Financial Market Commentary

by Mat Overbaugh, Rob Weigand and Zach Wilson.

Our last recommendation, which was to go long Procter & Gamble (PG) on August 30, has outperformed the S&P 500 by almost 4% over the past month. Today we’re going to review another “high-quality” stock that has not fared so well over the same time horizon: Wal-Mart (WMT), which underperformed the market by about 10% in September 2009.

Interestingly, Goldman Sach’s August 24-2009 Hedge Fund Monitor listed both PG and WMT as “Hedge Fund VIPs,” with 22 funds having WMT amid their top-10 holdings and 14 having PG as a top-10. We’re going to disagree with hedge funds’ positive outlook for WMT, however. Bottom line of this analysis is that if you don’t own WMT, don’t rush out and buy it. If you do own WMT, it’s acceptable as a long-term “hold,” although you should periodically coax a little more return out of the position by writing covered calls — starting now with the Jan-2010 $52.50 calls. Although WMT models up as financially stable and fairly valued, we can’t foresee any news catalyst that would get the market excited about this stock. WMT has gradually become compartmentalized into the same “no-catalyst” category as high-quality stocks like JNJ (although WMT earns than half JNJ’s return on invested capital). Writing covered calls 2-3 times a year should add 3-5% per year to this low-return position. And, if the calls you write suddenly lurch into the money and your WMT shares are called away . . . that probably won’t be a bad thing for your portfolio in the long run.

The table below shows the key assumptions we used in forecasting WMT’s financials and our discounted cash flow valuation model. The main forecast “stressor” we employed was slower revenue growth than the analysts’ consensus of 11.9% over the next 5 years, which is, in our opinion, a number that bears little relation to reality. WMT grew revenues at an average pace of 9.3% from 2005-2009; they even grew a respectable 7% in 2009. But we’re forecasting 2-3% growth in 2010, 3% in 2011, and 4% thereafter. Our model can therefore be interpreted as a slightly below-average scenario for WMT, which we think is entirely possible given the ruthless competition the discount retail space is known for, and greater-than-expected resistance to their overseas expansion plans that we foresee as they try to adapt their model to different consumer cultures.

We also increased WMT’s beta to 0.6 from their historical 0.2 — extremely low (and high) betas are known to revert closer to 1.0 in subsequent periods. Moreover, WMT’s beta of 0.2 resulted from the stock being an immutable, if not inert, force in the market over the past 5 years. We tapered their dividend growth rate as well, expecting that their plans for international expansion will consume a bit more of their free cash flow than their US expansion required.

WMT’s relative valuation is comparable to that of TGT based on their P/E ratio –

Price to cash flow ratio –

And price to sales ratio.

WMT’s EPS and DPS display reliable historical growth; our forecasting model indicates that this growth is sustainable and likely to continue in the future.

One reason WMT has been unable to grow shareholder value (the stock has matched the S&P 500’s return over the past 5 years) is its low operating and net margins. These are stable historically, and forecasted to remain stable.

WMT’s ROIC, ROE and ROA (return on invested capital, equity and assets) are also much lower than other high-quality stocks, such as PG and JNJ. WMT’s ROE has been gradually declining over the past 5 years. Our forecasting model indicates this is likely to continue. Their ROA of 8-9% is unexciting and unlikely to grow in the future.

WMT’s NOPAT and Free Cash Flow (FCF) have also grown steadily in recent years. Our model indicates that future FCF generation will probably slow as their international expansion plans result in a less efficient deployment of capital than their multi-decade US expansion. This is another factor that will make it challenging for WMT to grow shareholder value.

Not surprisingly, growth in WMT’s Economic Value Added (EVA) is also forecasted to level off through 2014, in sync with their slower FCF generation.

WMT does not score as highly on the 11-point Piotroski Financial Fitness Index as other high-quality stocks like JNJ and PG . . .

. . . although their Altman probability of bankruptcy scores are solid historically and on a forecasted basis.

Short sellers have never taken great interest in the stock. Short interest has subsided recently . . .

. . . and their days to cover ratio is a reasonable 2.0.

WMT’s low beta is probably the best reason to consider holding the stock. Its low volatility and low correlation with just about everything make it desirable from a risk-management standpoint, although its low expected return and low dividend yield (2.2%) make it an unexciting investment, and thus a good candidate for a systematic covered call strategy.

by Amanda Repp, Rob Weigand and Cheng Xi.

