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FORBES PUBLISHES 2008 INTERNATIONAL INVESTING GUIDE
Rising commodity prices, frail banks, inflation and a slowing U.S. economy are all taking a toll on global markets. The point of putting money abroad is not to duck economic risk but to diversify it. There are times when a strong dollar or a comparatively strong U.S. economy leave the dollar investor worse off for having ventured abroad. Other times a weak dollar or lagging U.S. profits send foreign portfolios ahead of U.S. ones. Since mid-2003 stocks in Brazil, China, India, Mexico and Russia have done particularly well. The S&P 500 has returned only 6.6% a year.
Nations from Brazil and Mexico to the Czech Republic and even several countries in Africa are benefiting from economic reforms, rising prices for their natural resources, growing export markets and the rapid rise of consumer markets within their own borders.
Below and next week we will feature several internationally-oriented articles from Forbes.
Buy on Weakness
The value stocks favored by Tweedy, Browne have not done very well lately. But if you are a true believer in value, that is all the more reason to be buying those stocks now.
If the über-value managers at Tweedy, Browne say that stock market bargains are starting to appear, one should take notice. Tweedy is finding particular value overseas. The one objection that we would make to their approach is that they hedge the foreign currency exposures taken on with their foreign stock purchases. This makes theoretical sense based on past results, as explained. But when we buy foreign stocks it because we want exposure the foreign companies and currencies.
It has been tough times at Tweedy, Browne, the venerable value firm that has been managing money in midtown Manhattan for the better part of a century. By 2005 its stock pickers could not find anything to buy, so they closed both their mutual funds and their institutional account business to new customers. Now, with the market down, they are ready to take on more assets -- but investors are staying away. In the past year a net $1.1 billion has walked out the door of the $6 billion Tweedy, Browne Global Value Fund, which buys mostly foreign stocks.
This is not rational behavior. If you are a believer in value, you should be putting more, not less, money into Tweedy's foreign stocks when they do badly.
In the 12 months ended May 31 Global Value lost 11% in value, compared with an average drop of 7% in the same period for a universe of 27 similar no-load value funds. One thing depressing Tweedy's performance of late is the firm's habit of hedging away currency exposure. If it buys a German stock, it simultaneously takes a short position in the euro. A reason for hedging currencies is to make a foreign stock portfolio a little less volatile for U.S. dollar investors. Over the long run hedging does not cost you anything, the statistics show. In the short run it could either add to returns (when the dollar is strong) or subtract (when the dollar is weak, as it has been since 2002). Most international stock managers do not hedge currencies, and so their recent results make them look smarter than the folks at Tweedy.
As for long-term results, Tweedy shines. In the 15 years that Global Value has been around, it has averaged an 11.9% annual return, versus 9% for the benchmark based on the MSCI EAFE and S&P 500 indexes (in dollar terms). Tweedy eats its own cooking. Its current and retired employees own $92 million of this fund.
Typical Tweedy stock: Signet Group (SIG), the world's largest jewelry retailer, headquartered in London. Shoppers who once splurged on new bling at its Jared or Kay Jewelers stores are spending their money on food and gas instead. Signet surprised investors with a profit warning, followed by a grim earnings report in April. Most analysts recommend selling the shares.
Tweedy started buying Signet when the ADR was trading at around $18 in October. The shares dropped to $10 in March, and Tweedy bought more. Thomas H. Shrager, one of the five directors who manage $12.5 billion for Tweedy, Browne's clients, says that even at a recent ADR price of $11, Signet is cheap at nine times trailing earnings and with a dividend yield of 7%. Here is another way of evaluating it. Take Signet's enterprise value, which is defined as market value of common shares, plus debt, minus cash in the till. That sum, $2.2 billion, is 4.8 times the company's operating income (in the sense of EBITDA).
Shrager works with John Spears, Robert Wyckoff Jr. and the Browne brothers: Christopher and William, sons of one of the original partners. Tweedy, Browne's strategy has not changed since it was founded in 1920: buy stocks of companies that are very cheap in relation to their assets, earning power or dividends. These companies may be suffering misfortunes or mismanagement, but value will out sooner or later. "We see a lot more companies that fit these criteria than we have in years," says Spears. "A lot of them are outside the U.S."
Canon (CAJ), whose revenues of $39 billion come mostly from cameras and printers, was trading at eight times earnings when Tweedy started picking up shares earlier this year. They have gained 27% since, so they are not as cheap as some of Tweedy's other holdings. At a recent $51, Canon trades at an enterprise multiple of six times operating income. Canon makes more single-lens-reflex digital cameras than anyone else, it is the second-largest producer of printers and it has more cash than debt, says Shrager.
