Monthly Archives: November 2013

pining for inflation to return

November 15, 2013 By in Constructing a Portfolio, Current Market Thoughts, Dividend Discount Model, growth vs value, inflation vs deflation Tags: , , , , , , , , Leave a comment

background

Every macroeconomics student quickly learns the lesson of the Great Depression–that deflation (an environment where prices in general are falling) is the gravest ill that can befall a country.  Why?   …for companies, deflation means continuously declining revenues.  At some point, the firm can no longer meet its payroll.  Eventually, it can no longer service, much less repay, any borrowings it may have.  As the 1930s showed, deflation breeds widespread unemployment and corporate bankruptcies.

Second place on the list of bad things that can happen goes to runaway inflation (accelerating rises in prices in general), a malady common in emerging economies–and one the US experienced in the 1970s.  The issue here is that no one knows what interest rates in the future will be–only that they’ll be crazy high.  So no one, neither individuals nor companies, invests in long-term projects–because they can’t figure out whether they’re money-makers or not.  Instead, everyone starts to shun financial assets in favor of buying and hoarding tangibles like gold or real estate, sometimes in a completely loony way, on the idea that they will rise at lest in line with the soaring price level.

When the US began to fight its incipient runaway inflation under Paul Volcker in the early 1980s, the question arose among  academic economists as to what was the “right” level of inflation.  The consensus answer:  2%.  Not so close to zero as to say “deflation,” but low enough not to suggest “runaway.”

So 2% inflation became the holy grail of US, and global, monetary policy.  It took the US twenty years to hit this target.

the present

Over the past several months, I’ve been reading and nearing comments from lots of different sources that suggest that 2% may be the wrong answer.   Not the academic world, of course.  Two reasons:

1.  The Fed has been perplexed at its inability to keep inflation at 2%. The number seems to want to gravitate toward zero, instead.  This raises the specter of deflation, the sure-fire investment killer.  So this tendency is bad.

2.  For small businesses, which have been the biggest engine of economic growth in the US in recent decades, a 2% rise in prices + at best 2% real growth = a 4% increase in annual revenues.  The first objective for most family-owned firms is to make sure that this year’s profits won’t fall short of last year’s.  That’s because any shortfall is money out of their pockets, not simply a theoretical loss.  Apparently, +4% in revenues isn’t far enough away from zero to create enthusiasm for taking the risk of investing to expand the business.  Therefore, no capital projects, no new hires.

significance?

Two reasons are most often cited for the current slow growth in the US:  hangover from the Great Recession and dysfunction in Washington that prevents growth-promoting fiscal policy from being enacted.

I think a consensus is beginning to form that there may be a third culprit–an inflation target that has been set too low and which has inadvertently mired us in a kind of Bermuda Triangle monetary situation that  the Fed can’t extract us from by itself.

This implies fiscal policy may be the only cure for sub-par growth.  Therefore, ineptitude in Washington, even if that has been the norm forever, is no loner as tolerable as it has been in the past.

If this is so, growth stocks will continue to outperform value names in a slow-growth economy–unless/until fiscal policy gives a helping hand.

goodwill: a quirky concept

November 14, 2013 By in Accounting, goodwill Tags: , , , , , Leave a comment

goodwill

My daughter, who’s in an MBA program, called up the other night to register her thoughts (read: complaints) on how bogus the concept of goodwill is.

She’s right…the concept of goodwill is a patchwork fix of a problem that arises with an accounting system like GAAP (Generally Accepted Accounting Principles, used for financial accounting)  whose ground-level assumption is that value resides in the net worth (after depreciation) of tangible assets.

On the other hand, past attempts to alter GAAP to account for intangibles have ended in disaster.  So, GAAP may be the least of the possible evils.

where GAAP goes wrong

1.  For tangible assets like buildings or equipment, GAAP assumes that they decline in value through use.  Depreciation/depletion reduces their balance sheet carrying value according to a regular schedule to account for this.