August 2009 has been a good media month for Proctor & Gamble (PG). Morningstar declared the stock was undervalued, Barron’s included PG on a list of “12 Quality Stocks Ready to Rally,” and last week Dividends Value and iStockAnalyst recommended PG based on the company’s record of increasing dividends for 55 straight years. In light of all this recent interest in the stock, we decided to evaluate PG’s financial health and relative valuation. We’ll start with a recap of PG’s 5-year and 6-month returns vs. the S&P 500. The chart below shows that PG’s returns lagged the S&P 500 from 2004-2007, and the stock has matched the market’s 5-year return only because it exhibited less of a decline during the 2008-09 bear market. Overall, it’s been a lackluster stock for the past 5 years.

Like many other “high quality” stocks, PG has been left in the dust over the last 5-6 months as the market rallied off its lows from March 2009:

Several MBA students starting our Applied Portfolio Management program ran PG through our fundamental analysis process to determine if the stock was legitimately undervalued. Our modeling process includes forecasting a company’s financials using a set of stressful, below-average assumptions, and then determining if, under these assumptions, the company still appears financially healthy and their stock registers as undervalued based on a discounted cash flow (DCF) model. (We obtain our data via our subscription to Thomson/Reuters Baseline Direct.)

The table below shows the key assumptions we used in forecasting PG’s financials. The main stressor we threw into the forecast was growing future revenues more slowly than the “high single digits” expected by several of the articles cited above.

We also increased PG’s forecasted beta to 0.8, higher than the 5-year historical value of 0.6, which increases the cost of capital and dampens the DCF valuation estimates. We also took some energy out of the future dividend growth rate, which bloats the forecasted balance sheets with excess cash — this suppresses some of the forecasted value creation metrics such as Net Operating Profit After Tax (NOPAT), Free Cash Flow (FCF), and Economic Value Added (EVA).

PG’s relative valuation appears attractive compared to other brand-management and personal care stocks such as Clorox (CLX) and Avon (AVP). PG’s price-to-cash flow of 10 is lower than both of these stocks, whose P/CF ratios are over 14.

PG also trades at a lower P/E multiple than either CLX or AVP.

PG’s EPS and DPS display good historical growth, although earnings were flat in 2009, and the dip in 2010E reflects our conservative modeling assumptions. After 2010E, however, our model indicates that PG will be able to resume growing profits and dividends.

PG has large and stable profit margins historically. Consistent with a conservative modeling approach, our model results in a slight contraction of PG’s gross, operating and net margins in the forecast period. At an average operating margin of 18% and average net margin of 12%, however, PG should exhibit the same consistent profitability as it has in the past.

PG’s Return on Invested Capital (ROIC) is consistently above 40%, and exceeded 50% in 2008 and 2009. Our model tapers ROIC back down to the low 40s throughout the forecast period. The spread of ROIC over the cost of capital is a key component of value creation; PG’s spread of over 30% is large and significant. Return on Assets (ROA) and Return on Equity (ROE) are stable and healthy between 8-10% and 15-18%, respectively.

PG’s NOPAT and FCF declined slightly in 2009; these metrics are forecasted to decline again due to sluggish sales growth in 2010. Beyond 2010, however, we forecast that, even with sales growth averaging well below 5% per year, PG can continue growing NOPAT and FCF, which will drive long-term shareholder value creation.

The chart below shows that PG is on pace to create over $10 billion in Economic Value Added (EVA) in 2009, despite a difficult macroeconomic environment. We forecast that PG’s EVA will rise steadily from 2011-2019, fueling gains in Market Value Added (MVA). PG’s MVA is expected to rise from $130B to $160B over the next decade.

Below we overlay PG’s historical year-end stock price 2005-2009 (2009 price as of 08.28.09) with our year-by-year forecasted price from a discounted cash flow model 2010-2019. PG closed at $53 on August 28 — we forecast a 2010 fair DCF price in the range of $65-$67, with their DCF price ranging as high as $87 by 2019. These capital gains are in addition to the 3.3% dividend, of course. Further notice that this modest price path is forecasted along with contraction of PG’s Price/Sales and Enterprise Value/EBITDA ratios over the next 10 years. These DCF valuations can therefore be interpreted as more of a worst-case scenario for PG.

As an important part of any “Buy” thesis for PG rests on their ability to maintain and grow dividends, we also run several earnings quality tests, including the Piotroski 11-point Financial Fitness Scorecard (historical and forecasted values shown below) . . .