He also likes Honda Motor (HMC), for its history of increasing sales every year since 1997 and having a balance sheet with more cash on hand than debt owed in its auto business. Another holding: Samsung SDI, which is trading at a 21% discount to its book value. The display and battery maker lost money last year in a very cyclical business, but a venture to make power cells for hybrid cars should give it a boost, says Shrager.
Not all of Tweedy's bets work out. Consumer finance companies are among the most entrepreneurial in Japan but got hit by new lending regulations and interest rate caps last year. Tweedy got out of Aiful before the shares plunged but was not as lucky with Takefuji.
Tweedy got lucky last year with ABN AMRO, the Dutch bank. The partners bought the stock because it "was very cheap, it had a yield of 5% and some truly good assets," says Wyckoff. "But management did not do a whole hell of a lot with it." For six years ABN AMRO shares languished. Then Barclays (BCS) and the Royal Bank of Scotland (RBS) started a bidding war that ended with a price more than double what it was when Tweedy started buying.
Grolsch, the Dutch brewer that uses distinctive old-fashioned green swing-top bottles, was another holding rescued by a takeover last year when SABMiller paid 190% of what Tweedy had for the shares in 1999. The stock barely budged for years, notes William Browne. "Grolsch was owned by the same family for 300 years. There were times we thought it might be in the family for another 300 years," he says. But Grolsch was well managed, paid a dividend and traded well below takeover value.
As SABMiller saw the value there and the Royal Bank of Scotland did with ABN AMRO, so Tweedy hopes others will eventually recognize the value of companies such as Signet, Home Depot (HD) and American Express (AXP). In the meantime, Tweedy is happy to collect dividends and wait -- decades if necessary. The mutual fund and some private client accounts have held Novartis (NVS), Wells Fargo (WFC) and Nestlé for more than 10 years. Tweedy's patience helps keep transaction costs down for investors. The turnover ratio of the global fund is around 20%. [See current picks from the fund here.]
The International Value Funds table [see article] lists a few global value funds, including Oakmark Global, which, like Tweedy, Browne Global Value, reopened recently. For investors who want to buy their own cheap foreign stocks, on top we list some of Tweedy's recent picks available as American Depositary Receipts.
Japanese Corporations Are Sitting on a Pile of Undervalued Cash and Securities
The Japanese stock market has been stagnating for, amazingly, almost 20 years. It started the period vastly overvalued, but it usually would take no more than a half decade of so to wash out such speculative excesses. The rest of the stagnation appears to be largely due to a failure to rationalize the malinvestments that occurred during the bubble -- which is indicative of the stagnation and corruption in Japanese politics in general. The ossified structure has been supported in a major way by the Bank of Japan's interest rates that have been so close to zero that even a bankrupt company can roll over its loans. In any case, now stocks over there have gotten so cheap that so are saying the values have become irresistable.
There is money to be bought in Japan. After years of painful deflation and stock market stagnation, managers of many Japanese companies have amassed large stockpiles of cash and liquid securities -- treasure chests that are, in many cases, undervalued by the stock market.
"The Japanese market tends to be more inefficient than the American and European markets," says Jean-Marie Eveillard, who manages several First Eagle funds. "There is, in Asia, a trading mentality. But if you are a value investor you can take advantage of this inefficiency."
Eveillard is an international value investor of no small repute. The situation described in Japan sounds similar, although not as dramatic, as the undervaluation that led John Templeton to blaze the international investing path back in the 1950s.
Eveillard's First Eagle Global Fund, which has enjoyed a 5-year annualized return of 18% (compared with 15% at MSCI's World Index), has been steadily increasing its positions in Japanese stocks to 21% of the fund, behind only U.S. stocks at 24%.
Among Eveillard's Japanese picks: property and casualty insurers, which, he says, "are disguised investment companies because they are vastly overcapitalized" [a la Berkshire Hathaway]. These insurers keep their money in large portfolios of Japanese stocks, and Eveillard estimates that these companies trade at 30%-to-40% discounts to their adjusted book value -- on top of the overall discounts in the undervalued Japanese stock market. "In a sense you get a double discount," Eveillard says. "We look at these securities as the equivalent of buying the Tokyo Stock Exchange at a discount."
Eveillard particularly likes Aioi Insurance and Nissay Dowa General Insurance. Their modestly profitable insurance businesses are scarcely a draw, and in fact they trade, respectively, at 31 and 40 times trailing earnings. But their stock portfolios are enticing.
Eveillard also sees cash-laden opportunities in the Japanese industrial sector. He cites heavy-industry exporters like SMC, which manufactures pneumatic equipment; Fanuc, a producer of automation systems; and Keyence, which makes sensing and measuring equipment. These three outfits are in cyclical industries, but all of them have conservative balance sheets -- SMC has nearly five times as much cash as debt, and Fanuc and Keyence are debt free. Eveillard figures that they would still be undervalued even if profits fell 25% to 30%.
