The Intelligent Consensus: It’s Too Early to Pull Back on the Stimulus Programs
by Rob Weigand.
Everyone generally agrees that the US and global equity markets have heroically priced in a remarkably optimistic scenario since the March stock market lows. An intelligent consensus appears to be emerging that government stimulus programs deserve some credit for this, as financial markets and the US economy are showing some signs of stabilization. John Hermann and Ron Insana had a spirited debate on this topic on CNBC on June 15. Hermann’s more optimistic, forecasting a slow but stable recovery as the stimulus programs help the global economy build momentum through 2011. Insana’s a bit more pessimistic, but does a fine job of thwarting Trish Regan’s “concerns” about government intervention while emphatically stressing that the Fed’s massive monetary stimulus efforts, both traditional and untraditional, must remain in place. You can watch the interview here:
Dominique Strauss-Kahn, head of the International Monetary Fund, made comments similar to Insana’s, stressing in a recent interview that the worst of the global economic downturn may still lie ahead and that world governments should maintain or increase their stimulus efforts:
Worst of Crisis May be Yet to Come: IMF Chief
Paul Krugman just published an analysis suggesting that this is the third time we’ve witnessed a liquidity trap — the point in an economy where traditional monetary stimulus stops working. The first time was the Great Depression, and the second time was Japan in the 1990s. Both times government stimulus was prematurely withdrawn, and both times the result was a relapse into economic contraction:
Of course, the consensus is far from unanimous. Those wild-eyed prophets at The Wall Street Journal see things differently. If you’re so inclined, you can watch reporter Jonathan Weisman fan the fears of socialism:
Summers Says US Not in Danger of Becoming a Socialist State
Overall, considering that world leaders are navigating through completely uncharted waters, the intelligent consensus is that they’ve done far more right than wrong thus far. For an even deeper and more thoughtful analysis of what our economic future will look like, I recommend Mohamed El-Erian’s May 2009 article in which he coins the term “A New Normal.” El-Erian, who has one of the best track records of all the pundits, envisions a higher-savings, slower-growth, low-return, consumer-constrained future where government spending constitutes a greater share of GDP than we’ve become accustomed to in the last quarter century:
Finally, if you’re still with me and want yet another intelligent take on our economic future that’s slightly more optimistic than El-Erian’s, Jeremy Grantham’s May 2009 newsletter is a great read (as always). As is the case with many of the authors above, Grantham credits government stimulus programs for his “VL”-shaped economic recovery thesis:
Bill Ackman, Dick Cheney, and the “Claim to Virtue” Strategy
by Rob Weigand.
[First, a brief disclaimer. Nothing in this article implies that Bill Ackman of Pershing Square Capital should be compared to former V.P. Dick Cheney, beyond strictly pointing out that they are both currently using more or less the same strategy to justify their recent behaviors -- a strategy that's so embedded in the Judeo-Christian and Western Scientific traditions that it's often overlooked for being too obvious. The strategy is known as a "claim to virtue," a concept elaborated on in the writings of the renowned psychiatrist Robert Jay Lifton. However, if you perceive that this article represents a personal attack on either Ackman or Cheney, or aspires to make some sort of political statement, you're projecting. I assure you, no such intentions exist. But I believe that anyone who is motivated to figure out how the world works -- something that applies to all investors -- the following perspectives will be interesting.]
The final stages of Bill Ackman’s attempt at shaking up Target’s board have been chronicled in some excellent jounalism recently, including articles by the NY Times’ Joe Nocera, Reuters’ Felix Salmon and The Street’s Eric Jackson. The first two articles express puzzlement over what Bill Ackman has been up to with his usually successful activist strategy, as Target’s stock was never that big of a disaster. True, TGT has underperformed WMT in recent years, but over 5- and 10-year horizons both stocks have been mild disappointments (although both beat the S&P 500 over the past decade).
Joe Nocera and Felix Salmon really lay into Ackman over his erratic and puzzling behavior at the Target annual meeting. Evidently Ackman, who makes a good living by being a professional pain in the rear end, found it appropriate to abruptly don a halo and invoke both John F. Kennedy and Martin Luther King. Nocera quotes Ackman as he tearfully insists that he would “pay any price, bear any burden, meet any hardship,” as well as asserting:
I have a dream that directors will be elected on character and competence. I have a dream that one day the director nominating process will be transparent. I have a dream that our efforts here will be fruitful.
Nocera concludes that Ackman is “full of sound and fury, signifying nothing” (Shakespeare), while Salmon predicts he’s going to become an ever-greater object of ridicule. I’m going to respectfully disagree with these writers, both of whom I greatly respect, and devote the remainder of this article to describing why I believe that the strategy Ackman adopted as his defeat at Target became increasingly clear to him, known as a “claim to virtue,” may instead have been yet another shrewd move by someone who’s proved himself an astute student of both financial markets and human nature over the years. Ackman’s claim to virtue is quite simple — he hasn’t been a shareholder activist for money all these years, he’s been working hard to make the world a better place for you and me.
The “claim to virtue” strategy is at least as old as the Judeo-Christian roots of Western Civilization. It’s often used as a justification when someone wants to take possession of something that doesn’t belong to him or someone wants to do great harm to another (or both). A few quick examples. In the Old Testament, Deuteronomy 21:11 rationalizes the appropriation of attractive women after victory on the battlefield: “And seest among the captives a beautiful woman, and hast a desire unto her, that thou wouldest have her to thy wife.” (In this case the claim to virtue is the “fact” that the advice is being handed down by God himself.) Or, take Genesis 1:28, for example, which uses the same “but God said to do it” justification for appropriating natural resources, as man is exhorted to “fill the earth and subdue it; and have dominion over the fish of the sea, and over the birds of the air, and over every living thing that moves upon the earth.” In both past and present times this exact justification has been used as an excuse for colonial conquest, deforesting, overfishing, etc.
Now, of course Ackman didn’t claim that he was shaking up Target in the name of the Almighty, but he did attempt a decisive strategic move to the moral high ground with his quoting and paraphrasing of Kennedy and King. In my opinion, this was a based on a split-second calculation on his part as he astutely perceived he would win no seats on Target’s board — he shifted to the best possible position left to him in an attempt to mitigate the humiliation inherent in his high-profile defeat, and set himself up to raise more funds for future ventures, which he will do, and do bathed in the glory of his own high-mindedness. We’ll come back to the full brilliance of this positioning in just a moment.
Nocera and Salmon’s puzzlement stems from the fact that Ackman’s positioning of himself as a socially-concerned corporate activist is almost completely implausible to anyone with basic common sense. Modern applications of the “claim to virtue” justification always reflect some aspect of implausibility, however, often in the extreme. And, sad but true, the American Capitalist tradition is rife with these sorts of implausible justifications. Philosophies like Manifest Destiny were at first used to justify the slaughter of 60 million buffalo and 20 million antelope to make life tougher on Native Americans, and later the philosophy was used more directly to justify the mass genocide of these people. It was still God’s will in this case, but this time in the name of progress and profit. Pretty implausible from a modern perspective — but only because modern claims to virtue have become increasingly subtle. The implausibilities get harder and harder to argue with. Next, notice one more thing: no history scholar ever got a contract to write a textbook reporting these sorts of things. Or the fact that George Washington crossed the Potomac during a Christmas Even cease fire and murdered drunken Hessian mercenaries. Facts like these get sanitized by the time the next generation sits down for its history lessons. That’s how the for-profit world works.