. . . and the Altman Bankruptcy Z-score. PG averages 8 out of 11 on the Piotroski test, and consistently scores in the low Safe Zone and/or high Grey Area based on the Altman test. We interpret these results — along with the company’s 55-year record of growing dividends — as evidence that PG is sufficiently financially stable to maintain and grow dividends according to investors’ expectations.

Additionally, PG has not attracted significant interest from short sellers since 2005. Many firms experienced a similar surge in short interest in Fall 2008 after the failure of Lehman Brothers.

As shown by the chart below, the surge in short interest in 2008 was proportional to an increase in PG’s volume, which explains why PG’s Days to Cover ratio has been stable for the past 3 years.

The last chart shows PG’s cumulative insider trading since 2004. For a large company, cumulative selling of $50 million in stock is not significant; insiders of most large companies are net sellers over time as they attempt to diversity their holdings. Since September 2008, PG’s insiders have actually slowed their selling; insiders of many comparable companies have been increasing selling over the same period.

Overall, our analysis suggests that, from a fundamental perspective, PG is a solid play for dividend-focused investors. The stock’s dividend yield of 3.3% is approximately equal to the yield on a 10-year T-note (about 3.5%). Of course, the company faces potential headwinds if consumers shy away from the premium brands in their portfolio and resist the company’s “trade up” strategy. Even if sales growth over the long term is half of what it’s been in the past 5 years, however, our analysis indicates the company is likely to be a slow and steady, albeit unexciting, value creator over the long run. We rate the stock a tepid “Buy.”

by Rob Weigand.

One of the things I find puzzling about the recent bear market is investors’ incredible sense of denial — a deep-seated unwillingness to believe that equities can lose 50% of their value in a matter of months. In my conversations with investment advisors, individual investors and endowment and pension officers, the question of “how could this have happened?” comes up again and again.

The simple answer to their question is that equities tanked because this is what they do from time to time. The behavior of equities isn’t what changes — what changes is our willingness to believe that our portfolios can be devastated by a “super bear” market tsunami from time to time.

The chart below depicts the annualized real 10-year return (dividends reinvested) that a buy-and-hold investor in U.S. equities would earn from each starting date on the x-axis (data courtesy of Robert Shiller). For example, someone who bought at the peak in 1929 and reinvested all dividends would have underperformed inflation by about -3% per year for the next decade. Conversely, an investor who bought at the market bottom in 1982 would have beaten inflation by about 13% per year for the next 10 years. A lot of investors’ current angst is probably due to the fact that buying and holding from the 1999-2000 peak yielded inflation-adjusted returns of about -6% per year. Thus the popularity of the phrase “the lost decade.”

The chart makes it clear that investors in past times have also experienced persistently negative real returns. It’s my impression that some of investors’ disbelief regarding the carnage visited upon their portfolios — and some of what’s driving the bull run from March-August 2009 — is a continued belief in the “culture of equities” propaganda that was perpetrated on investors throughout the 1990s and early 2000s.

Jeremy Siegel’s Stocks for the Long Run propagated a belief that equities were less risky than bonds in the long run. Now we realize that the research he conducted for the book was started when stocks were consistently beating inflation by double digits. It’s fair to assume that equities’ amazing performance over this period influenced his views a bit — and his unwaveringly bullish stance probably didn’t hurt his money management aspirations, either. Glassman and Hasset’s Dow 36,000 reinforced Siegel’s point of view — equity premiums have been too large historically! Stock values should be much higher! Hey, they were only off by 30,000, give or take a few Dow points.

Even Ben Bernanke told us that we were in a period he dubbed “The Great Moderation” just as the wheels were starting to come off the global economy and financial markets. Nice call, Ben. The point is that if these experts can get it so wrong — Siegel’s an esteemed Wharton professor, Glassman is a senior economist with J.P. Morgan, and Bernanke’s the Chairman of the U.S. Fed, for goodness sakes — we shouldn’t feel so bad about getting it wrong as well. But maybe, going forward, we can learn that during euphoric periods approaching market tops, popular cultures’ alleged “experts” also tend to get it wrong and give us bad advice, again and again.

I’ve redrawn the above chart with 36 month smoothing to take out some of the shorter-term wiggles and emphasize the longer-term trends. (The chart has an eerie sort of  ”Elliott Wave” appeal, don’t you think?) A few noteworthy things stand out.