The rich cash position of Japanese companies is not quite as seductive to William Fries, whose Thornburg International Value Fund has returned 23% on average over the last five years. Fries notes that Japan's population is flat and aging -- a combination that is hardly a recipe for organic growth. The other big problem, says Fries: managers' reluctance to maximize shareholder value.
"Corporate governance is not necessarily focused on minority shareholders. It is just a different culture," Fries comments. For that reason, he says, "we would not invest in a Japanese company just because it has lots of cash."
Nevertheless, Fries agrees that Japan's persistently low valuations are attractive enough that he has recently pressed his staff to spend extra time scouring the country's markets. He says that Japanese managers tend to be extremely conservative with their accounting -- particularly with depreciation and amortization of goodwill -- and this makes some companies appear to be expensive on a price-to-earnings basis. He suggests looking at a company's enterprise multiple. That is the ratio of enterprise value (market value plus debt less cash) to operating earnings (EBITDA).
Fries likes Toyota Motor (TM), which is strong in exporting, manufacturing overseas and developing fuel-efficient cars; Nintendo (NTDOY.PK), which rolled out its phenomenally successful Wii gaming system in 2006; and Komatsu, whose construction and mining equipment has been in high demand during the worldwide infrastructure expansion.
Eveillard is more optimistic about the Japanese economy, as he foresees possible resolutions to the country's demographic and management issues. "We are value investors, and everything has a price. If the valuations are low enough, we don't expect perfection."
The article concludes with a table of "big Japanese companies have both healthy balance sheets and strong growth prospects." They do not exactly look like the sub-5 P/E's that Templeton found, but that was another era.
Germanic Europe’s Midcap Morsels
Warren Buffett has discovered Europe’s Mittelstand – midsize, family-owned businesses. Here is a way to play the same game.
Warren Buffett toured Europe this past spring, and publicly announced that he wanted to be "on the radar screens" of Germany's family-owned businesses who were interested in selling out. Some high quality small-cap companies of that sort are selling at reasonable valuations, judging by P/E's vs. growth rates.
Palfinger AG, headquartered in a sleepy village just outside Salzburg, Austria, is a $1.1 billion (revenue) business. Established in 1932, this publicly traded company, still majority-owned by the Palfinger family (free float, 34%), makes 150 models of knuckle-boom cranes, a sort of airborne forklift usually mounted on trucks. It has 30% of the world's market for this appliance. Over the last five years Palfinger's sales have been growing at 19% annually, net income at 45%.
Despite those results, and yet another record first quarter in 2008, Palfinger's stock -- trading in Vienna and as an American Depositary Receipt in New York -- has been caught up in global recession worries. Its shares are off 40% over the past year in euro terms. They now go for 11 times trailing earnings and 2.8 times book value.
Palfinger is just the kind of company Warren Buffett is after. This May Buffett made the rounds of Europe, announcing to the press he wanted to be "on the radar screens" of Germany's family-owned businesses, where tax bills or family disputes might inspire owners to give him a call. According to his reported remarks, he is looking to buy well-managed, family-owned companies with consistent earnings power, pretax profits of at least $80 million and products enjoying a "durable competitive advantage."
Buffett discovered what any euro hand knows: The economic backbone of German-speaking Europe is the Mittelstand -- medium-size, family-owned businesses. Drive through towns in Germany, Austria or Switzerland, and you could find an unassuming, well-run family company like Palfinger.
Like their North American counterparts, some of Europe's best family firms have tapped the public markets to raise capital for expansion or for the cashing out of departing insiders, giving retail investors a chance to buy a sliver of the Mittelstand.
The stocks in our table [see article] have all had impressive sales and profit gains over the last five years but are otherwise diverse. Some are run by first-generation entrepreneurs and sell things such as Web security equipment, and others are controlled by fourth-generation family members, run by outside professionals and in unglamorous fields such as flat glass or polymers.
"Our research shows that as long as the founder is at the helm, either as chairman or chief executive, on average the retail investor will still be better off buying shares of the family-controlled firm than in a widely held nonfamily-composed firm," says Raphael Amit, Wharton's professor of entrepreneurship and academic director of its Global Family Alliance. Family firms also tend not to load up with debt, another reason they attract Buffett and private equity.
Sonova is a 61-year-old Swiss company that sells $1.1 billion a year of hearing aids (Phonak and Unitron are two main brands). It goes for a rich 23 times trailing earnings but is probably worth it. Hearing loss is unaffected by recessions, so sales (59% of which come from products less than two years old) should be up this year. It is buying in 10% of its shares, and the founding Rihs family still owns a stabilizing 20%.
