Monthly Archives: December 2010

baggage tail wagging the airline dog

December 14, 2010 By in Airlines, Current Market Thoughts, Industry Analysis Tags: , , , , Leave a comment

Although I know a lot of value investors, I’ve never met one who was enthusiastic about holding domestic airline stocks.  For those who are, and I’m sure there must be some, I imagine that part of the appeal is that most times they have the field to themselves.  So the fact that information about airlines flows fairly slowly on Wall Street offsets some of the risk in this highly volatile industry.

True, I was a big holder of Southwest in the Eighties, and had large positions in Singapore Air and Cathay Pacific.  But, for me anyway, the attractions of even the Pacific ex Japan carriers have long since dimmed.

Yesterday the global airline trade group, the International Air Transport Association (IATA), issued a press release in which it increased its full-year profit forecast for the industry from the $8.9 billion forecast in September to $15.1 billion (in March, the IATA was projecting an industry-wide loss of $5.6 billion for 2010).  This follows two years of losses.

Basically, almost all the money will be made in the Pacific ($7.7 billion) and the US ($5.1 billion), with Europe barely holding its head above water.  Passenger traffic is back to normal.  Freight, recovering from its worst performance on record last year, has slowed a bit recently after a torrid first half driven by corporations rebuilding the inventories they cut so drastically in 2009.  Profits will contract next year, according to IATA, as the industry adds capacity faster than demand will grow.  In other words, back to “normal” in the airline biz.

Yesterday, the Chicago Tribune published an article on the US airline industry that caught my eye.  According the newspaper, the top 20 US airlines collected $906.4 million in passenger luggage fees during the three months ending in September.  They have taken in $2.6 billion in baggage fees and $1.7 billion in charges for reservation changes/cancellations–a total of $4.3 billion–year to date.

If we make the simple-minded (but probably very accurate) assumption that the December quarter will be just like the September one, then the US airline industry will collect $3.5 billion in baggage charges for the full year.  I think it’s reasonable to say that these revenues drop straight to the bottom line, since the airlines have to process passenger baggage whether they charge explicit fees for it or not.  So the fees themselves are pure gravy. Remember, too, that having tax loss carryforwards from two years of losses, pretax income for the airlines on an IRS basis and net income are probably just about the same.  If so, baggage fees will amount to a whopping 69% of industry profits.  Add charges for reservation changes to that and you have a number well in excess of industry profits.  (I’ve looked in vain on the Bureau of Transportation Statistics website for the data release the Tribune article refers to, so I don’t have a third quarter figure for change/cancellation fees.)

How strange!  the airlines essentially give away their transportation services for free , to get the opportunity to collect baggage and reservation change fees.

There are, or have been, other industries like this.  For example:

–At one time, the chains of furniture stores that used to operate along the side of local highways, and whose carcasses can to this day still be seen in some places, made all their money on finance charges from the sofas and easy chairs they sold.

–The last time I looked seriously at movie theaters, admittedly more than a decade ago, they made nothing from showing movies.  All the profit derived from the huge tubs of popcorn and the sodas and candy they sold at the refreshment stands.

–In its early days (no longer), Costco’s pretax profit equalled almost exactly the membership fees it charged. In effect, it sold the merchandise in its warehouses at its cost.

Back to the baggage fees.  On the one hand, I think it’s admirable that the airline industry is taking steps to try to cover its costs.  The fact that IATA expects the US airline industry profits to drop next year by about $2 billion, despite an improving economy,  says this is more a band-aid than a life-saving operation.  It could be that the IATA is just a horrible forecaster, but I suspect that’s not the case.

 

 

 

Wells Fargo: US economic recovery ISN’T sub-par

December 13, 2010 By in Current Market Thoughts, inflation vs deflation, Inventory Cycle, Recent Market Action, Shaping a portfolio for 2011, Strategy Tags: , , , , , , Leave a comment

a better than average recovery

A month or so ago, I wrote about the thesis of Jim Paulsen, the chief investment strategist for Wells Fargo, that the US is actually doing a bit better than average for economic recoveries over the past twenty-five years.  The perception that the economy is relatively weak comes, in his opinion, from comparing apples with oranges–from comparing this recovery with all post-WWII economic rebounds, not with those of the last quarter century.  This latter group, however, are the only ones that occurred with an economy like we have in the US today.