Everyone’s noticed that Dick Cheney has been busy lately. For such a reticent and press-shy V.P., Cheney has devoted enormous energy to a prolonged speaking tour. But he knows exactly what he’s doing. Cheney is re-writing his entire legacy around a simple claim to virtue: I wanted to keep the country safe. So I had to approve enhanced interrogation techniques. It’s not torture when you’re trying to keep the country safe. And we had to invade Iraq. No invasion is unjustified when you’re trying to keep the country safe. In my opinion, Cheney is making a smart calculation that’s eventually going to pay off. No mass market history textbook is going to dig deeply into the enormous mess Bush and Cheney created. Right now, about 30% of the country views Cheney favorably. With time, that number is likely to go up, as the implausible justifications, repeated again and again, become faintly plausible — just another point of view that must be considered if one wants to be “fair and balanced.” Eventually, no history scholar is going to get a contract to write a chapter called “The Bush and Cheney Debacle.” The facts will need to be sanitized because textbook publishers won’t take the risk that 30-40% of children’s families in any particular school district will take offense.
Bill Ackman just made a similarly shrewd calculation with his invocation of Kennedy and King. Ackman doesn’t care what I think of him. Or you either, probably. Unless one of us has $5 million or more to invest. Ackman only needs 30% of the smart money to like his latest move, wiping away those crocodile tears in front of the press in Minneapolis. If that 30% liked it, or just remembers it favorably later, there will still be a new pool of money available to him when he gets his next great idea. And, tempered with the humility maturity can bring, it will probably be a damn good idea, and we’ll all wish we had invested in it, or saw it ahead of him. Another $1 or $2 billion of personal profit later, and no one will remember that Bill Ackman looked a little silly on a cool June day in Minneapolis. The facts will get sanitized, and Bill Ackman will be pestering corporations and making heaps of money while you and I are . . . watching and commenting.
Astrazeneca Is The Best Dividend Play in Big Pharma
March 28, 2009 by Jamie Coonce, Amanda Repp, Rob Weigand and Cheng Xi.
The 2008-09 bear market has created some apparent dividend plays in certain industries, big pharma among them. Widows and orphans, tax-free endowments and pension funds should naturally be interested in these opportunities. We took a look at 4 compelling dividend yields and analyzed which stock was best in class in terms of financial stability and the ability to maintain the high dividend payout throughout the downturn and over the long run (10 years or longer). The analysis below suggests that at Friday’s closing price of $32.38, Astrazeneca’s dividend is best in class and the one most worth chasing. Note that this forecast focuses only on sustainable dividend yields, and does not include a prediction regarding future price appreciation.
We compared Merck (MRK), Pfizer (PFE), Astrazeneca (AZN) and Eli Lilly (LLY). The chart below shows that MRK, PFE and AZN currently have the best yields, although PFE’s expected future yield falls due to their announcement that they intend to cut their dividend in half to help finance the merger with Wyeth.
High, sustainable return on invested capital (ROIC) is a key variable in our stock selection process. The chart below shows that both historically and in our forecasts, AZN and PFE are the clear winners in this category.
We believe the market also prices in more conventional earnings and margin metrics; we therefore compared the 4 firms based on net profit margin. LLY’s margins fell through the floor after their poor earnings performance in 2008, and MRK’s margins have been declining for several years. AZN’s margins are the most stable, while our forecasts indicate that PFE’s margins could be best in class if all the proposed synergies and cost savings with Wyeth materialize (although these big mergers rarely work out as well as management expects, we’ll give them the benefit of the doubt for now).
With their lower dividend yields, lower ROIC and lower margins, MRK and LLY are starting to fall behind in our little horse race experiment. We next calculated two financial fitness “scorecards”: the 11-point Piotroski score and Ed Altman’s probability of bankruptcy Z-score. Once again, PFE and AZN move to the top of the group. AZN scores a solid 10 out of 11 on the Piotroski score, with PFE and MRK scoring a respectable 7. LLY lags with a score of 6. AZN and PFE are solidly healthy according to the Altman test, with scores of 3.98 and 4.22, respectively. MRK lags a bit with a score of 3.01, and LLY falls into Altman’s “grey area” of concern, with a low score of 1.86. Based on our preference for holding financially stable stocks, we eliminated LLY at this point.
We next examined each company’s Economic Value Added (EVA), which measures the extent to which firms are earning an economic profit, i.e., have the greatest amount of total capital deployed that is earning the largest spread of return on capital above their cost of capital. Historically PFE’s EVA is largest, while AZN shows steady EVA momentum. MRK clearly lags, with their EVA contribution turning negative in 2007, and tailing off in our 10-year forecasts.
We looked at each firm’s Enterprise Value/EBITDA ratio to determine if there were any compelling bargains in terms of relative valuation. MRK would appear to be the big bargain, but as if often the case, we believe their low relative valuation reflects their poor prospects going forward. AZN still appears to be reasonably priced (their 1-year trailing P/E ratio is 7.7 compared to PFE’s 11.8). Our analysis indicates PFE has the best potential for future margin expansion, but that’s contingent on perfect execution with the Wyeth merger.
Conclusion: If you’re looking for a high dividend yield stock with reasonable upside potential, AZN is the stock for you. AZN beats PFE, LLY and MRK in terms of current yield, ROIC and profit margin, and is slightly more financially stable than PFE, whose management has a lot on their plate in managing the merger with Wyeth. If that merger works out as forecasted — a rarity in markets — PFE probably has the most upside price potential. But in terms of a pure dividend play, AZN’s decision to raise dividends in 2009 by a full 10% confirms our analysis that their current large dividend yield is the safest and most sustainable in the sector.
What Will the Stimulus Bill Stimulate? An Analysis of Likely Winners and Losers
by James Martin and Rob Weigand.
Proponents. It is probably no surprise that President Obama’s economic stimulus package is attracting at least as much criticism as support. One of the package’s few outright advocates, Robert Aliber, Professor Emeritus of International Economics & Finance at the University of Chicago School of Business, considers the plan a good deal overall. Professor Aliber calls it “80% ideal and 20% baggage.” He is particularly keen on the large tax cuts that should lead to an increase in both household spending and an improved sense of optimism, which he predicts will result in noticeable improvements in the economy in the near term. [1] CNN’s Ted Barrett and David Goldman echo the more widespread sentiment that there is no true optimism for the bill. They report that few proponents of the stimulus package are in love with every provision in the bill, but support it more because they feel it is necessary. [2]
Skepticism. Expert opinion is mainly confined to varying degrees of skepticism. CNBC Mad Money’s Jim Cramer asserts that the stimulus bill is essentially useless in confronting any real economic problems. Cramer referred to the package as an “utter joke,” because it comes up short on job creation, falling home prices, and the banking crisis. [3] Michala Marcussen from Societe Generale Asset Management shares Cramer’s sentiments – she claims that a lack of transparency about the details of many of the bill’s provisions are fueling pessimism and the negative market reaction. The bill is essentially long on ideas and short on concrete details. Pierre Gave from Gavekal Holdings agrees that the lack of information is causing many to express reservations. [4] James Falkiner, director & CEO of Falkiner Global Investors is not optimistic about the short term effects of the stimulus package. Most experts are in agreement that consumers will continue to save money to shore up their personal balance sheets. [5]
Market Reaction. US and global markets have not responded well to the stimulus bill. Laura Mandaro of Dow Jones MarketWatch observed a few weeks of mixed sentiment surrounding a second economic stimulus package manipulate the benchmark indexes. She asserts that optimism fueled a rally in stocks during the first week of February, but the S&P 500 Index and Dow Jones Industrial Average gave back most of those gains in the past two weeks with some spectacular intraday dives on February 10th and 12th, due to anxiety that the stimulus would fall short. [6] Bill Rhodes, chief investment strategist at Rhodes Analytics, maintains that people are concerned about the provisions of the stimulus package and about how they are going to play out. This investor pessimism about the US economy pushed the S&P 500 down 5 percent during the second week of February, and left the Dow at its lowest close since November 20. [7] Mark Luschini, Chief Investment Strategist at Janney Montgomery Scott, asserts that at some point the stimulus will instill some confidence in the economy that the markets can grasp onto. However, the investment community is waiting for positive prospects of the effectiveness of the government interventions. Investors are showing skepticism about whether these government injections are worth their face value. Luschini holds that the market is currently retracing its steps. It is returning the gains made in January when after benefitting from expectations that the market would recover. [8] In the 10 trading days following February 13, the Dow lost over 600 points (7.6%), and the S&P has followed giving up 8%, or nearly 70 points.