First, stocks’ long-term real returns can be below average — and below zero – for extended periods. Investors buying in during the 1910s, 1920s-30s, 1960s-70s, and 1990s have repeatedly suffered these agonizing fates. The returns aren’t what’s nuts — they’ve happened again and again. For me what’s nuts is the fact that, collectively, we are so eager to ignore history and embrace the delusional messages of Siegel, Glassman and Bernanke. If you instead followed the John Bogle equity allocation (100 minus your age) you still lost some wealth in the recent bear market, but not nearly as much as a culture-of-equities asset allocator.

Second, if you’re a market-timer, you’ve got to be good. If you can’t call a market bottom within a few months, the outsized real returns will pass you by. You might still perform a few points above average, and miss a few market crashes, but to do this repeatedly you need to live to be about 150 years old.

Third, after “super bear” market tsunamis, returns can languish for long periods. As a matter of fact, the only V-shaped long-term stock market recovery following a super bear began in the 1910s. The stock markets of the Great Depression and the late-60s early-70s were characterized by long, drawn-out periods of lackluster returns. So we really need a “perfect storm” type of recovery in corporate and residential real estate, credit markets, consumer spending and corporate earnings for the great bull market of 2009 to establish itself on an economically solid foundation. I’m not saying it can’t happen, but the recovery scenario needs to unfold according to a mainly positive narrative that’s occurred only rarely in the long-term history of the U.S. economy.

by Larry Gorman, Steven Sapra and Rob Weigand.

I recently teamed up with Steven Sapra from Analytic Investors and Larry Gorman from Cal Poly San Luis Obispo on a research paper that investigates the relation between stock market volatility, alpha and the information ratio. We find that measures of market volatility provide forecasts of when alpha-capture opportunities in U.S. equity markets improve or worsen. This article will present an executive summary of our findings; readers interested in the technical details can download the complete paper from SSRN.

Investors are apparently interested in the connection between volatility and the availability of alpha. For example, in his August 6 post on alpha/beta separation, Chris Holt mentions an article by Janet Rabovsky of Watson Wyatt  that explores the proper balance between indexing and active management. In particular, Rabovsky’s article makes note of a connection between expected market volatility (measured via the VIX) and the effectiveness of active management:

Not surprisingly, the higher the volatility of the market, the more likely it was for active managers to perform better than the index.

Before presenting our findings, we’ll clarify a few terms. Volatility refers to the standard deviation of stock returns around their time-series mean from the previous year. Dispersion refers to the cross-sectional standard deviation of stock returns around their mean on a particular day. The VIX, of course, is the CBOE implied volatility measure, computed from the implied volatilities of various S&P 500 index options.

It makes intuitive sense that alpha-capture opportunities should improve with higher market volatility — particularly as the dispersion of stock returns around their daily, weekly, or monthly average expands. When active managers predict which stocks are likely to perform better than others, they are essentially forecasting the cross-sectional dispersion of returns. For a given level of skill, there should be a greater opportunity to add value as the return differential between high- and low-performing stocks becomes larger. This is true for both long-only and long-short strategies.

To formally test this idea, we first compute the daily alphas of every stock in the S&P 500 from 1980-2008 vs. a Fama-French 4-factor model. This means that our alphas are measured net of the risk-free rate of interest and 4 betas (market, size, value and momentum). We then document how the supply of alpha varies with the volatility measures mentioned above. Noteworthy results include:

The dispersion of returns is positively related to time-series volatility (correlation = +0.73)

and the VIX (correlation = +0.76).

Moreover, the dispersion of alpha is positively related to return dispersion:

The upshot of this finding is that the alpha spread, or opportunity to add value vs. a benchmark, is expanding and contracting in sync with return dispersion and the VIX (due to its positive correlation with dispersion).

Even better, this relation is not just contemporaneous — dispersion and the VIX provide forecasts of the dispersion of alpha over 3-month and 1-year horizons (3-month results, reported as annualized returns, are shown below). Active managers can calculate dispersion — or observe the VIX at zero cost — and obtain reliable signals of when the dispersion of alpha will expand and contract. The table below divides all the trading days from 1980-2008 into quintiles based on the daily value of cross-sectional dispersion (from low to high), and shows the median annualized alpha from the 10th, 50th and 90th percentiles over the next 3 trading months.

As dispersion increases, the performance in the 10th percentile worsens (from -52% to -76%) and the performance in the 90th percentile improves (from +53% to +86%). This means that the expected alphas from shorting stocks in the 10th percentile and going long stocks in the 90th percentile get larger as dispersion increases.

