Tag Archives: economics

inflation on the rise?

May 5, 2015 By in bond market, currency effects, currency markets, Current Market Thoughts, Dividends, inflation, securities markets, stock market, Strategy Tags: , , , , , , , Leave a comment

Regular readers know that I like the economic work done by Jim Paulsen of Wells Capital, the Wells Fargo investment management arm.  His May 1st “Economic and Market Perspective” piece argues that the US has turned the corner on inflation, which will –contrary to consensus beliefs–be on the rise from now on.

His argument:

–the first signs of upward wage pressure in the US are now becoming visible (in developed economies, inflation is all about wages)

–recently, a rising dollar has kept the price of imported goods from rising (in some cases, they’ve been falling) and suppressed demand for US goods abroad.  That’s changing, turning the currency from a deflationary force into in inflationary one

–productivity is low, meaning that companies will have no way of offsetting higher wages other than to raise prices

–in past economic cycles, the Fed has somehow invariably remained too loose for too long.

 

I’m not 100% convinced that Paulsen is correct, and to be clear, he expects only mild inflation, but I’ll add another point to the list:

–although it doesn’t talk much about this any more, the Fed has clearly in mind the lost quarter-century in Japan, where on three separate occasions the government cut off a budding recovery by being too tight too soon.  In other words, there’s little to gain–and a lot to lose–by being aggressive on the money tightening trigger.

 

Suppose Jim is right.  What are the implications for stocks?  This is something we should at least be tossing around in our heads , so we can have a plan in mind for how to adjust our portfolios for a more inflationary environment.

My thoughts:

–inflation is really bad for bonds.  As an asset class, stocks benefit by default.  But bond-like stocks–that is, those with little growth and whose main attraction is their dividend yield–will be hurt by this resemblance.

–if the dollar is at or past its peak, it’s time to look for domestic-oriented stocks in the EU and euro earners in the US (the basic rule here is that we want to have revenues in the strong currency and costs in the weak).

–companies that can raise their prices, firms whose labor costs are a small percentage of the total, and consumer-oriented firms that are able to expand unit volumes without much capital investment should all do well.

–I think that average workers, not the affluent, are the main beneficiaries of a general rise in wages.  So firms that cater to them may be the best performers.

 

 

 

spinoffs (3)–“bad” spinoffs

May 1, 2015 By in spinoffs, stock market Tags: , , , , , , , Leave a comment

In the typical case where multi-line company ABC spins off C, the biggest rewards go to holders of C, although there’s no reason to believe, simply from the fact of a spinoff, that the residual AB won’t do well, too.

value, but for whom?

There are some instances, however, in which the apparent intention of ABC is to stuff C full of detritus before spinning it off.  The whole idea is to make the residual AB more attractive, without regard for the fate of C and its owners.  In some cases, C is so weighted down with liabilities that it almost seems designed to fail.   Some do end up in bankruptcy a short time after they become independent.

In this case, the spinoff may create value   …but it is value for AB, not for C.

the Deal Doctor’s litany of bad spinoffs

I wrote a post about spinoffs that deals with the toxic variety about two years ago.  In it I reference a New York Times article which recites a litany of spinoff failures.  By Steven Davidoff Solomon, the “Deal Professor,” who teaches law at Cal Berkeley, the article is well worth reading.

what a bad spinoff looks like

The characteristics of a “bad” spinoff include:

–having weak operating performance and unattractive prospects

–being burdened with potential legal liabilities from, say, the cleanup of toxic chemicals improperly disposed of

–being loaded with excessive debt, sometimes caused by AB allocating too much of the corporate total to the spinoff.  Sometimes it’s worse, though.  As you can read in the NY Times article linked to above, sometimes AB forces C to borrow large amounts of money pre-spinoff and fork over the proceeds to AB.  This is pretty awful.  To my mind, it’s a clear sign not only to steer clear of the spinoff, but the parent as well.

bad, but not a secret–read the deal documents!

The one point I would make about defending ourselves from “bad” spinoffs is that none of the bad pre-separation stuff that is done to a C (and its shareholders) happens in secret.  Everything must be disclosed in the offering documents filed with the SEC.  The facts may not be in bold print, or underlined or in ALL CAPS.  But it’s there for anyone to read.