Breakdown. The stimulus bill allocates spending to three roughly equal sectors of the economy. The Congressional Budget Office reports that $308.3 billion, roughly 39%, is allocated to appropriations spending. That includes $120 billion on infrastructure and science and more than $30 billion on energy-related infrastructure projects. It devotes another $267 billion, or 34%, on direct spending, which includes things like unemployment benefits and food stamps. The bill also apportions $212 billion, or 27%, to tax breaks for individuals and businesses, with most of these enjoyed by individuals. 2
Stimulus Multiplier. The most hotly debated issue concerns the likely effectiveness of each spending category. Most experts rely on the concept of the stimulus multiplier, which is the expected amount of increase in GDP per unit of stimulus. The Global Insight group calculated the fiscal multipliers used by the Obama economics team. They found that the most effective component of the fiscal stimulus is infrastructure spending, which provides a multiplier of 1.7. This type of spending fuels GDP directly by putting idle resources to work, and indirectly by giving businesses and individuals extra income, which allows them to spend more. Transfers to state and local governments also give a highly effective multiplier of 1.4. The direct economic boosts will be as diverse as these different government units, but the key idea behind this spending is to prevent the economic downturn from becoming more severe. With many state and municipal budgets nearing default, there is little argument against this type of spending. The personal tax cuts/transfer payments have the smallest bang-for-the-buck, with a multiplier 0.6. They have no clear direct effect on GDP because they boost activity only when spent. It is widely agreed that a large proportion of the tax cuts will be saved as households try to rebuild their financial assets. [9]
Christina Romer, head of the Council of Economic Advisers, claims that tax cuts and fiscal relief to the states are likely to create fewer jobs than direct increases in government purchases. However, because there is a limit on how much government investment can be carried out efficiently in a short time frame, and because tax cuts and state relief can be implemented quickly, they remain crucial elements of any package aimed at easing economic distress quickly. [10]
Arpitha Bykere of RGE ‘s U.S. EconoMonitor holds that with the limited multiplier effects of tax cuts for households and firms, and a delay in the multiplier effects of federal and state government spending, much of the impact on growth in 2009-10 will come from automatic stabilizers such as unemployment benefits, food stamps, Medicaid and transfers to states. She therefore asserts that the stimulus should have allocated higher spending on automatic stabilizers, transfers to states and payroll tax cuts, and reduced spending on government projects that have high short-run fiscal costs but will impact growth only in the long run. [11]
Winners/Losers. Partisanship aside, passage of the economic stimulus bill has created winners and losers. The following list describes who came out on top and whose expectations were spoiled.
Winners
Education. The package includes a $25 billion down payment on K-12 school reforms and $47 billion to prevent cuts in state aid to school districts. Schools got roughly $100 billion in stimulus funding to be used for school construction bonds, programs for disabled students, low-income school districts and Pell grants.
The jobless and the poor. Unemployment benefits will be temporarily extended and increased while food stamp programs also receive a boost. Billions of dollars will flow into job training and temporary welfare payments.
The alternative energy industry. The package allocates $50 billion for energy efficiency and renewable energy programs.
General Motors Corp. Automakers got a tax break worth $3.2 billion that preserves its ability to claim refunds against taxes paid when times were good.
Large hospices. They won a reprieve, worth about $134 million, from cuts in the amount Medicare pays them to care for dying patients.
Technology companies benefit on two fronts: $7 billion to expand broadband Internet services, particularly in rural areas, as well as potential new business from $19 billion to help doctors and hospitals convert paper medical records to electronic files.
Losers
Homebuilders suffered a scale back of a $39 billion tax break that would have provided a $15,000 tax credit for homebuyers. The housing market will have to wait for another day for government help.
The nuclear energy industry lobbied relentlessly for $50 billion in federal loan guarantees for technologies that use little to no carbon, but saw it cut from the package.
The defense industry. There is no significant money for weapons systems; however, lawmakers approved several billion for military facility construction.
Large and medium-sized businesses. They lost $18 billion in tax breaks that would have allowed them to get refunds from applying current losses against taxes paid in years when they were profitable. [12] [13] [14]
How Will the Banking Crisis be Resolved? Causes and Possible Solutions
by Ryan Johnson and Rob Weigand.
The credit crisis and dire position of banks remain the major roadblocks to recovery of the U.S. economy. Although the recession and credit crunch began in late 2007, thus far the injections of TARP capital have done little to stabilize the ongoing deterioration among larger banks. Many now blame former Treasury Secretary Hank Paulson for not laying out explicit guidelines regarding the purpose of the TARP funds, although his successor, Timothy Geithner, has been equally ineffective. Banks had other ideas of what to do with the capital, which in most cases has been hoarded to shore up their balance sheets and ward off insolvency. Recently, the New York Times and Wall Street Journal have reported that the only bright spot can be found among smaller banks that specialize in more basic lending relationships, including US Bancorp, BB&T Corp and Keystone Financial. Larger banks, such as Citicorp, continue their slide towards partial or total nationalization as the only feasible solution, however.
Banks have been roundly criticized for their failure to lend because it’s generally believed that increasing the flow of credit will prime the economic pump and help curb the rate at which economic growth is declining – particularly on the consumer and bank-to-bank levels. This was a major problem early in the recession, as banks froze lending due to the inability to quantify risks with both consumers (due to plunging real estate values) and other institutions. However, we propose that lending today may be at a fairly normal level given the severity of the current recession. The Wall Street Journal recently reported that a majority of banks have slowed lending at an average of 1.37% from the 3rd to 4th quarter of 2008. Although it may sound scandalous that banks would decrease lending while receiving government funds intended to be loaned out, their actions appear more appropriate when the current state of the economy is considered. The deepening recession has triggered a massive de-leveraging among households, which has dramatically reduced the demand for credit. The same effect is seen among businesses, as the incentive to invest continues declining along with the ever-worsening economic outlook. Moreover, it’s unrealistic to assume that lending will grow from the inflated levels of the past decade, especially as banks resume tighter lending standards. The fact that overall lending is off only 1.37%, and that some banks reported increases in lending, is probably evidence that credit is beginning to flow more freely. So, rather than fretting about the lending levels of banks that received TARP funds, everyone’s attention should be focused on the major reason banks were given the funds in the first place: de facto insolvency due to insupportably low levels of capital on their balance sheets.
Like it or not, the financial sector will be unable to fully recover until a majority of the toxic assets are removed from banks’ balance sheets. These assets continue pushing banks toward insolvency, with many already technically insolvent. The insolvency stems from the large amounts of securitized assets that were financed with bank capital, which now stands at impossibly low levels. In addition to this problem, banks have had to write down these toxic assets, leaving the value of their liabilities permanently lower than the value of their assets — the classic definition of insolvency. The most crucial problem with these illiquid assets remains the inability to value them, which is an unintended consequence of the last administration’s and Alan Greenspan’s misguided obsession with the ability of markets to regulate themselves. Virtually all securitized mortgage contracts contain nonperforming loans at many times the rate originally predicted. The potential for further defaults, as the housing market continues to plummet, makes it impossible to forecast the future cash flows of these securitized assets. If the housing sector continues to struggle and defaults rise further, as they are predicted to do, the market will continue to devalue these assets, which just keeps pushing banks closer to insolvency (Nouriel Roubini’s “death spiral” scenario).