Anyway, I’m suddenly on the mailing list for Dr. Paulsen’s monthly commentary (Thanks, Wells Fargo!).

a new angle

In his December comment, Dr Paulsen expands on his idea of a “back-loaded” economic recovery.  I don’t necessarily intend to talk about Dr. Paulsen every month, but I think he is making some interesting points.   They argue that we will be seeing accelerating economic performance out of the US economy in the months ahead.

women entering the workforce

In a nutshell, Dr. Paulsen’s November observation is that the US economy of the 1950s through the mid-1980s had a faster potential rate of growth than we have today because in the earlier period  the large-scale entrance of women into the workforce acted as a significant tailwind that we no longer have.

the effect of inflation

In his December commentary, Paulsen makes the additional observation that the switch from the inflationary mindset of the Seventies and early Eighties to a disinflationary one of the Nineties and beyond also has a significant effect on the behavior of corporations.  As he puts it, in the earlier period, “sales always rose and prices could always be increased.”  Therefore, it made no sense to worry about staffing levels or the size of inventories.  Price increases would always ensure that companies could report a satisfactory, and rising, level of profits.

The world has changed dramatically since the Sixties and the Seventies.  The Fed’s thirty year long fight against inflation has stamped out in customers’ minds the idea that prices inevitably rise.  In the new environment, a company has got to concentrate on keeping costs low and increasing productivity.  Hiring increases and capacity additions come only as a lost resort.

my thoughts

In my view, Dr. Paulsen’s observation about inflation is basically correct.   In fact, the old inflation-prone world of the Seventies is so foreign to today’s experience that it’s hard for people who didn’t experience it to comprehend how or why the economy ran the way it did back then.

But there are also a lot of other things different about the Sixties and Seventies:

–the industrial firms in Europe and Japan were still rebuilding after WWII

–trade barriers were much higher than today

–therefore, there were far fewer true multinationals, who aimed at selling large amounts of stuff at moderate prices all around the world

–electronic products, where performance always gets better while prices decline, were a much smaller percentage of industrial production

–the rate of technological change was much slower (so fewer worries that bloated inventories might become obsolete)

–there was no Internet and no online commerce

–there was no supply chain management software, so managements had little of today’s ability to analyze and control operations.

Yes, the Fed’s actions in the Eighties destroyed expectations of inexorably rising prices.  But the world is much more complex now.  Change is faster and competition is much more intense.  So cost control and productivity increases are essential for firms to remain competitive.  And today’s managements have powerful tools that allow them to dramatically curtail operations–as they did in late 2008 and early 2009–confident that this is the profit-maximizing thing to do.

good news

Today’s coin has another side, however.  Cost cutting and squeezing more output from a given amount of capital equipment can only go so far.  At some point, firms have to add people and plant in order to continue to grow.

Jim Paulsen thinks, and I agree, that we’re now at that point in the current recovery.  Productivity growth has been slowing for a while.  And there’s substantial evidence that companies are beginning to hire at a faster rate.  If so expect profits for publicly listed companies to accelerate in the months ahead.

ASML’s orders bonanza

December 12, 2010 By in Current Market Thoughts, Stock ideas, Technology Tags: , , , , , , Leave a comment

ASML’s announcement

ASML is a leading maker of semiconductor production equipment, based in the Netherlands.  Its specialty is lithography machines, which semiconductor makers use to transfer the design structure of their chips onto silicon.

When reporting 3Q2010 earnings on October 13, ASML said it anticipated December quarter order bookings to be over €1.3 billion.  Last Thursday, the company said it now expects the figure to exceed €2.0 billion.  This compares with new orders of €1.0 billion in the comparable period of 2009.

ASML made several comments about this recent rush of new business:

–it’s coming from all sectors of the market,

–the DRAM segment, which tends to lurch wildly between under- and over-supply, is on the downswing, but it’s milder than anticipated,

–demand for NAND flash is up, particularly for use in new devices (meaning tablets and maybe Chrome-OS netbooks–anything that uses “solid-state” storage), and

–decisions to build new fabrication plants, both by foundries and logic chip makers.

my thoughts

1.  ASML’s customers are highly capital-intensive.  Firms like this–at least the ones without a death wish–rarely, if ever, outspend their cash flow.  Most  times their spending will stay close to that level, however.  So it’s reasonable to conclude that chip makers have seen a large boost to their cash intake over the past couple of months.  Demand for their products is surprisingly strong.

2.  Consolidation in the chip making industry over the past decade has given the surviving, now much larger, chip makers a considerable increase in market power over suppliers.  This allows them to order at the last minute, three to six months in advance of needing new capacity.  I think it’s safe to conclude that semiconductor makers believe the recent upsurge will carry over well into 2011.  Yes, orders can be cancelled, but Intel, Samsung, TSMC and whoever else is placing large new orders all believe this upturn is for real.

3.  I don’t think it’s an accident that these new orders are materializing at the same time as we are hearing reports of increasing consumer confidence and a surprising uptick in consumer spending.  Looking at stocks in general, I’m not sure whether it matters if the force ultimately behind the new ASML orders is consumer or industrial.  I suspect it’s an interaction between the two.  An employee sees his company upping its capital spending by 20% for 2011.  He concludes business is better, his job is (finally) safe and he might even get a raise.  So he loosens his purse strings.