But the parking lot that was on the outskirts of town fifty years ago may be in the center of downtown today–and worth a fortune, even though its current balance sheet value is close to zero.  This kind of thing has been the idea behind the recent wave of takeovers of retail companies like JCP–that their properties are worth way more (sometimes in alternate use) than the balance sheet shows.

2.  For intangible assets, like patents, software, brand names, the ability to make extra-good, extra-dependable products that consumers love, distribution networks…, they usually don’t appear on the balance sheet anywhere.  In fact, the money spent creating these company attributes–like advertising, R&D, and training–appear only as expenses on the income statement.  These expenditures reduce income, and, therefore, shareholders’ equity.  GAAP treats them as a net minus!

how goodwill arises

Suppose Company A buys Company B.  Company B has book value of $1,000,000, but Company A pays $2,000,000 to obtain it.

Overbidding?   …maybe not.  Maybe Company B has a lot of undervalued property.  In that case, Company A is allowed to revalue Company B’s tangible assets upward to reflect current market values.  Say that adds $200,000 to asset value.

What about the other $800,000?

Maybe Company A has indeed overpaid.  If so, it has to immediately write the $800,000 off as a loss.  But maybe Company A wants Company B because it has valuable patents or a great brand name or a powerful sales force–all intangibles.  In Company A’s view, these factors alone justify the entire purchase price.  If it can make its case convincingly to its auditors, Company A can add the value of the patents, etc. to the balance sheet at a value of $800,000 as goodwill.  That way it avoids a gigantic writedown on the acquisition–something that wouldn’t thrill Wall Street, and might ding its credit rating.

What’s bogus about the concept is that Company B can’t do this for intangibles it developed itself while independent.

Why not?

a history of abuse

1.  At one time, GAAP allowed tech companies to put their R&D expenditures on the balance sheet as an asset.  But after widespread abuse–companies claimed tons of loss-making activity was “R&D”–led to the bankruptcy of a bunch of companies with apparently pristine income statements, the practice was prohibited.

2.  In the early 1980s, the SEC required companies to calculate and disclose their own shareholders equity using “current cost” accounting, a method of dealing with the effects of then-rampant inflation.  The idea was that companies would know the true value of their assets better than anyone else.  They could, in effect, write up their assets for increases in value of their tangibles, as well as give a value to intangibles.

Firms did know their true value, all right.  But the way I read the resulting numbers, company managements fell in to two categories.  Those afraid that disclosing their true value would make them takeover targets lied by making their book value figure extraordinarily low.  Those that wanted to be taken over made their book values laughably high.  Despite the fact that the SEC was asking, few companies told the truth, in my view.  The project was abandoned.

 

But I think the lesson was learned.  Management political agendas are too powerful to allow companies to do their own asset valuations.  GAAP is as good as we’re going to get.

four reasons retailers are antsy about the upcoming holiday season

November 13, 2013 By in Industry Analysis, Retail Tags: , , , , , Leave a comment

The first two are obvious:

1.  Retailers make a disproportionately large shares of their profits during the final quarter of the year.  For some highly seasonal businesses (toys, coats, ski equipment…), they aspire to simply break even during the first nine months of the year and cash in during the last three.

2.  The continuing erosion of bricks-and-mortar market share to online merchants.  Highly seasonal firms are particularly susceptible to online competition, but they have also been battered for decades by general merchants like WMT or TGT, which expand and contract various departments as the seasons change.

The third is very simple, but often overlooked by Wall Streeters:

3.  The holiday selling season runs from Thanksgiving to Christmas.  But the number of selling days can vary considerably from year to year.

Thanksgiving is the fourth Thursday in November.  If November begins on a Thursday, as it did last year, Thanksgiving is on the 22nd.  So the holiday selling season consists of 8 days in November and 24 in December = 32 days.  That’s the longest.