What to do with the toxic assets leaves banks and regulators in a true quandary. In order for banks to benefit from the sale of these assets, their value must be high enough to keep banks from becoming insolvent. If the price is not sufficient, banks will continue to hold these assets in hope of a rebound in the housing sector (which is unlikely if history is any guide — home prices would be expected to stagnate for a significant period after they reach bottom). The ultimate extent of mortgage defaults and their effect on the value of these assets remains unknowable, which provides banks with further incentive to hold out (essentially risking all or nothing on a desperately deep out-of-the-money call option). On the other hand, no private company or government agency has incentive to purchase these toxic assets, given the unquantifiable risks. There should be an increased urgency to create a market mechanism to establish the value of these assets so the banking sector can purge them from their balance sheets and move forward.
Exactly what plans are in place to value toxic assets and shore up banks’ balance sheets? Surprisingly few, up to this point. On February 10 Treasury Secretary Geithner unveiled his plan to bail out troubled financial institutions. The plan included the development of a Public-Private Investment Fund (PPIF) – an attempt to obtain as much as $1-2 trillion of financing to create a market for these toxic assets, which would allow a more accurate assessment of their value. This is also an attempt by the government to limit taxpayer exposure and allow private equity to benefit from potential gains resulting from “cents on the dollar purchases” of these assets. This plan, which in our assessment was generally on the right track, has been mercilessly criticized for its vagueness. Geithner’s lack of details regarding the organization and implementation of the investment fund triggered a sharp and protracted market selloff that continued through February 23.
It is imperative to restore confidence in the financial sector by dealing with the toxic assets in a timely fashion. Banks will be unable to resume anything resembling normal operations until they are relieved of these assets. For those who believe that Geithner’s public-private fund is flawed and will take too long to obtain the needed results, the only remaining solution appears to be temporary nationalization of insolvent banks. The most well-known proponent of this strategy, Nouriel Roubini, was recently quoted in the Washington Post explaining that
“Nationalization is the only option that would permit us to solve the problem of toxic assets in an orderly fashion and finally allow lending to resume. Of course, the economy would still stink, but the death spiral we are in would end.”
More recently, Roubini continued to sell the idea to fiscal conservatives by telling the Wall Street Journal that it was also the most cost effective solution. The severity of the situation is perhaps best underscored by conservative leader Lindsey Graham’s warning to his colleagues “not to get hung up on the word nationalization.” Whether the next move is Geithner’s public-private fund or nationalization – Citicorp appears to be the first likely victim of this fate – there should be no doubt that every day without a solution contributes to the worsening of the financial crisis.
You can find Rob Weigand on the web at http://www.washburn.edu/faculty/rweigand. Ryan Johnson can be contacted at ryan.johnson@washburn.edu; Rob Weigand can be contacted at profweigand@yahoo.com.
Don’t Just Do Something — Stand There! Why the Stimulus Package Won’t Work
by David Sollars.
It appears that the U.S. Congress is set to pass a $850 billion dollar spending package designed to provide fiscal stimulus for the U.S. economy. It is a mix of spending increases, transfers and tax cuts purportedly designed to pump up aggregate demand. Both tax cuts and spending increases create budget deficits, and therefore the government must increase borrowing to finance its operations. Add in the interest charges and this legislation easily surpasses a trillion dollars in total cost.
They idea of fiscal policy stimulus goes back to the Great Depression and the work of John Maynard Keynes. The basic idea is pretty simple — in times of weak aggregate demand, government could fill the void by spending more directly, or taxing less, thereby increasing consumer demand and business investment. All policymakers would need to do is measure the needed stimulus (taking into account the multiplier effect, and then properly time the injection of stimulus in the economy. If the economy got overheated and inflation became a problem, then presto, the federal government could raise taxes or reduce spending to slow down the economy.
In theory, traveling to the moon is easy as well. All you need was the right vehicle, pointed in the right direction, traveling at the right speed, etc. But in practice, manned space flight turned out to be a little more complicated and costly. Unfortunately, economic theory and policy tools have not advanced to the point that we should have any confidence in the ability of this short run program to work as advertised. There are timing problems, scale issues and efficiency costs associated with discretionary fiscal policy that are well known (and discussed in any Econ Principles textbook) and will reduce the potential benefits and create unintended consequences. But the political need to do something will win the day, and Washington is all a-twitter with the single largest discretionary budget package ever devised.
Good politics is often bad economics. Even a cursory look at the bill being rushed through the Congress reveals its Frankenstein-type nature. It is a wish list for unrelated spending programs that, on their own, would not be considered reasonable. Even the parts that make some sense, like the much-touted infrastructure spending, are small potatoes in the bill. Instead we get millions for the National Endowment for the Arts. The Department of Education gets $66 billion for . . . well, we aren’t sure, but how can you oppose to education? Amtrak gets a billion so that it can continue to lose money each year. Congress even provides more millions to help those poor souls who will flounder from a lack of analog television transmission. Some of the items are laughable – Speaker of the House Pelosi defending contraception subsidies as stimulus on the weekend new shows was a sure sign of some of the insanity behind this bill. Even traditional liberals can’t stand the stench. Former CBO head and Clinton budget guru Alice Rivlin suggests separating the defendable stimulus pieces from the pork and the other things that have magically appeared without the usual substantive review. According to some analysts only 5 to 10 percent of the total bill is actually related to stimulus spending. Even worse, the “buy-American” requirements will likely result in WTO sanctions and encourage retaliation by our trading partners, hurting U.S. companies and workers in the export market – one of the few remaining shining lights in our current economy. Just ask Caterpillar.
The little hard analysis that has been done reveals another serious flaw in the bill. Much of the actual stimulative spending won’t occur this year, or the next year. The recent CBO report suggest that most of the new spending that is part of the omnibus-bill won’t kick in until next year and the year after, long after our best estimates on when the trough is reached http://www.cbo.gov/ftpdocs/99xx/doc9968/hr1.pdf. The levers of government are slow and unwieldy even for someone as brilliant as Larry Summers! Even Keynes later thought that public works and infrastructure projects were poor vehicles for short run stimulus given the realities of actual government expenditure — it takes time to build roads and bridges.
My proposed solution: Take a deep breath and let’s consider what useful things might be in the bill. The less controversial things like temporary transfers to the states to extend unemployment benefits, foodstamps or Medicaid make some sense in the interest of helping those who have lost their jobs in the recession. But these aren’t job creators; they are more in the spirit of what we used to call public assistance. Speeding up some public infrastructure spending might be useful, but it is limited. If you really want to spur investment then include investment tax credits. If you want to help working consumers, then halve the payroll tax for the next year. Let the results show up in the end of February paychecks, and let actual taxpayers choose how to spend it. The Senate version of the bill has the AMT fix for 2009, which is a good thing—but why don’t we just fix AMT now and forever instead of relying on one year fixes? Any pretense of fiscal discipline is now officially shattered, so get on with it already.
Will any of this really work to stimulate the economy? Probably not. But it will impose fewer costs and not drive up the deficit as much as the current bill, which won’t work either. We seem to forget we tried the lump-sum tax rebate trick last year. The emergency TARP bill that was passed year is starting to reveal its immense shortcomings. Why do we expect this outcome to be different? If we are going to go into debt for a trillion dollars, could we require some standard ROI analysis to demonstrate how this spending is going to stimulate the economy? At least that might actually create jobs for the thousands of financial analysts laid off in New York and around the country.
David Sollars is Dean of the Business School at Washburn University in Topeka, Kansas. You can reach him via email at david.sollars@washburn.edu.
The Case for Constructing New Coal and Nuclear Power Plants
by Jim Haines.