One study by Wharton's Amit, conducted with a professor at Harvard, examined what happened to the stocks of family-controlled public firms over several generations. They discovered that founders enjoy a share premium, while the second generation usually suffers through a discount. In the third generation and beyond, however, the stock often trades at a premium again (albeit never as high as the founders').
Why? Could be that third and later generations have enough family members from which to choose a competent executive or enough sense to bring in professional managers. Or it could be that by the third generation the likelihood of a sale of the whole business is high enough to put a bit of a takeover premium into the shares. Each case is unique, but ideally, buy during the second generation and sell in the third.
H&R Wasag is a fourth-generation family outfit in Hamburg, Germany. Founded in 1891 as an explosives maker, it supplies 30% of Europe's highly refined mineral oil used in textiles, chemicals and plastics. For the past five years the company's sales and profits have compounded annually at 39% and 64%, respectively, until a few months ago when quarterly results showed the twin pressures of rising costs of petroleum and the slowing global economy. At the same time, the company's name surfaced in connection with an eu Commission investigation into a paraffin cartel.
Wasag's shares sell for half what they were a year ago. A buying opportunity? Only 10% of its $1.2 billion in sales are paraffin-related, and the firm is more a "victim than an actor" in the antitrust case, according to its subsequent public statements. (Europe hits price-fixers only with fines, not criminal charges.) In the last months directors have been net buyers of shares. Multiple: 12 times trailing earnings.
Do not want to sweat individual stocks? Try iShares MSCI Austrian and Switzerland exchange-traded funds, with positions in Palfinger, Sonova, Straumann and Vontobel.
The article concludes with a table, "Germanic Europe's Midcap Morsels."
Tech in Taipei
The world loves gadgets. Buy the beaten-down stocks of companies that make them.
Taiwan's technology-oriented stock market tanked along with the U.S. dot-com bubble burst, and, unlike the U.S., never really recovered. Of course the U.S. is now experiencing a major hangover from the economic amphetamines used to create a fake recovery. Taiwan, however, looks interesting. World industry leading companies are selling a high single-digit or low double-digit multiples. If one thinks the macro technology story still has some legs, these situations certainly bear examination.
Did a technology bubble burst in Taiwan? To judge from the display screens, cell phones, laptops and semiconductors pouring out of that country, no. Volume is higher than ever. But look at the stock market and you come to a different conclusion. Tech stocks there disintegrated eight years ago, along with their U.S. counterparts, and have not entirely recovered. That phenomenon makes for some real bargains today. If you think the world will absorb ever more electronic gadgets, you should put some money into the Taipei stock market.
A month ago Taiwan hosted two big technology exhibitions, Computex and SemiTech Taipei. Computex attracted 35,000 visitors and 1,700 exhibitors from 25 countries. They already knew Taiwan as a technology powerhouse, but the 2008 inauguration of President Ma Ying-jeou on a platform of increased business ties to China promises to recharge the economy. The Council for Economic Planning & Development, a Taiwan government agency, forecasts 4.3% real growth in GDP in 2008. That is not big by Asian standards, but it is more than triple what will come out of the U.S. [which are rigged to look positive when the numbers are actually negative].
These developments have yet to be matched with bullishness in Taiwanese technology stocks. "It has been a bad market for seven years, since the bubble burst in 2001. However, we are starting to look at this market," says Khiem Do, portfolio manager of the closed-end Asia Pacific Fund (APB). Over the past year the Taiwan Taiex, an index of the overall market, rose 5% in U.S. dollar terms. But the TSEC Taiwan Technology Index was off 6%. Computer stocks, in short, are cheap.
Asustek Computer sells for nine times its Thomson IBES profit forecast for 2009. Asustek pulls in $23 billion a year in revenues from motherboards, desktop and laptop computers and cell phones. Vincent Chen, an analyst at Yuanta Securities in Taipei, likes the stock, in part because he expects the world market for low-end laptops to triple in size over the next year. The company gets half its revenue from Asia and the rest from North America and Europe. This is a growth company, with revenues climbing at a 45% annual rate over the past five years. Shares of Asustek sell for 0.4 sales, half of their 5-year average price-to-sales ratio.
Acer does a $14 billion annual volume making desktops, monitors and other computer hardware. Last year it acquired Gateway (GTW) in the U.S., and this year it bought Packard Bell in Europe and smart phone manufacturer E-Ten of Taiwan. Acer's net profit margin is only 2.7%, versus 7% for Hewlett-Packard. But it is growing faster. Its sales were up 26% last year, compared with 14% at HP.