Don’t expect the warts to be headline material for the deal roadshow, either.  Don’t think the head of C, who (finally) gets to be an independent CEO, will be 100% objective about his (poor) prospects.  He probably figures he can manage himself out of anything–and it may be his only chance at commend, to boot.  So he’s likely to have serious stars in his eyes.

preliminary prospectus and final:  an arcane note

The preliminary prospectus, sometimes called a red herring, is circulated in advance to potential investors.  Technically speaking, it’s not the official information, however.  That’s only in the final prospectus, given to investors right after the offering.  In my experience, although professionals pore over the preliminary, no one reads the final.

I’ve only seen one instance where the final differed from the preliminary in any meaningful way.  It was Occidental Petroleum’s “bad” spinoff of its meatpacking subsidiary, IBP.  IBP was loaded up with $1 billion of debt at the last minute.  The information only appears in the final.  More info at the bottom of my 2011 post on preliminary and final prospectuses.

 

 

 

 

spinoffs (2)–the ugly duckling

April 30, 2015 By in mergers and acquisitions, spinoffs, stock market Tags: , , , , , , , Leave a comment

Yesterday, I wrote about the stock market value that can be created by separating multi-line companies into their components.

Today, the real world counterpart in value creation–the ugly duckling.

the ugly duckling…

Many times the top managers of company ABC come mostly or entirely from A and B.  As a result, they typically don’t understand C.  In many cases, they don’t care to put in the effort to figure out how C works, especially if C is significantly smaller than A or B.

Because of the perception that C “doesn’t fit” in ABC, it may be starved of the capital it needs to expand.  Because it’s small it may be perceived as not worth the trouble or to be incapable of moving the profit needle significantly no matter what it does.  No matter what its standalone prospects, it may be run simply to generate cash for the rest of the company.

Management of C will likely be poorly paid by industry standards, because of this perception.  A significant portion of that compensation will through stock options.  Since C isn’t publicly traded, those options are doubtless on ABC stock. There’s very little the management of C can do to influence their value.  More than that, if ABC is a mature firm these options may only accrue value slowly.

…can become a swan

If C is spun off, however, the hands of the management of C become untied as it gains control of an independent enterprise.  Freed of the shackles of an unimaginative ABC corporate mindset, it can raise and use new capital to expand.  It can change its corporate structure and focus.  It can experiment.

Management will participate directly in the success of C both through higher salaries and by holding options on C’s stock.  So it will probably be a lot more highly motivated to grow.

the Coach spinoff from Sara Lee

The spinoff of Coach(COH) by Sara Lee in 2000 in an offering that valued all of COH, now a $10 billion  company, at $140 million is a prime example.  At the time, Sara Lee said it wanted to spend its time managing larger brands like Sara Lee baked goods, Ball Park franks, Hanes underwear and Kiwi shoe polish.

The Sara Lee statement is telling.  The businesses whose prospects it understood, and valued most highly, were low-priced, slow-growth, commodity-like consumer goods sold predominantly in retail outlets, like supermarkets, that Sara Lee did not control or run.  Even before its amazing post-spinoff transformation, COH owned its own retail outlets and sold predominantly to women in families with income of $100,000.  Not Sara Lee-like at all!  COD’s biggest issue was that, because it had a very narrow range of leather products, customers only bought something new when the old one wore out, that is, every seven or eight years.

Sara Lee (SLE) no longer exists.  It split itself in two, changed names and had both parts bought out within the past few years.  That total buyout price was about $17 billion.

The earliest market capitalization figure for SLE that I can find is $14 billion at yearend 2002.  By that time, COH, which went public in late 2000 had quadrupled in price and had a market cap of just over $500 million.

 

discounting and today’s equity market

April 21, 2015 By in Discounting, EU financial crisis, Greece, securities markets Tags: , , , , , , , , Leave a comment

Discounting is the term Wall Street uses for the idea that investors factor into today’s prices, to a greater or lesser degree, their beliefs about the future (I wrote a detailed post about the process in October 2012).

 

Two of the major macroeconomic factors the market is wrestling with now are the timing and extent of the Fed’s future moves to raise interest rates from their current emergency lows, and the possibility that Greece will default on its debts and exit the euro.

 

My experience is that almost nothing is ever 100% discounted in advance.  There’s always some price movement when the event actually happens.  Having said that, the coming rise in interest rates in the US has been so anticipated–and talked about by the Fed–for such a long time that there may even be a positive market reaction to the first rise.  This would be on the idea that Wall Street would give a sigh of relief when there’s no more anticipatory tension to deal with.  More likely, there’ll be a mild negative movement, for a short period, but that’s all.