Anyway, the ASML orders suggest that the economic upturn is reaching critical mass, where it is beginning to feed on itself–or reach “escape velocity,” as economists seem to want to characterize it.

4.  I take the ASML announcement as yet another piece of confirming evidence that the news for stocks will be good over the coming, say, six months.  I also think it means good things are in store for technology stocks and for ASML as a company.  ASML the stock?  …I don’t know.  Semiconductor production equipment companies are a highly volatile, highly cyclical bunch, that trade on second- and third derivatives of the actual orders news.  They also trade on anticipated timing of the peaks and troughs of the equipment cycle–and, again, far in advance of the actual events.  For me, this industry is better left to experts.

marketing bonds when interest rates are rising

December 10, 2010 By in Current Market Thoughts, Investment firms, securities markets, Shaping a portfolio for 2011, Strategy Tags: , , , , , , Leave a comment

US Treasury yields rising from a cyclical low…

In early October, the 10-year Treasury bond yields reached as close to zero in this cycle as they are going to get, at 2.4%.  I think this figure will prove to be a low that will hold for a very long time.  Since then, yields have bounced back to the current–and still low–3.2%.

What has changed in the past two months?  Three things:

1.  The US economy is showing clearer signs of life.  These are evident in macroeconomic indicators like the money aggregates and in bank lending, as well as in announcements by individual company managements and by retail and other trade associations.

2.  Washington–or at least Mr. Obama + the GOP–is saying it’s willing to use fiscal policy to help the US economy along, meaning that the Fed would not have to strain so hard to keep interest rates ultra-low so that the economy doesn’t stumble.

3.  Bond buyers may be beginning to realize just how expensive bonds are.  If you figure that a ten-year bond should give you, say, a 2.5% real yield + protection from inflation, the 2.4% nominal yield implies no inflation–basically a dormant economy–for the next decade.

...means capital losses for bond holders

Roll the clock back to October 7th.  Suppose you bought a 10-year bond from the government on that day.  For your payment of $1,000 to the Treasury, you would have gotten the promise of interest payments of $24 a year, or $240 in total,  plus return of your $1,000 ten years hence.

Today, if you did the same thing you’d get the promise of $320 in interest plus your principal back, or about 6.5% more.

If today’s bond is worth $1,000, then October’s must be worth less–maybe 5% less.  In other words, if you sold the October bond in the secondary market today, you’d only get about $950.  You’d have a capital loss of $50.

the response to the prospect of losses varies…

…by product.

In all cases, the seller of bond products probably stresses that we don’t know for sure what will happen in the future.

For the holder of individual bonds, there may be no getting around the fact that the holder has a minimum requirement for current income, which may require keeping longer dated bonds despite the prospect of capital loss.  In this case, a financial advisor probably stresses this fact, and also tries to point out that “you haven’t lost money, you’ve just lost time.”  In other words, the advisor will point out that–unlike the case with stocks– the stream of interest payments will gradually offset any capital loss.  Also, if you hold the bond to maturity, you’ll get your principal back.  These words may give some psychological comfort.

In the case of bond mutual funds, the marketing departments of the major bond managements companies have been working overtime during the past couple of years spreading the story of the “new normal.”  That’s the idea that the damage done to the world by the financial crisis was so severe that global economic growth will be close to zero for many years.  Therefore, bond yields will remain at emergency-low levels for a very long time.  It’s hard to know if the bond management companies actually believed this, but it never made any sense.  And, other than for Europe, we have clear evidence that it’s wrong.

As a result, the bond fund marketing pitch has changed.  The fund managers are constantly trading their holdings–and have, to my (equity-oriented mind) surprisingly small accumulated unrealized gains to show for this–so there’s no equivalent of holding to maturity and getting your principal back.  What bond managers are saying now is that the global bond market is so wide and deep and has so many different products that there are opportunities to ride through the upcoming rise in rates with minimal or no losses.

Of course, if you listen carefully, the companies aren’t saying that they can do so–like equity managers, most bond managers serially underperform their benchmarks–just that it’s theoretically possible.  Egos buoyed by close to three decades of rising markets, they may believe they can do so and are being held back in their public statements by their legal departments.  But if so, I diagnose this as a case of the ultimate Wall Street sin–confusing brains with a bull market.

ETFs fall into two categories, actively managed and index.  Index funds have no scope to change their composition.  ETFs focused on longer-dated bonds will feel the brunt of higher rates.  Management companies will, as usual, say nothing.  For actively managed ETFs, the marketing pitch will be the same as for mutual funds.

what they won’t say

During times of rising interest rates, stocks have typically been flat to up, while bonds have made losses.  (Stocks are negatively affected by higher rates, but rising rates of profit growth have had a counterbalancing effect.)