“That we are in the midst of crisis is now well understood. Our nation is at war, against a far-reaching network of violence and hatred. Our economy is badly weakened, a consequence of greed and irresponsibility on the part of some, but also our collective failure to make hard choices and prepare the nation for a new age. … and each day brings further evidence that the ways we use energy strengthen our adversaries and threaten our planet.”
President Obama is right. We are in a crisis. What, at best, he only alluded to in his inaugural address are the common threads that link our military, economic, and energy crises. Perhaps the dominant thread in that tapestry is energy. And energy policy surely presents many and immediate opportunities for president and citizens together to demonstrate their resolve to make hard choices.
It is not a hard choice to endorse more efficient uses of energy or conservation of energy or alternative sources of energy. No reasonable person, no energy company, no interest group is opposed to these as ideas or as manifested in actions that people take to accomplish them. To focus just on electricity, the first hard choice is to recognize two stubborn facts: Under any realistic assumptions about the potential success of efficiency and conservation, and assuming even modest economic recovery, 1) levels of electricity consumption (nationally and globally) will continue to increase over any forecast period, and 2) alternative sources of electricity generation, together with conservation and efficiency, will reduce but will not eliminate our need for new base load power plants fueled with uranium and/or coal. Currently, coal supplies about 50% of US electricity demand and uranium about 20%.
Those facts beg a crucial question: Can the earth sustain energy consumption at the rate necessary to assure global-wide availability of increasing supplies of electricity, if such supplies depend in large part on continued use of fossil fuels? Treatment of that question raises an intense and often emotional debate involving fundamental political, social, and ethical considerations – and that makes the heroic assumption of consensus on the science and responses to climate change.
At the root of it, we are embedded in the Middle East because of energy issues. As the Asian economies continue to grow and as third world economies develop, the pressure on US consumption of foreign sources of energy will only increase. Coal and uranium are our most secure and abundant sources of energy for electricity generation.
President Obama said with emphasis: “We will not apologize for our way of life….” Trying to connect the dots, does that mean we will aggressively incorporate efficiency and conservation and alternative sources of electricity into our way of life while still pursuing that way of life – a way of life that even with efficiency and conservation and alternative sources will require increasing amounts of electricity? If that is what he meant and means, then he himself has a very hard choice and he must make it sooner rather than later.
At the same time that he aggressively leads us (as I believe he should) toward challenging goals for efficiency and conservation and alternatives sources, he must also aggressively lead us to continued construction of new coal plants (even as we await the as yet undemonstrated clean coal technology) and/or a resumption of construction of new nuclear plants. Both coal and nuclear plants have long licensing and construction periods. To the extent that climate change is a factor in this consideration (and it should be a substantial factor), then there should be greater emphasis, perhaps exclusive emphasis upon nuclear plants – at least until clean coal technology is proven. Waiting until the safety of a second term to launch such an effort would have catastrophic consequences for US energy security and sustained economic recovery and growth.
Jim Haines, retired CEO of Westar Energy, is holder of the Ned Eldon Clark Professorship in Business at Washburn University in Topeka, Kansas. You can reach Professor Haines via email at james.haines@washburn.edu.
McDonald’s (MCD) Is Looking a Little Overvalued
by Rob Weigand
I’m thinking of a stock that’s beaten the S&P 500 by over 300% in the last 6 years and by 70% in the past 6 months (see charts below) . . .
. . . and, it’s accomplished this heady feat with an average 5-year compound growth rate of 7%, an average return on capital of 12%, average operating margins of under 20%, and modest growth in free cash flow. Yes, that’s MCD I’m talking about, whose admirable run is starting to look a little tired.
I modeled MCD’s value using the following assumptions: 1.) an average 5-year growth rate of 7% tapering to 5.5% over the following 5 years, and a long-term growth rate of 5.0%; 2.) a moderate reduction in its SG&A/Sales ratio from 10.7% (historical average) to 10.0%; 3.) slightly lower marginal tax rate of 30% (historical average 32%); 4.) long-term dividend growth of 6.0%; 5.) lower Cash/Sales of 8.0% (historical average 10.0%); 6.) and a gradual decline in its PPE/Sales ratio from 92% to 86% over the next 10 years (a generous assumption). At a weighted average cost of capital of 9.5%, MCD’s 2009 intrinsic value from a discounted cash flow model comes in right around $44 a share, vs. its January 12 closing price of $60. Re-running the model with 9.0% growth for 10 straight years and bringing down the PPE/Sales ratio several additional points, the intrinsic stock price perks up — but only to $53 a share. Additionally . . .
Insiders love to sell this stock. Cumulative insider selling (data provided by Thomson/Reuters) for the past 4 years is shown below. Insiders have cashed out of their positions to the tune of over $160 million over this time frame. There’s no evidence of any insider accumulation in the past 4 years. The selling is broad-based as well; it’s not just one or two big sellers.
Short interest in MCD has eased off recently:
But short selling has been off all year; considering this year’s light market volume, MCD’s Days to Cover Ratio is higher than it’s been since 2004, suggesting this overvaluation story may be gaining some traction:
MCD also sells at a premium Price/Sales ratio vs. competitors such as Yum Brands:
Although their Price/Earnings ratios are comparable:
One major caveat: This is not a short-sale recommendation. Given investors’ overall fearfulness these days, I have no compelling thesis suggesting MCD should fall sharply in value in the next few months. This is the type of stock investors have been crowding into, which is probably how it’s become modestly overvalued. For current shareholders, however, MCD seems like a prime candidate for writing covered calls. June 2009 calls with a strike price of $65 closed at an ask price of $3.20 today. Collecting that premium yields another 5% in the next 6 months — not bad in this market — plus another 8.3% return if your shares are called.
You can find Rob Weigand on the web or send him an email at profweigand@yahoo.com.
A List of Things That Won’t Happen in 2009 (But Sorely Need To)
by Rob Weigand
The phrase “off balance sheet” will be permanently removed from the global vocabulary.
Barack Obama and Congress will jointly pledge to reduce the size of the Federal Budget by 20% before the end of his first term, with every dollar of that savings going towards tax cuts that really pay for themselves.
A broad consortium of US CEOs will sign a pledge to smooth their salaries down to the level of their European counterparts by the end of Obama’s first term.
American universities will sign a pledge that limits all further tuition increases to the rate of CPI inflation.
The last remaining US Auto Manufacturer will spend at least five times more on research and development than marketing and advertising and finally build a car people want to drive.
The quest to produce the first 100 mpg car will attract the global brainpower that has been siphoned off by financial engineering over the past 10-15 years.
What remains of this brainpower will be directed at developing clean coal- and safer uranium-based electricity generation.
Active money managers from all disciplines — equities, fixed income, currencies, hedge funds — will refund any fees they’ve “earned” that are not transparently related to alpha generation, roll their clients’ remaining wealth into passive index strategies, and pursue more honest lines of work.
Standard & Poor’s and Moody’s will admit they don’t know anything about rating bonds.
Google Finance will publish free online spreadsheets where investors can calculate whether or not their active money manager generated true vs. dirty alpha, and offer a Monster.com-type information sharing system so everyone can see the average market price managers charged for true alpha.
A few additional items for the list, more for the fun of it:
Bill Miller will redeem his reputation by publishing a book entitled “Equity Analysis is Descriptive, Not Predictive.”
Nouriel Roubini will cheer up.
Jerry Jones will either let the Cowboys play football or change his surname to Steinbrenner.
George Bush will publish his memoirs, entitled “I Never Understood the First Thing About Anything.”
Arthur Laffer will sue George Bush, claiming he had first dibs on that title.
Jim Glassman (author of “Dow 36,000″) will join the lawsuit, quickly followed by the CNBC pundits, at which point the suit will turn into a class action.