Contract manufacturing is big in Taiwan. Customers include companies like Dell, HP and Toshiba. One provider is Quanta Computer, a $24 billion (revenues) business, whose sales increased 45% last year. Its stock sells for half its 5-year average price-to-sales ratio.
AU Optronics is Taiwan's largest manufacturer of liquid crystal displays and the 3rd-largest such company in the world. It recently introduced light-emitting diode backlight displays, a screen technology that promises better image quality, thinner panels, mercury-free construction and energy savings. Most analysts are raising their 2009 earnings forecasts. The consensus number is $3.10 per ADR. The stock goes for just six times that figure.
Hon Hai Precision Industry in Taipei is a giant of electronics manufacturing. Its president and chairman, Terry T.M. Gou, is a billionaire. Its top line ($53 billion) has been growing at a 48% annual rate since 2003, and the only weakness is a slight profit margin decline, says the Asia Pacific Fund's Do. You can buy in for 11 times the IBES forecast for 2009.
The world's largest contract manufacturer of semiconductors, Taiwan Semiconductor Manufacturing, generated $10 billion in revenue last year, on which it netted $3.4 billion. Taiwan Semiconductor is moving into the next generation of chips, cut from silicon wafers 18 inches across. The industry's scale-up does two nice things for fab plants that can afford the move. The first is that it cuts the plant's per-chip cost. The other is that it scares away small fry. The new foundries cost three times as much as the 12-inchers that preceded them, according to Yuanta Securities.
Advanced Semiconductor Engineering (ASX), a provider of semiconductor packaging and testing services, tests many of the chips that come out of Taiwan's fabs. Last year ASE generated $3.1 billion in revenue, up from $1.3 billion in 2002. The company is likely to benefit from the industrywide switch to a faster form of memory called DDR3 (double data rate), a design that requires additional testing time. This company sells for 10 times its 2009 consensus earnings estimate.
Asia Pacific's Do expects a wave of mergers among Taiwanese electronics companies. A lot of deals will be for cash, which some big players (notably including Taiwan Semiconductor and Hon Hai Precision) have more than they know what to do with. Benefits are likely to rebound to investors both in acquired companies and in acquiring companies.
Advanced Semiconductor, AU Optronics and Taiwan Semiconductor all trade as American Depositary Receipts. Acer, Asustek and Hon Hai Precision are listed in London as well as in Taipei and can be bought in either market through a brokerage like TD Ameritrade by investors willing to put up with the usual currency conversion nuisances.
The article concludes with a table, "Wired for Growth: Taiwanese technology stocks are out of favor, which explains why the most expensive stock below sells for only 14 times estimated 2009 profits." The article also a table of recommended foreign mutual funds.
Shopping Latin America
Money is flowing from the pockets of shoppers in Brazil and Mexico. Buy the companies that are benefiting.
While the U.S. consumer is clearly exhausted, consumers south of the border are just getting onto the borrow-and-spend train. Moreover, the commodities boom is fueling increases in real incomes throughout the region. Thus a secular trend is in motion, perhaps equivalent to where the U.S. was 25 years ago. The consumer sector of the Latin American stock markets do not look super cheap, but they probably are legitimate growth stocks.
Consumerism is afire in Latin America. In Brazil, sales of big-ticket items like cars have risen 80% since 2005. Consumers are flocking to buy new homes, personal computers and clothing. In Mexico, access to credit has been fueling a boomlet of consumer spending: The dollar amount of residential mortgages issued in that country more than doubled since 2003, to $23.3 billion last year.
This is good news for a region long plagued by currency devaluations and hyperinflation, both punishing to consumers. In January 1999, as the Asian financial crisis spread to Latin America, the Brazilian government abandoned the dollar peg and the value of Brazil's real tumbled. In Mexico the financial crisis that began in late 1994 forced the country to borrow $51 billion from the U.S., the IMF and other indulgent lenders. It took years for Mexico to recover from the accompanying peso devaluation.
"Go back 20 years and it was cycles of boom and bust in Latin America," says JPMorgan Latin American equity strategist Ben M. Laidler. "A lot of it was driven by too much debt, bad macroeconomic management and fiscal deficits that were too high. That has changed."
Economies in much of Latin America have been growing steadily for the last four years. The rise in demand from China for commodities such as iron ore, steel and petroleum has helped fill government coffers. In Brazil and Mexico governments have implemented sound macroeconomic policies, dousing inflation and gradually reducing interest rates. Since 2002 inflation in Brazil has fallen from 12.5% to 5.6%. The Central Bank's benchmark interest rate, though still high at around 12%, has dropped from 25% over the same period.
