Warning: this is Lewis Black on health care reform. I take no responsibility. Gentle sensibilities, steer clear.
I have come to the distressing summertime conclusion that blueberries are the only blue food – and even they are not really blue (on the inside, they are greenish). What was God thinking? We should have more blue food.
As a long-time Wal-Mart shareholder, I was pleased last week to read that ‘Wal-Mart is on a mission to determine the social and environmental impact of every item it puts on its shelves. . . . In the future [shoppers may] have information about the product’s carbon footprint, the gallons of water used to create it, and the air pollution left in its wake.’
That will help us shop smarter, encouraging producers to be more green in the first place.
ARE WAL-MART AND COKE GOLD?
And speaking of Wal-Mart (and, earlier this week, Diet Coke) . . . my friend Boykin Curry of Eagle Capital likes them both. I don’t have remotely enough capital to have him manage it for me, which is a shame, because he generally beats the market by a few points and has for the last 20 years, but he graciously shares his views from time to time anyway. I thought you might be interested to read his most recent quarterly client letter:
At a recent luncheon we had the good fortune to be seated next to Freeman Dyson, one of the twentieth century’s most brilliant mathematicians and physicists. Dyson, a laser-sharp 85, is most famous for the unification of the three versions of quantum electrodynamics formulated by Feynman, Schwinger and Tomonaga. Today he is at the Institute of Advanced Study in Princeton, considered the nation’s ‘most rarified community of scholars.’
The most investment-relevant subject we discussed at lunch was model-building. Dyson pointed out that models can be helpful in explaining the past, but they are often poor at predicting the future, especially in dynamic environments.
When one is looking at earning estimates, asset allocation, value at risk, or global economic prospects, a nearly infinite number of variables affect the outcome. A backward-looking model can isolate the key variables, making the result easy to understand, but over time these variables and their relative impact can change in unpredictable ways. Furthermore, many of the inputs respond to the outputs themselves, sometimes exacerbating volatility; sometimes muting it.
Dyson warned that people who spend their years developing models often grow to love them and attribute greater power to them than they deserve. Model-builders are naturally susceptible to the same enthusiasm the rest of us have for anyone who seems able to predict the future. Trusting PhD’s and their computers is easier than asking tough questions.
Risk managers at Lehman Brothers, Long-Term Capital, Bear Stearns and other firms found that over-reliance on past relationships in their risk models produced a poor result when markets changed. The investment lesson is to use models as tools but to pressure test the assumptions as well as the output with common sense logic.
A number of credible economic models predict an inflationary outcome to the economic policies of the U.S. and other governments around the world. It is important to understand how the spending and monetization of debt will create inflationary pressure, and we want to be sure that the companies we buy can maintain their profits in real terms in an inflationary world. But for inflationary pressure to become actual inflation, it must be accommodated by the Central Bank, which today insists it will tighten when necessary. Models help us understand the pressures that will build and the tools that institutions have, but relying only on the math will not get us all the way.
Ben Bernanke is an example of an unpredictable input.
Perhaps, in the face of inflation, he will capitulate, accepting higher prices for short-term relief. Certainly, the pressure will be immense. His term ends in January, and he wants to be reappointed.
But perhaps Bernanke will pull in liquidity, even if it means a slower recovery. We think he may realize that forsaking monetary discipline to get economic growth would leave the nation with neither. In addition to the long-term costs, inflation would be an immediate catastrophe for the Treasury. Government bond durations are so short now that any attempt to inflate our debt away will raise the borrowing cost just as fast. It is a treadmill to nowhere.
Mr. Bernanke is a smart man with a healthy ego, and as he considers his historical legacy, he surely ponders the tattered reputation of Arthur F. Burns, the Central Bank Chairman responsible for accommodating U.S. inflation in the 1970’s. What are the odds that Bernanke will choose to go down as the fool that ended three decades of low inflation?
More to our point: How do the most sophisticated economic models get into the head of a single man, as he debates his own place in history?
We don’t know which outcome will occur, and neither do the models. But we believe that Coca Cola and Wal-Mart will retain their pricing power and will grow their value in real terms, whether prices are rising or falling. Happily, at a time when many are placing big aggressive bets on inflation, depression, or both, we don’t have to predict either. If one is careful, rigorous, and thinks long-term, there are plenty of opportunities to profit through either scenario.