Dick Cheney will undergo a Scrooge-like epiphany and devote the rest of his life to explaining to people why an economic system that promotes a consumption-based lifestyle that gradually poisons the planet is a form of collective suicide.
You can find Rob Weigand on the web at http://www.washburn.edu/faculty/rweigand or send him an email at profweigand@yahoo.com.
A Long-Term Comparison of the Returns to the S&P 500 vs. the Nikkei 225
by Rob Weigand
Motivated by Cassandra Does Tokyo’s eloquently-written post about the pundits prematurely anticipating economic and financial conditions returning to “normal” (because normal may not mean anything any more), and Paul Krugman’s recent comments at the National Press Corps Luncheon about ZIRP in Japan vs. the U.S, I decided to share a little experiment I’ve been keeping track of for about 5 years now. This is a picture that’s truly worth the proverbial 10,000 words: I overlayed the compound returns to the Nikkei 225 and S&P 500, beginning 4 years before each market’s bubble top, and continuing for the next 8 years. I believe the graph speaks for itself:
The behavior of each market is similar for the 4 years preceding their peaks and the subsequent bursting of the respective bubbles. In early 2005 the S&P 500 diverges as returns are positive through the summer of 2007, which back then was hailed as proof that “it’s different this time,” but we are now wise enough to attribute to the artificial tailwind created by the credit, real estate, emerging market stocks and commodities bubbles.
As of December 15 2008 the total cumulative return over the two 12-year periods was +38% for the Nikkei 225 vs. +37% to the S&P 500. And we all know what happened to Japan 1997-2008 . . .
By itself, of course, the graph means absolutely nothing. Given the similarities between our two economies and our governments’ and central banks’ efforts at reviving them, and the well-known belief that the stock market is a forward-looking discounting mechanism, however, the message I take away from the graph is that the resurgence of U.S.-style capitalism is hardly a given at this point. We’re going to need sharp, focused leadership from the Obama administration, and maybe even better, more than a bit of luck. I don’t think it would take much more in the way of economic and/or financial shocks to plunge the U.S. into a Japan-style funk for a protracted period of time.
You can find Rob Weigand on the web at http://www.washburn.edu/faculty/rweigand or contact him via email at profweigand@yahoo.com.
GM Needs a Buyout, Not a Bailout
Posted by Rob Weigand.
There’s been a lot of cyber ink and hot air devoted to the question of whether or not the US Government should get involved in General Motors’ difficulties. Here’s my two cents on the issue: Don’t bail out GM with loans – you’ll never see a nickel of that money again. Instead, the government should execute a hostile takeover of the whole company, hire one or more private equity firms to turn the company around, and bank a profit when GM’s stock can be sold to the public again in a few years.
At today’s price of $3/share, GM has a market cap of a little under $2 billion. The government should not only provide $25-$50 billion of emergency low-cost loans, but should spend another $4 billion and buy up all of GM’s stock at a 100% premium — $6 a share. That’s more than fair to existing shareholders.
There is more private equity talent sitting on the sidelines these days with nothing to do than can be imagined. Invite the best of the best in as equity partners. Ask them to put up a couple of hundred million to ensure they have sufficient skin in the game, and let them share proportionately when GM goes public again a few years from now. Let’s see what Steve Schwarzman and Henry Kravis are really capable of. These characters allegedly like high-adrenaline challenges; well, I’d say that GM qualifies. It’s one of the most broken companies of all time. If Schwarzman, Kravis, or some other PE genius can pull off this turnaround, they’ll preserve at least 100,000 jobs directly (although many will be lost), perhaps millions of jobs indirectly, save Detroit and Michigan from a horrible fate, re-invigorate American manufacturing, and make some money for both themselves and the US taxpayer. And I can’t think of any better way for the US Treasury to make sure it gets paid back on the loans it provides to GM than to buy up the whole company and retain majority voting rights while the firm is taken private. If Schwarzman or Kravis can turn GM around they’ll not only get richer, but they’ll forever be remembered alongside American icons like Lee Iaccoca. So they’ll get a “big-ego” payday as well — exactly what these guys are all about.
We need to break free of labels like “socialism” and “nationalization” that are limiting our thinking right now and recruit some of our most highly-talented American entrepreneurs to help us fix the monumental problems our country is currently facing.
Or, if you prefer to hear the case against bailing out GM made with a little humor in video format, check out this “truth hurts” offering from cartoonist Mark Fiore: Why GM Should Not Be Bailed Out.
You can find Rob Weigand on the Web at http://www.washburn.edu/faculty/rweigand or send him an email at profweigand@yahoo.com.
Causes and Consequences of the Financial Crisis
Posted by Rob Weigand. (These are some of the most frequently-asked questions I hear in the various speaking engagements and media interviews I’ve participated in over the past several months.)
How did we get into this mess?
The recent mess is due to a “perfect storm” of factors interacting with and accelerating one another. For example, the Greenspan Fed’s policies of fast money supply growth and low interest rates allowed for increases in leverage (debt financing) by banks, brokerages, investment banks and households during the early years of the 21st century. This high leverage fueled a “global asset bubble” in virtually all investable asset classes — US and global stocks, real estate, commodities, etc. Regulatory standards were also lax: the Fed, the SEC, the Treasury Department and Congress rationalized these rising valuations as evidence of the health of the global economy, and relaxed the financial regulatory structure, which paved the way for creation of the toxic financial instruments that have brought bank lending and other forms of financing to a halt around the world.
Why did big banks stop lending?
When banks create new credit by extending a loan, it lowers the reserves they are required to hold on their balance sheets. Normally banks can replenish these reserves by borrowing from other banks that have a surplus of reserves. Banks are not extending as much new credit now because most banks are hoarding their surpluses of reserves rather than lending them out to other banks. Until banks have confidence that they will not need these reserves to stave off liquidity crises (caused by panicky investors withdrawing their deposits), credit creation will not return to normal levels, and economic growth will be suppressed.
What will happen to Fannie Mae and Freddie Mac?
That’s tough to predict, because it depends on the outcome of political and regulatory processes. My best guess is that Fannie Mae and Freddie Mac will re-emerge as more closely-regulated entities. They will use lower leverage and be more restricted in the types of mortgages they can buy. These higher standards will ripple through the mortgage system and have the effect of tightening mortgage lending terms. You can think of this as “the return of the down payment” — one of the most troubling aspects of our current economy is the percentage of homeowners with negative net equity in their homes. Declines in housing prices are bad enough, as this triggers a negative wealth effect worldwide. But it’s another matter entirely when homeowners have negative equity in their homes, as this works in conjunction with restrictive credit markets to bring real estate transactions to a screeching halt.
Congress approved a $700 million bailout. Will taxpayers get their money back? Was the bailout needed?
No taxpayer should doubt that the government’s emergency intervention in credit markets was desperately necessary. This underscores the severity of the problem currently facing credit markets — the effect of the bailout on the deficit and the question of moral hazard (bailing out risk-takers only encourages them to repeat their behaviors) are secondary compared with the dire need to jump-start the credit creation process.
Regarding taxpayers getting their money back . . . they will probably get some of it back, but my guess is it will be less than 25 cents on the dollar.
What is a credit default swap? Is it legal? Is there likely to be re-regulation of these types of securities?
A credit default swap is a type of financial insurance on either a bond default or the bankruptcy of a company. Just like auto or life insurance, if a severe event occurs, the insured are mostly covered — in theory. Credit default swaps are legal, which underscores how loose financial regulations had become. The problem is, unlike auto or life insurance, the creators of credit default swaps were allowed to hold little or no reserves in case the entitites they insured filed claims. But the mainstream insurance industry is regulated, of course — these insurers are required to hold reserves in the event of claims. There will almost certainly be tighter regulations on credit-default insurance in the future.