Grouping trading opportunities by quintiles of the VIX provides an even more powerful alpha signal.

Active managers can anticipate tighter alpha spreads over the next 3 months when the VIX is in its lower two quintiles (comprising 40% of the trading days from 1991-2008, a shorter time period than the dispersion results because the CBOE began publishing the VIX in 1991), and wider alpha spreads when the VIX is in its top two quintiles (comprising another 40% of the trading days over that time period).

The signals do not identify opportunities to earn higher information ratios, however. We find that active risk (tracking error) expands and contracts proportionately with market volatility. The volatility signals are therefore most likely to be useful to absolute return alpha-hunters or relative return investors simply trying to outperform a benchmark, but less useful to relative return investors who measure performance using the information ratio.

Our findings partially explain why active managers, as a group, have such a difficult time outperforming their benchmarks. The best time for skilled managers to hunt alpha is often during periods of declining equity values (because volatility is higher during bear markets) — exactly when investors desire to decrease their equity allocations and reduce their overall risk exposure.

On the other hand, active managers are not underperforming their benchmarks due to an inadequate supply of alpha. In the presence of skill, the alphas that can be earned in U.S. equity markets are large and economically significant. Our analysis shows that a manager who is skilled at going long stocks in the 75th alpha percentile and short stocks in the 25th alpha percentile could earn average gross alphas of approximately 28-30%. Skill is apparently the commodity that is in short supply.

by Rob Weigand.

As we all know, there are many problems facing the economy and financial markets right now. One of the longest-lived and most pernicious problems is one of the least discussed — or even recognized. For example, this problem is responsible for many American’s longstanding (and misguided) obsession with cutting taxes, which is the primary reason the federal debt has been allowed to explode out of control (and California is on the brink of bankruptcy). This problem fueled the market’s overvaluation in the 1990s, culminating in the infamous tech bubble. It lent a significant tailwind to the crazy lending standards and housing bubble that propped up the bull-market-that-wasn’t from 2003-2007, and the problem is still with us today, preventing us from clearly evaluating conditions in the economy and financial markets — particularly how we arrived at our current state of affairs. Behavioral psychologists bestow two technical terms on this problem — cognitive dissonance and cognitive consonance — but they are two sides of the same coin, or in this case, two sides of the same problem. To understand these terms is to understand one of the major roadblocks preventing us from moving forward decisively as an economy and as a nation.

People are probably more familiar with the term cognitive dissonance — the tendency to ignore, or underweight, information that contradicts our current opinion or set of beliefs. Cognitive consonance is the “flip side” of dissonance — we also have a tendency to overweight information that reinforces our opinions and beliefs. And, with our consciousness severely crippled by these two flaws, we bravely venture forth into the world as consumers and investors, fated never to live up to John Stuart Mill’s vision of homo economicus (“economic man,”  the hyper-rational decision-maker in which most microeconomists still believe). Unlike Socrates, however, most of us don’t even know what we don’t know. The tendency to prefer dogma to facts is, in my opinion, one of the main factors that threatens our future prosperity. We can’t embrace a way forward until we fully appreciate the deep hole capitalism has dug for itself.

The Market’s Emotional Roller Coaster. I gave a talk on the economy recently, and my last slide was borrowed from Liz Ann Sonders at Charles Schwab Market Research (reproduced below). It’s entitled “The Market’s Emotional Roller Coaster,” and it depicts 12 stages of emotion that investors go through in a full bear-to-bull-market cycle.

Someone asked where I thought we were in the emotional cycle. Without hesitation I answered “We never finished the capitulation phase back in March, so we’ve been stuck at that point for months,” and everyone groaned — they wanted me to say we were almost through with the despair phase so they could justify not having to experience any further pain, and instead sooth their psyches with false hope for a big bull market in late 2009 or early 2010 — the bull that will bail out their 401(k)s and allow them to resume their borrow-and-spend consumerism. But I don’t think we’re anywhere close to that point yet (and I’m in good company — more on this below). The market lows of March 2009 represented a brief moment of realism, as equity valuations were accurately discounting the torrent of bad economic news we’ve had from just about every indicator — real estate values, consumer spending, employment, corporate profits, etc. But we couldn’t “bear” Dow 6,400 or S&P 666 (yes, that was the March low), so our collective consciousness created a better narrative — a market rally that sparked 3 months of drivel about “green shoots.”