In Mexico inflation has fallen by 2/3 in the past decade, to 5%, slightly higher than in the U.S. Interest rates for short-term Mexican treasury notes have dropped nine percentage points since 2000, to 7.7%, though consumers may pay twice that for mortgages and auto loans.
All this has led to several years of steady economic growth and booming stock markets. Brazil's economy should expand 4.4% this year after last year's 5.4% spurt. Its Bovespa stock index, in dollar terms, is up more than 5-fold since January 2004. Says Geoffrey Dennis, Latin America equity strategist at Citigroup, reached during a trip to Brazil in early June, "The buzz of this place, it is just palpable. This is not going to go away."
Mexico, which sends 80% of its exports to the U.S., is likely to grow 2.6% this year, faster than the predicted 1.6% for the U.S. Mexico's stock market has climbed 240% in dollar terms since early 2004. "Mexico is doing a lot better than it normally would in a U.S. recession," says Dennis. That is because so far the U.S. recession (if that is what we have got) is mainly tied to housing, a sector that does not affect Mexico much, he says, except as a drag on remittances sent by Mexicans working in the U.S. The Mexican peso's weakness against the euro has also helped drive up Mexico's exports to Europe. Consumers in Mexico are still spending steadily.
Despite the dramatic rise in stock indexes in Brazil and Mexico, Dennis is bullish on consumer-driven stocks because of the long-term growth he expects in domestic demand. "It is an inflation story and a credit story. You have to focus on the long-term beneficiaries: the banks, the consumer stocks and real estate."
Lending has been growing in Latin America, but the region is still underbanked, says JPMorgan's Laidler. Total outstanding bank debt, including mortgages, in Brazil comes to 35% of annual gross domestic product, compared with 220% in the U.S. Laidler recommends buying Unibanco, Brazil's 3rd-largest private sector bank. Its shares, available as an ADR on the New York Stock Exchange, have drifted lower of late as interest rates have been nudged upward in Brazil to combat inflation. But Laidler says positive loan growth and improving operating efficiency support a higher price for Unibanco. It trades at 11 times its Thomson IBES consensus estimate for 2008 profits.
In Brazil Laidler also likes Net Serviços de Comunicação, the country's largest cable TV operator, another beneficiary of buoyant consumer spending. Net Serviços offers cable, Internet and phone service in 79 cities. Its Net Fone package bundles broadband access, Internet phone service and free-to-air TV channels, and is attracting nearly 30,000 new customers a month. The company has an ADR on Nasdaq and sports a market capitalization of $4.3 billion. At a recent $12.50, the company trades at 27 times 2008 expected earnings.
Citigroup's Dennis recommends home builder Desarrolladora Homex in Mexico. The introduction of more-affordable mortgages in Mexico, coupled with lower interest rates, has fueled a boom in home building that began five years ago, but the country still faces a deficit of 4.3 million homes. Homex, one of Mexico's largest home builders, focuses on the entry-level and middle-income housing segments. Last year it sold 52,000 homes in Mexico. The company, which has an ADR on the New York Stock Exchange, was recently trading at 17 times expected 2008 profits.
Another stock Dennis likes: Wal-Mart de México, a listed, 68%-owned subsidiary of the U.S. retailer and one of the largest retail chains in Mexico. It has 1,030 stores across the country and plans to open 35 more over the next few months. Citigroup expects sales and profits at Walmex, as it is commonly known, to both increase a bit more than 10% this year.
Walmex has a thinly traded ADR on the Nasdaq small-cap market. It is probably better to buy the stock on the Mexican market. Buying shares online with an E-Trade account entails the same fees as buying a U.S.-listed stock: $13 a trade. Walmex is a bit pricey at 22 times expected 2008 earnings versus 18 for its American parent. But Dennis says it is a solid bet, given its growth prospects. If economic conditions deteriorate, he figures, more cost-conscious shoppers will head to Walmex.
Cell phones are another hot business. Over the next three years cellular penetration in Latin America, allowing for people who own multiple phones, will grow from 70% to 90%. That helps América Móvil, a pan-Latin American mobile phone service provider headquartered in Mexico and controlled by Carlos Slim Helú, Latin America's richest man. JPMorgan's Laidler likes América Móvil's projected 9% annual revenue growth for the coming three years. The ADR trades at 16 times 2008 expected earnings.
The article concludes with table of Mexican and Brazilian stocks favored by Citigroup's Dennis and/or JPMorgan's Laidler.
WORKOUTS WORK OUT
The U.S. home foreclosure boom is generating a huge market for those who can efficiently work out agreements between distressed borrowers and their respective distressed lenders. Here is one example.