The stock market declined in September and October. What should investors do?
(Before making any changes to their portfolios, all investors should seek professional advice from a certified financial planner.) Investors’ personal course of action after a large market decline depends on their age and how soon they might need to convert their investments to cash. Younger investors (under 40) should move more heavily into stocks now — stocks haven’t been this cheap relative to fundamentals since the early 1990s. Investors are being paid to take risk again, which is good news for long-term buy-and-hold types. Older investors face a tougher decision. Moving too much portfolio wealth into cash at a market bottom exposes retirees to the risk that they will miss out on future equity returns they need to repair and extend the value of their portfolios. But, as the recent bear market has reminded us, just taking more risk is not a guarantee of higher returns. After a bear market/credit crisis/recession like the one we’re in, the economic and financial market recovery could be far off in the future (just look at Japan since the early 1990s). My advice to investors would be to have a financial planner assess their individual needs and create a strategy based on their personal circumstances.
What is the silver lining in this economic fallout? Opportunities?
The silver linings are mainly Pyrrhic victories. The relative valuations of stocks, real estate, and other investable assets will be more in line with fundamentals going forward (another way of saying that their risk premia will be positive and appropriately large) — at least for a while. Starting from a low level of interest rates increases the odds that future stock returns will be lower than long-term average historical returns for an appreciable period, however. Although the equity premium (stocks minus bonds spread) is normal, in the early 1980s that spread suggested 16% returns on stocks and 10% returns on bonds. Today we’re looking at returns more in line with 9% returns on stocks and 3% returns on bonds. Moreover, US households will almost certainly be forced to gradually de-leverage their balance sheets, exposing themselves to less financial risk, which will dampen consumer spending for a considerable period, as consumer spending has been propped up by greater borrowing since the 1980s. The best opportunities exist for investors with a lot of cash and a long time horizon — I would recommend these people increase their exposure to US and global equities.
Do you expect deflation?
I do not expect a Japan-style deflation, at least in the short run. As a matter of fact, I’m more concerned with the opposite — a slow-growth stagflation scenario like the 1970s. Real wages have gone nowhere in the US in 30 years. With the election of a Democratic president and Congress, the middle class is going to expect improvement in wages and their standard of living. Unfortunately, wage increases are often inflationary. In the longer run, however, if the economy remains stagnant, a deflationary spiral cannot be ruled out as a possibility. That’s why it’s so important to repair the function of credit markets and begin paving the way for the next economic expansion, which will hopefully begin sometime during the second half of 2009.
What impact will the new president have on the economy?
I think the new president’s impact on the economy should be judged in the long term. In the short term, given that President-Elect Obama has inherited enormous budget and trade deficits, the worst financial crisis since the Depression, two wars, insolvency of the social security and medicare systems and rising household insolvency, I believe that the first several years of his term will be characterized by financial and economic malaise. Moreover, if his administration does the right thing, it may make things worse before they can get better (tightening the federal budget in an attempt to stabilize the federal budget deficit). If we ever want to see the US restored to economic and financial preeminence in the world, however, we need national leadership that’s capable of making tough choices on behalf of the US right now.
How does the average American get ahead financially during these times?
It may not be possible for many families with credit card debt, negative home equity, and uncertain employment prospects to get ahead in the near term. Americans can sow the seeds of prosperity by reducing debt, increasing their saving rates, and taking more appropriate risks with the equity and real estate portions of their personal wealth than has been the case in recent years.
You can find Rob Weigand on the web at http://www.washburn.edu/faculty/rweigand or email him at profweigand@yahoo.com.
Macroeconomic Forces Bode Well for Agribusiness
Posted by Jessica Collins.
In recent years, a confluence of macroeconomic and industry-specific factors has led to record-high prices and unprecedented volatility in the global agricultural commodity markets. [1] Specifically, simultaneous increases in demand and production costs along with intensifying supply-side pressures have led many experts to forecast extended periods of higher-than-average prices for many commodities. [2]
Farm-based commodities have recently experienced unprecedented growth in demand from both traditional and non-traditional sources. Traditional demand has increased primarily via worldwide population growth. The world’s population currently exceeds 6.5 billion, is projected to reach nearly 9.5 billion by 2050. [3]
Increases in demand have also been driven by global industrialization’s positive effect on disposable income in emerging economies like China and India. [4] As a result, citizens of these countries have begun to shift away from the grain-centric diet of developing countries to the protein-rich diet common to countries with higher per capita GDP. [5] Because, on average, one pound of protein requires nearly seven pounds of grain to produce, the increase in demand for meat has a large multiplier effect on the demand for grain. [6] Moreover, increased globalization, free trade, and currency exchange considerations have increased agriculture-based exports from producing countries like the U.S., Canada, and Australia, as well as Europe and South America, which has increased competition and intensified demand on a global scale. [7]
In addition to traditional food-related demand, coarse grains such as corn, sorghum, barley, oats, and rye and edible oils and edible oil products have experienced exponential demand growth due to the rapidly expanding biofuels initiative in the United States, Brazil, and the European Union. [8] The World Bank estimated that nearly all of the increase in global corn production between 2004-2007 was used for biofuels production in the United States. [9] Moreover, as evidenced by Congress’s recent mandate to increase domestic ethanol production nearly five-fold by 2022, the biofuels component of agricultural commodity demand is not likely to decline in the near, or even intermediate, future. [10]
Most agricultural commodities are also experiencing significant supply-side pressure from a variety of sources. Recently, the global supply of agricultural commodities has been severely affected by unfavorable weather conditions (e.g., droughts, flooding, and freezes) in several regions, including the U.S., Europe, Canada, Argentina, Ukraine, and Russia. As a result, global stockpiles of agricultural commodities have fallen to their lowest levels in many years. [11]
At the same time, increased competition for productive crop land and the reconfiguration of planting decisions to maximize returns from biofuels-related plantings (e.g., corn and soybeans) have drastically affected the supplies of most agriculture commodities. [12] Significant increases in production costs, led by record oil and fertilizer prices, and increasing scarcity of productive farmland and sufficient and accessible water supplies have further contributed to limits on worldwide production capacity. [13] [14] Finally, political unrest in producing countries has slowed or stopped production on otherwise physically productive land, further tightening supplies. [15]
Unlike many other commodities, agricultural commodities are crucial to the survival of nations. In a recent study, researchers concluded that nearly 60 percent of all global conflicts over the past two decades have been primarily driven by disputes related to food, land, or water. [16] Recent spikes in food prices have lead to food smuggling in some countries and riots in others. [17] Because of the universal necessity for food and the irreplaceable role that agricultural commodities have in worldwide food production, market analysts, including the United Nations Food and Agricultural Organization (FAO) predict that “when commodity supplies eventually recover and prices moderate from current high levels, the new equilibrium prices will be significantly higher than has traditionally been observed during periods of market balance.” [18] As summarized in the table below, even when the volatility is removed from short-term prices, long-run commodity price projections forecast equilibrium prices for most major crops that are 19 to 110 percent higher than their recent five-year average. [19]
The preceding analysis suggests agribusiness and agricultural-related firms may present interesting investment opportunities. Companies with operations and/or substantial investments in one or more key grain producing nations, such as the U.S., Canada, Europe, Russia, Brazil, and China, may be favorable over countries operating primarily in resource poor nations.
Companies with significant command over their supply chain are likely to display significant operating advantages, but because of the capital-intensive nature of the industry, especially for companies with significant supply chain investment, firms with low debt, good credit rating, and/or relatively easy access to credit markets are preferred in light of current global economic conditions. Moreover, any company with significant supply chain investment should be providing logistical synergies and optimizing efficient operation of all its assets. In particular, companies that invest in technology to produce more robust, more efficient farmland and crops may provide unique opportunities for investment in the short- and intermediate-term.