The Greek financial crisis has also been in the news for a long time.  But we don’t have the same extensive history of behavior during past economic cycles to draw on, the way we do with the Fed.  We do have Argentina as a case study in what happens to the defaulting country (personally, I expect the consequences of default for Greece would be pretty terrible for its citizens).  But the focus of investors’ concern is what damage might be done to the EU by Greece’s leaving.  In addition, lots of non-economic factors are involved in this situation.  There’s Greece’s central role in Europe’s beliefs about its own exceptionalism.  There’s the Greek portrayal of the EU’s requirement that Greece implement structural economic reform as a condition for debt relief as 21st-century Nazism.  There’s the status quo in Greece that has benefited from the country’s profligate borrowing.  There’s fear of the unknown that must be urging politicians to paper over Greece’s problems.

In addition, my sense is that the markets’ overriding emotion so far is denial–hope that the whole situation will go away.  Current thinking seems to be that the parties will arrange for some sort of default, along with capital controls to restrict the flow of euros out of Greece, that will allow Greece to stay in the EU.  Still, I find it very hard to calculate odds or even to anticipate what the worst that can happen might be, or the best.  This makes me think that very little of the possible negatives of “Grexit” are factored into today’s prices.

More tomorrow.

Berkshire Hathaway and Kraft

April 20, 2015 By in Current Market Thoughts, economics, from growth to value: the life cycle, growth vs value, mergers and acquisitions, stock market Tags: , , , , , , , , , , Leave a comment

A little less than a month ago, Warren Buffett’s Berkshire Hathaway and Heinz (controlled by Brazilian investment firm 3G) jointly announced a takeover offer for Kraft.  The Associated Press quoted Mr. Buffett as asserting “This is my kind of transaction.”  I looked for the press release containing the quote on the Berkshire website before starting to write this, but found nothing.   The News Releases link on the home page was last updated two weeks before the Kraft announcement.  Given the kindergarten look of the website, I’m not so surprised   …and I’m willing to believe the quote is genuine.  If not, there goes the intro to my post.

 

As to the “my kind” idea, it is and it isn’t.

On the one hand, Buffett has routinely been willing to be a lender to what he considers high-quality franchises, notably financial companies, in need of large amounts of money quickly–often during times of financial and economic turmoil.  The price of a Berkshire Hathaway loan typically includes at least a contingent equity component.  The Kraft case, a large-size private equity deal, is a simple extension of this past activity.

On the other, this is not the kind of equity transaction that made Mr. Buffett’s reputation–that is, buying a large position in a temporarily underperforming firm with a strong brand name and distribution network, perhaps making a few tweaks to corporate management, but basically leaving the company alone and waiting for the ship to right itself.  In the case of 3G’s latest packaged goods success, Heinz, profitability did skyrocket–but only after a liberal dose of financial leverage and the slash-and-burn laying off of a quarter of the workforce!  This is certainly not vintage Buffett.

Why should the tiger be changing its stripes?

Two reasons:

—the opportunity.

I think many mature companies are wildly overstaffed, even today.

Their architects patterned their creation on the hierarchical structure they learned in the armed forces during the World War II era.  A basic principle was that a manager could effectively control at most seven subordinates, necessitating cascading levels of middle managers between the CEO and ordinary workers.  A corollary was that you could gauge a person’s importance by the number of people who, directly or indirectly, reported to him.

Sounds crazy, but at the time this design was being implemented, there was no internet, no cellphones, no personal computers, no fax machines, no copiers.  The ballpoint pen had still not been perfected.  Yes, there were electric lights and paper clips.  So personal contact was the key transmission mechanism for corporate communication.

Old habits die hard.  It’s difficult to conceive of making radical changes if you’ve been brought up in a certain system–especially if the company in question is steadily profitable.  And, of course, the manager who decided to cut headcount risked a loss of status.

Hence, 3G’s success.

—plan A isn’t working  

One of the first, and most important, marketing lessons I have learned is that you don’t introduce strawberry as a flavor until sales of vanilla have stopped growing.  Why complicate your life?

Buffett’s direct equity participation in Kraft is a substantial departure from the type of investing that made him famous.  I’ve been arguing for some time that traditional value investing no longer works in the internet era.  That’s because the internet has quickly broken down traditional barriers to entry in very many industries.  It seems to me that Buffet’s move shows he thinks so too.