This is as good a place as any in this little tale I’m telling for you, the reader, to wake up to the reality of our current situation. The average 1-year trailing P/E on the S&P 500 has remained in the low to mid teens during this bear market (see the graph below). The last recession and bear market that approached this one in severity, during the 1970s-1980s, resulted in a market P/E ratio of less than 8. The current recession is far more severe than that one, yet equity valuations remain far above their levels from 1981-82.

If estimates of Q2 corporate earnings are reasonably accurate, the current level of the Dow and S&P imply a trailing P/E ratio of approximately 40! Without a dramatic rebound in earnings in the next couple of quarters — and how likely is that? — the implication is that stock prices could fall another 50-60% before equities are priced to deliver their “normal” long-term annual returns of about 7% (real). And even from much lower levels, earning 7% per year from stocks would require that GDP and corporate profits resume growing at their rates from previous decades — something few respected forecasters believe is possible (elaborated on below).

To understand why equity values discounted economic events more realistically in previous bear markets we need to ask “what’s changed since the 1970s?” The answer is “us.” Or, more precisely, the media we consume and the way many of us use it to fuel our dogmatic fantasies. We use our media subscriptions, the internet and television to indulge in cognitive dissonance and consonance to the point that many of us have talked ourselves onto a precipice of dogma. For those of you balanced on this precarious ledge, I’m going to try to talk you down. Why do I care if you jump or fall, someone might ask? Because, like it or not, we’re all in this together. If the dogma-addicted don’t get themselves into rehab they’re going to pull us over with them.

What are some of the dangerously dogmatic opinions I’m referring to? Well, here are a few. Have you not figured out by now that Ronald Reagan is the engineer of our crushing federal debt? You might have to read that one again — Ronald Reagan is the inventor of borrow-and-spend government. He was a Keynesian, but instead of tax-and-spend, he preferred to borrow-and-spend; it’s basically the same recipe. The data are in, folks — $14 trillion of debt and counting — the fictional Arthur Laffer “tax-cuts-pay-for-themselves” narrative has been proven false beyond a shadow of a doubt. California tried its own version of this with Proposition 13 and they are on the brink of bankruptcy. It’s not unthinkable that our federal government could be in similar straights soon. If a household cannot escape this basic common sense, then neither can a business or a government — you have to pay your bills as they come due. You either raise taxes or cut spending, but you have to live with a balanced budget every year. But once Reagan’s minions got us believing that a different alchemy existed, hundreds of politicians have reinforced that dogma in their hollow campaign promises to the point where about a hundred million Americans now accept something false as true. And these believers find it too painful to look at the simple, factual history of the situation — that’s cognitive dissonance. They instead prefer indulging in even more Laffer and Grover Norquist — cognitive consonance. Many would rather “feel” right than have to pass through a phase of recognizing previous opinions as wrong to ultimately arrive at opinions and views that are more accurate.

Here’s another one — are you all riled up over “news” stories about the shocking involvement of government in business? Especially those Karl Rove psycho-torials in The Wall Street Journal? Well, here’s another little fact you need to digest. Government gets involved in business because business asks them to. That’s right — pop your eyes back in your head and read it again — it’s another undeniable truth. Businesses in the U.S. spend billions every year begging politicians to intervene on their behalf. It goes by the politely sanitized term of “lobbying” — but we all know it’s a legalized form of bribery. Moreover, the worst-performing industries that wreak the most havoc on the lives of citizens spend the most. That’s right. It’s well-known that banking and finance spent at least $4 billion (officially) in the past decade lobbying politicians. Banking and finance — the industry that’s been in a crisis every 10 or 20 years since the 1800s! In second place is — you guessed it — the health care industry. This is the industry that charges Americans more for prescriptions than the citizens of all other countries. It’s also the industry that makes us pay almost twice per capita for health care compared to Canadian and French citizens. It’s the industry that’s engineered a massive propaganda campaign to convince Americans that it would be too expensive for everyone to have health insurance and access to health care. Too expensive? How hard-bitten of a nation have we become when we elevate an economic issue (health care profits) over a human rights issue (access to affordable health care)? If we took a fraction of those lobbying fees and used them to hire consultants from Canada and France, not only would we have more affordable health care with better outcomes (Americans are unhealthy!), our housekeepers, landscapers, restaurant waitpersons and the person who cooked our dinner the last time we ate out could afford to take their kids to the doctor! Approximately 1 million Americans declare bankruptcy each year because of medical bills — and many of them have insurance!