In summary, although current prices and volatility may not be sustainable in the long term, the long-term factors affecting agricultural commodities will most likely result in an extended period of high, although not necessarily record, prices. As a result, investments in agriculturally-oriented firms appear to be promising over intermediate- and long-term horizons.
Are US Auto Manufacturers Too Big to Fail?
Posted by Joshy Madathil.
The automotive manufacturers have suffered as soaring energy prices, the collapsing housing market, and the crumbling banking industry have roiled the US economy.
Does it matter if large US automotive firms fail?
General Motors, Chrysler, and Ford provide over 200,000 well-paying jobs in the US, and many other jobs in factories around the world. [1][2][3] Paying unemployment benefits would represent a significant cost for the US government. Warranties of purchased vehicles would be worthless, and many dealers would end up with a surplus of vehicles that would be sold for a loss. These companies’ multi-billion dollar pension plans might also require intervention by the Federal Pension Benefit Guaranty Corporation if the automakers filed for Chapter 11 bankruptcy protection. [4]
The auto industry has posted sharp losses and has had several consecutive months of declines in sales. In August of 2008, Ford’s sales dropped 26.6%, Chrysler’s 36%, and GM’s 20.4%. [5] GM has also forfeited the crown of market share leader, a title it held for an astounding 76 years, to Toyota. [6] As difficult as it is to keep the US consumer from spending, high fuel costs, the rising threat of unemployment, and a sluggish economy has made it easier for the consumer to cut down to the bare necessities (see related MarketBlog post on Consumer Spending).
Moreover, the recent housing market debacle and meltdown among financial firms has raised consumers’ anxiety levels and made it difficult to justify the need for a new vehicle – especially with thoughts of home foreclosure and/or recession in the back of everyone’s mind. Couple this with soaring gas prices and there’s a recipe for disaster brewing – American automakers have relied on the sales of high profit trucks and/or SUV’s to drive company earnings. [7] Slowing sales in this sector were detrimental to Ford and GM and are reflected in their stock prices. Ford’s stock is trading at a near 20-year low of $4.80, and General Motor’s hit a 53-year low of $9.38 during July of 2008. [8][9]
Energy and oil prices have also affected the cost of the materials which go into producing vehicles. In addition, gas prices have increased the overhead of transporting vehicles to dealers, which cuts into the bottom line and reduces overall profitability. [10] Funding the factory upgrades necessary to manufacture fuel efficient vehicles has become a difficult task for the auto industry. Finding this capital at an affordable rate is an issue for an industry in financial turmoil. [11] The credit crunch from the housing and banking crisis has led to widening credit spreads that increase the rates at which Ford and GM can access capital. This affects Ford and GM more than the average firm because they are perceived as high risk (and rightly so) to investors who, in turn, demand appropriate returns for their investments. [12][13]
Widening Credit Spread
So how does a seemingly bankrupt corporation find the capital necessary to re-invent themselves?
The automakers have requested $25 billion in low interest loans (4% – 5%) from the government to help in the renovation and upgrade of current facilities. [14] The automotive industry has shown resilience in the past to overcome market downturns, as evidenced by the auto industry in the 1970’s. In late 1979 Chrysler was in the midst of bankruptcy. With the help of a federally-backed loan and the leadership of Lee Iacocca, Chrysler paid back the loans ahead of schedule and posted a $500 million profit by 1983. Through a strategy of consolidating suppliers, employee pay cuts, and the leadership of Iacocca during the process — who took a $1 annual salary during the downturn – Chrysler was able to regain its position in the market. [15][16]
There has been much debate over the question of whether a massive federal loan for the auto industry is justified. If the industry’s downturn is likely to have a significantly negative impact on the US and global economy, then the government can and probably will step in with the requested support. With the recent government takeover over of Fannie Mae and Freddie Mac, as well as a $700 billion package in the works to help the financial system, the Feds have shown that they will do what is necessary to maintain a stable economy. [17][18] Without the necessary facility upgrades and strong leadership at the helm, the US auto industry will remain weak and will not see strong profitability until the US economy has stabilized.
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Fundamental Analysis of Jacobs Engineering Suggests a Strong Infrastructure Play
by Ryan Johnson and Rob Weigand.
David Fessler wrote a recommendation in favor of Jacobs Engineering (JEC) on June 26, summarizing the many compelling macroeconomic themes that favor this stock right now:
Additionally, Fessler notes: “Jacobs has over 100 years of experience in the gasification and carbon-capture technologies, electrical transmission systems, and power and switching plants . . . [and] is active in the development of renewable energy projects, including wind farms, tidal power, hydro-power, tidal stream and waste energy plants.”
Some commenters on Fessler’s article asked for a complementary financial analysis of the stock — we provide a brief analysis below. As is the case with all the stocks we run through our process, we analyzed JEC’s financials for the past 5 years and forecasted their financials for the next 10 based on the following assumptions:
Jacob’s 5-year historical compound revenue growth is 25.3%. Normally, with the global recession, we’d be concerned about a huge dropoff in revenues in 2009. With the resurgence of government spending and the compelling need for world spending on infrastructure, however, we’re confident that JEC will only grow slightly more slowly in the next 5 years (average of 20% per year).
JEC’s margins are low, but consistent with the rest of their industry, including McDermott (MDR), Quanta (PWR) and Fluor (FLR):
Although our forecast assumptions result in stable margins over the next 10 years, note that if JEC increases the mix of government-funded contracts in its portfolio, these will tend to have a positive effect on their margins (as governments wastefully pay higher prices than private-sector firms).
Jacbos’ ROA and ROE are not particularly high, but unlike many firms, their historical and forecasted ROIC is much higher — close to 20% historically and a little higher in our forecasts — due to their efficient balance sheet management (driven primarily by the low PPE/Sales ratio cited above).
The key point here is, even using a very high WACC hurdle for this firm (13.4%), their ROIC is well above the WACC, which is one of the principle drivers of long-term value creation. Add in the fact that JEC is likely to grow at 20% per year into that robust ROIC – WACC spread, and the stock is well below its high of $86 from last year (recently trading at $41), and the story on JEC begins to get interesting.
Jacobs has had good growth in Net Operating Profit After Tax (NOPAT) and Free Cash Flow (FCF) historically. After forecasting a slight decline in 2009, we predict that growth in these items is likely to resume over the forecast horizon.
The consistent growth in NOPAT and FCF means Jacob produces positive EVA (Economic Value Added) and MVA (Market Value Added). All JEC has to do to continue growing these value-creation metrics is grow revenues 5% slower over the next 5 years, taper down to 4-6% in 10 years, and maintain its other ratios at their historical averages.
Jacobs had an abrupt rise in its short interest in Summer-07, but short interest subsided in 2008-2009.
JEC’s Days to Cover ratio has been more stable because the increase in short interest was accompanied by a general increase in trading volume as JEC began attracting the attention of traders in 2007.
Insider selling in JEC is modest (most firms have cumulative insider selling over time as insiders diversify their holdings):
JEC scores a solid 10 out of 11 on the extended Piotroski Financial Fitness Evaluation Scorecard:
And their Altman Bankruptcy Z-Score of 5.2 is triple-A compared to most firms these days.
Using the forecast assumptions outlined above, we obtain a discounted cash flow price on Jacobs of $50 a share, vs. its current price of $41. Overall, we think Dave Fessler has it right and Jacobs Engineering merits a strong buy recommendation, based on the macroeconomic themes outlined in his blog posting and the fundamental analysis provided above. We’d love to hear what you think about this and other infrastructure plays.
June 28, 2009 Posted by marketblog | Market Commentary | | 1 Comment