Michael Moore and his wife, Rebecca, began careening toward foreclosure in 2005. That year the couple refinanced their $300,000 home in Livonia, Michigan, going from a $149,000 30-year fixed-rate mortgage at a 7% interest rate to a $300,000 adjustable-rate loan with a teaser interest rate of 8%. They used a chunk of the cash to cover Rebecca's mother's medical bills. Some of the rest evaporated last year when the rate on their loan jumped to 11.35% and the monthly payment rose to $3,100. The couple started falling behind on payments, prompting foreclosure warnings from their lender. "You pray it will all work out," says Rebecca, 54.
Enter Moose M. Scheib. His 27-person loan modification processing firm in Dearborn, Michigan, called Mizna, works as a mediator between lenders and overextended homeowners. Scheib collected the Moores' W-2 forms, tax returns, bank statements -- and ordered an appraisal and best-price offer from a Realtor on the Moores' 3-bedroom house. After 45 days of negotiations with Litton Loan Servicing, Mizna helped the Moores keep their home by lowering their monthly mortgage payment to $2,500 with an 8% fixed-rate mortgage last October. "Most homeowners are too scared to speak with their mortgage company; that's where we come in," says Scheib, 28.
Mizna, which means "desert cloud" in Arabic, claims to have saved 3,900 harried loan customers of Litton (a Goldman Sachs subsidiary), HSBC, Washington Mutual and Countrywide since January 2007. That work helped Mizna net $875,000 pretax on revenue of $3.9 million over the past four quarters on 4,015 loan modifications. Scheib and equal partner Sonny Mandouh hope their company will modify 20,000 more loans by the end of 2009. Mizna's fee, which has risen 5-fold since early last year, is now typically $1,500. It is paid by lenders, who are under pressure by state and federal policymakers to modify loans and repayment plans for troubled borrowers. Mizna clears $500 per loan after salaries for 20 loan processors.
A 10th of Mizna's clients have come in via loanmod.com, the Web site Scheib bought for $50,000 in 2007. Most come through mortgage companies that would rather pay Mizna than spend $50,000 in a typical foreclosure process. Mizna has completed modifications for an impressive 42% of the Litton customers it contacted last year. Only 1% of customers Litton contacted directly the year before did loan workouts.
Scheib, a former associate at Proskauer Rose law firm in Manhattan, is not alone in this game. Well-connected nonprofit groups are getting grants and free software to help them negotiate cheap workouts for big lenders. Scheib says there is plenty of business to go around, especially as more well-to-do folks have trouble: "Borrowers with high-end homes are reaching out to us for help."
FAREWELL, BILL GATES
Will Steve Jobs be the next to go?
Microsoft by all signs looks to be a company that is easing into comfortable middle age. With its huge operating margins and cash flows, and a still growing user-base that can be counted on to generate an annuity-like stream of revenues and profits, Microsoft is probably not going disappear any time soon. But for visionaries like Bill Gates, it is time to check out. As the author of this article points out, Gates mentally checked out long ago.
"Change is the only constant" is a favorite cliche among technology types. [Another one we like is: "You can slit your own throat, or let your competitor do it for you." ... Or something like that.] But for an industry that loves to talk about change, its leading lights do not do too much of it, at least not when it comes to turning over control of their companies. Apple, Dell, Microsoft and Oracle are all run by the guys who founded them back in the 1970s and 1980s.
But soon those leaders will move on. First to go is Bill Gates, who on June 27 stepped aside at Microsoft. Next, I would wager, will be Steve Jobs, for health reasons. Jobs, 53, underwent surgery for pancreatic cancer in 2004 and lately has been looking unwell. Apple p.r. folks claim he is fine. Apple p.r. is known for having a Clintonesque relationship to the truth. If Jobso is still running Apple at year-end, I will be shocked.
Also headed for the exits will be Larry Ellison at Oracle. Ellison claims to be 63 but is barely aging (I secretly believe he is several hundred years old, and a vampire), and these days he seems more passionate about sailboat racing than about vending database software. My guess is that Ellison will acquire software seller Salesforce.com and replace himself with its 43-year-old founder and chief executive, Marc Benioff, a former marketing whiz at Oracle.
These looming handoffs will have mixed effects. For Apple, expect a 30% drop in the stock price on the day the news breaks, followed by a period of disarray and confusion. Apple has strong managers. These guys (and yes, they are all guys) are smart and experienced. But Apple has recklessly avoided setting in place a succession plan. Who will take over? Timothy Cook, the chief operating officer, who ran the company when Jobs was on sick leave in 2004? Jon Ive, the head of design? Both are bright. But Steve Jobs is beyond bright. He is one of a kind. The sad truth is this: Without Jobs, Apple will never be the same.