If November begins on Friday, as it does this year, Thanksgiving is on the 28th.  That means the selling season is 26 days long.  That’s the shortest.

Historically, people shop until December 24th–and spend more when the selling season is longer.  So revenue and earnings comparisons are the toughest possible this year.

4.  In the post-Great Recession world, retailers hold another belief as firmly as they hold #3.  It’s that consumers have firmer budgets than they previously have had.  Therefore, if a retailer isn’t the first place a consumer goes to, it runs the risk that the potential customer will have run through his budget already–and (contrary to pre-Great Recession behavior) won’t purchase, no matter how attractive the merchandise is.

So this year there’s immense pressure both to get off to a good start and to move the starting line forward, to Thanksgiving Day or even earlier, if at all possible.

my take

My guess is that the holiday season will be more successful for retailers in general than Wall Street currently expects–despite the shortest possible selling season.  Why?   …strengthening employment and lower gasoline prices.

The more interesting question, to my mind, is who the relative winners and losers will be.  In particular, will AMZN’s agreement to collect state sales tax on its online transactions affect its business negatively?  My guess is that it will.  I think the beneficiaries won’t be the bricks-and-mortar stores that lobbied heavily for this, but instead smaller online merchants who still sell tax-free–including (maybe especially) the ones AMZN displays on its site but only fulfills for.

Also, will BBY’s decision to match online prices in its stores and to rent out space to third parties like Samsung and MSFT have a positive impact on sales?  I say yes.  What about profits?  I think they have to be lower.  But my instinct is also to say they’ll be better than the consensus expects.  I’m not about to bet the farm that this will be so, however.

 

October 2013 Employment Situation: eye-popping gains

November 11, 2013 By in Constructing a Portfolio, Current Market Thoughts, economics, employment, Employment Situation report Tags: , , , , , , , Leave a comment

the report

Last Friday at 8:30 est, the  Bureau of Labor Statistics of the Labor Department released its Employment Situation report for October 2013.

Given the general tone of deep discouragement about the economy-retarding actions of Washington–and the impending government shutdown, in particular–the ES figures were surprisingly, even shockingly, good.

The economy added 204,000 net hew jobs during the month.  The private sector accounted for +212,000, government lost -8,000.

In addition, revisions to the two prior months’ figures were also strongly positive.  August job gains, estimated last month at +193,000 were upped to +238,000.  The September figures, initially put at +148,000, were increased to +163,000.  Together, therefore, revisions added +60,000 to the +204,000 total for October–meaning employment in the US on Halloween was over a quarter-million positions higher than estimated a month earlier.

One more positive:  economists, who had called the October ES figure at +130,000 new jobs, also estimated that the impending government shutdown depressed job creation by another +50,000.

There’s only one month since employment turned up in October 2010 where job gains are clearly on a par with, or better than, this October.  That was January 2012, where the final job tally was a gain of +311,000.

what this means

On the surface, the figures appear to be some sort of weird outlier.  If employment gains should be weak during any month, this October should have been it.  And that’s the way I perceive Wall Street to be taking the Employment Situation  report.

Suppose it’s not   …that the economy actually gained about +300,000 new jobs last month and will continue to do so.  This would mean that the US has shifted from creating just about enough new positions (+150,000 or so) to absorb new entrants to the workforce to creating around +150,000 a month more than that.   This would be enough to bring the economy back to full employment–reabsorbing the country’s 3 million long-term unemployed into the workforce in less than two years.

Hard to believe.

If it were so, that would mean that the “normalization” of interest rates–that is, bringing short-term rates from the present zero to 3%+–could/should proceed much more quickly than anyone now expects.

In some ways, that would turn my current idea for portfolio construction on its head.  In particular, it would imply a stronger dollar (therefore a weaker euro) and a preference for purely domestic US companies, not international earners.

I’m not making any changes yet.  I’d like to see next month’s ES first.  But I am putting the search for domestic-oriented EU names on the back burner.