So what type of cognitive dissonance are we engaging in regarding the economy? The carefully-scripted narrative that’s broadcast every day on Fox Business and CNBC must be recognized for what it is. Under the guise of “objectivity,” every negative opinion is immediately balanced by a guest suggesting that he sees “green shoots,” and the next great bull market is right around the corner. The market will come back because it’s always come  back. We have forgotten the useful cliche, “Consider the source.” The programming on these business channels first and foremost serves their advertiser base — the financial services industry. The industry that wants to gather assets, at minimum, and even better, get you to trade as much as possible, while it continues spending a significant fraction of its considerable profits to buy the political influence that ensures that they’re free to do it again and again, regardless of the havoc they wreak on our economy and way of life. Thus programs with names like “Fast Money” and actors like Jim Cramer, who 5 days a week stars in a sitcom where an escapee from a lunatic asylum sneaks into a television station, raids the wardrobe department, dresses up as if its Halloween, and speaks in tongues.

In a world too full of mis- and dis-information, may I instead suggest that you let yourself be guided by the opinions of long-term thinkers with successful track records. They do exist. People like Warren Buffet (who warned us that “derivatives are weapons of financial destruction” many years ago), Jeremy Grantham, Bill Gross, and Mohamed El-Erian, all of whom are on the record regarding “green shoots” — they never existed. Bryan Marsal – whose firm is overseeing the unwinding of Lehman Brothers, which is about as close to the smart money as anyone gets — told CNBC on July 6 that he doesn’t see spending coming back — ever. In the past weeks and months, every one of these individuals has tried to guide our view of the future of capitalism to more realistic expectations. The rampant consumerism and the leverage that propped up the economy for the past decade was not sustainable — game over. Corporate profits, when they begin growing again, will grow more slowly from their 2009 lows. Like Japan, we’re going to get older and save more. And that’s the good news. The United states may have recently passed into what I believe to be the ultimate indignity — we now have to manage the value of the U.S. dollar to please the Chinese, so that we can entice them to keep buying more of our nearly worthless debt. And the Chinese keep buying it — at least for now — but in ever-shorter maturities, which provides them with the option of not rolling over their holdings when these shorter-term T-notes come due over shorter horizons. Much of the recent steepening of the yield curve is due to financial, not economic events — when the Chinese buy shorter-maturity debt and shun longer-maturity debt, the yields on short-term debt stay low while the yields on long-term debt rise, and voila, we have a steeper yield curve. Not one that’s forecasting a recovery, however — one that sadly depicts how, like any profligate debtor, the U.S. is now forced to manage its financial affairs to please the whims of its foreign lenders rather than benefit its citizens.

The first step towards breaking free from this sad reality is to recognize it. The U.S. cannot make a shred of progress until we realistically assess what we’ve become as a nation, and how we got here. Tax cuts aren’t going to save us, nor is denying our neighbors and fellow citizens access to health care. That’s more dangerous dogma that will just dig us in deeper. When we embrace the same values that we claim to admire in the Great Depression/WW II generation — thrift, economy, modesty, charity, generosity and a strong work ethic — we’ll have taken at least one authentic step on the long path to being a great nation of great people again.

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:

• The need for higher capacity transmission lines to move power from the midwest to the densely populated coasts.
• Larger pipelines to move natural gas from Alaska and Canada to the lower 48 states.
• Storage facilities for both oil and natural gas.
• Liquid natural gas terminals in the U.S. and other countries.

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:

• Average growth in revenues for the next 5 years of 20%, tapering to 6% by year 10, growing at 4% per year thereafter.
• Ratios held stable at their historical averages in the forecast include COGS/Sales at 85.8%, SG&A/Sales at 9.7%, an effective tax rate of 36.0%, Cash/Sales of 5.5%, and PPE/Sales of 2.6% (pay particular attention to this last ratio in the analysis below).
• JEC does not pay a dividend and we did not forecast a dividend initiation.
• Beta of 1.5, cost of equity of 13.5%, and because they carry almost no debt, a weighted average cost of capital (WACC) of 13.4%.

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.

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:

The Shape of the Recovery

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:

Stay the Course

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:

Secular Outlook: A New Normal

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:

The Last Hurrah and Seven Lean Years

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.

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.

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]

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.

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.

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.

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.

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.