-with-the-debt-ceiling/2011/07/12/gIQA5Q4ADI_story.html?wpisrc=nl_wonk

Let's just hope that rationality reigns.