We recently received a set of questions from a client regarding our views on the economy, the market, and investment opportunities. We thought it might be helpful to share our responses.
1. Is the recession over? Do you expect steady growth or another recession on the horizon?
The recession seems over, but the cost of ending it quickly is that monetary and fiscal policy will have to be tighter for the next ten years. At every sign of recovery, the Fed will need to tighten and to sell down its bloated balance sheet. The Federal government will probably raise taxes at every possible juncture. Combined, these factors should make a strong recovery difficult.
Consumers will also be a long-term drag. The core problem has been too much debt. If we are now to live within our means, then the nation will have to adjust to a lower base.
Finally, if a consensus builds that the government is debasing the dollar and investors lose confidence in US bonds, interest rates will have to rise in order to finance new government borrowing and to roll the debt already on the books. Even a moderate increase in 3-year rates from 1% to, say, 7% (not high by historical standards) would be very tough on mortgages, real estate and many types of asset values. The idea that we can just inflate our way out of this assumes that lenders here and abroad are permanently confused.
2. Are the current EPS estimates too low?
EPS estimates seem generally appropriate, though 2010 and 2011 estimates are probably a little optimistic.
3. How worried are you about inflation?
We are concerned about inflationary pressure, but the Central Bank may press back as described above. In any case, long-term interest rates would rise, and some popular inflation bets may not do well. We are looking for businesses that will preserve their real earnings power in either inflationary or deflationary environments.
4. How do you see growth in the U.S. compared to Europe, Japan and emerging markets?
The U.S. GDP will probably do better than Europe in the coming five years — our fiscal and financial situation is not as bad, our demographics are better, and our economy is more flexible and innovative. However, emerging markets will almost certainly grow faster, in part because they don’t need innovation to get huge gains. With human and financial capital in abundance, they only need to adopt proven techniques from the developed world to build rapidly.
5. How do you view equity valuations in Europe, Japan and emerging markets?
Valuations seem reasonable across the board. Note that stock market returns do not necessarily follow economic growth. For one thing, markets may not reflect the domestic market; Toyota earns more of its profit in the US than Coca Cola does. Also, profitability does not simply follow GDP. Many emerging market businesses are in industries with structurally low profits. Certain companies that are based in the U.S. could grow earnings much faster in third-world countries than the companies that are based in those markets.
6. How much attention do you pay to interest rates? What are your views for long term rates and their impact on stocks?
As long as our companies have pricing power and can raise their profits along with inflation, then their shares can be viewed like an inflation indexed bond. If Coca Cola has an earnings yield of 7% plus 2-3% of international growth, then investors should earn 9% plus inflation (whatever it is) on their investment. If inflation is zero, then the total return will be 9%. If inflation is 6%, then the total return should be 15%, but after inflation it is still 9%.
Currently, interest rates seem too low, even without a spike in inflation. Fortunately, stock prices already reflect higher rates. In any case, we would rather own a staple with a 7% earnings yield + growth + inflation than a 20-year bond yielding fixed 4.5% and no inflation adjustment.
7. How is your portfolio positioned for Q3 and 2H 09?
To ignore the macro economy is naïve, but to predict it is arrogant.
We do not try to predict the coming quarters, but we believe we are defensively positioned for a difficult period, and we are constantly trying to upgrade the portfolio and add attractive securities when we find them. We are steadfastly focused on preserving capital and finding companies that will thrive in a challenging economy.
Jeff Cox: “I like you and I agree with you. I drive a small car. I carpool. I use fluorescent light. However, one advantage of reading is not having to watch documentary films in order to stay informed. Enough with the movie propaganda already. Tell me what you think of Glatfelter (GLT), a stock with a 4-percent dividend and a price below book value.”
☞ Never heard of Glatfelter, so I’ve asked someone smarter than me to look into it for you. In the meantime, watch Earth 2100 and Home. The latter seems to be experiencing technical issues but “will be back soon.”
Here’s what Aristides’ Chris Brown says about GLT: “I’ve owned it 2 or 3 times in the last couple years on eps beats. It’s a poorly managed cyclical company with lots of labor discontent and a forward EV/EBITDA that is slightly on the rich side given the company’s debt. The price-to-book is where it should be given the company’s inability to get a decent cash return on its assets. Definitely not a buy here.”
Quote of the Day
Every debt is ultimately paid, if not by the debtor, then eventually by the creditor.~Jim Grant
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