For Microsoft the loss of Gates will not be nearly as profound. Gates narrowed his involvement at the company eight years ago when he gave the chief executive job to his college buddy and right-hand man, Steve Ballmer. The reality of the last few years is that Gates has been mentally checked out, pursuing loftier goals at his foundation.
Under Ballmer, Microsoft is enduring one of the worst times in its history. The stock has been flat. Vista, the latest version of Windows, has been such a disastrous technical flop that Microsofties themselves are said to refer to it under their breath as "Vistaster." (A recent industry study suggested that only 26% of business customers will have switched to Vista four years after its 2007 launch.) Ballmer's recent failed attempt to acquire Yahoo ended up making Microsoft look clumsy, weak and ridiculous. 20 years ago Microsoft's young Turks loved to mock the clueless old backslappers who ran IBM. Today upstarts see Microsoft as a sad old bully that makes lousy software.
Considering how bad things have been lately, you might almost argue that Gates's departure could be a boon, a chance for some fresh thinking. Except look who he has left in charge. Ballmer is smart and relentless, but he is no techie. And he is 52 years old. Ray Ozzie, who replaced Gates as chief software architect, is also 52. He began his career at Data General, which vanished a decade ago when it was acquired by EMC. Craig Mundie, Microsoft's chief research and strategy officer, is 59 and also started out at Data General -- in 1970. That is the year the Beatles broke up and Jimi Hendrix died. Microsoft's three top guys came of age when the Internet was called the Arpanet and the personal computer had not been invented.
Microsoft hastens to point out that other managers are younger. But come on. Kevin Johnson, the guy running Microsoft's Internet efforts, is 47, has been with the company since 1992, has a background in sales and used to work at IBM. He also oversees Vista. Ahem. Robert Bach, president of the division that handles Xbox and Zune, is 46 and has been at Microsoft since 1988. Stephen Elop, president of the Office applications group, is 44 and joined Microsoft this year. Kevin Turner, chief operating officer, age 43, spent 20 years at Wal-Mart.
Smart guys. Great guys. But not a pack of wild-eyed visionaries operating at Internet speed. Take a look at that photo of Gates and his crew in 1978, looking like the Manson family. Those are the kind of crazies who change the world. Sure, Microsoft will participate in the Internet revolution, just as IBM played a role in the PC revolution. But IBM ultimately abandoned PCs and now chugs along on its mainframe franchise and services business. Not exciting, but not a bad business, either.
I think Microsoft will play defense from here on out. Its army of MBAs will milk the monstrous franchise around Windows and Office for all it is worth and try to cushion a decline in originality and create a soft landing. The future for Microsoft looks lucrative, predictable and boring. No doubt Bill Gates realizes this. That, I suspect, is why he is checking out.
A hilarious video of Bill Gates's last day at the office can be seen here.
INVESTING IN FUEL EFFICIENT CARS
When the government does not thwart things, major changes in relative prices lead to entrepreneurial efforts to take advantage of the created opportunity. This has certainly been the case following the huge increase in energy prices this decade. Here is an interesting update on promising initiatives within the automobile industry.
It was Ben Franklin who once said, "every problem is an opportunity in disguise ..."
One of the problems with American culture is that we do not fix anything until it is beyond repair -- levees, the housing, bubble, debt, healthcare, social security, you name it. Unfortunately this also applies to the ongoing energy crisis.
While a potential cellulosic industry (ethanol made from cellulose, the most organic compound on Earth) could break out in the future, it will not put a dent into $135-plus barrel prices until years from now. America's dependency and current shortages has forced itself to find an alternative. Improvise would be a more appropriate word. We will see some new and exciting technologies in the following years.
No, it will not be flying cars, hydrogen cells, or teleporting atom machines -- although those would be a fun. Instead, we are talking about simple energy and cost efficient cars. The recent closings of four GM truck plants and $4-plus per gallon gasoline prices are a tall tale sign our SUV days are over. The fact that soccer moms cannot even get $10,000 when trading in their Chevy Suburbans proves that times have changed. Hybrid and smart cars are starting to emerge. We are now heading toward two feasible automobile options that both fit under cost and energy efficiency categories -- electric and air.
Building a Better Hybrid
When we think of hybrids, we think of unattractive cars mired with technical problems, short battery lives, and difficult and costly to fix. However there is a new generation of hybrids that may change its reputation ...
Several automakers have already implemented plans to commercial produce lithium-ion battery powered cars. These vehicles are far different than the standard nickel metal hydride-based battery used in today's current hybrids. General Motors plans to release the first lithium ion hybrid to U.S. markets in 2010, the Chevy Volt, followed by Toyota, Mitsubishi and Subaru.
In a nutshell, the new lithium-ion batteries will last much longer and provide up to 20 times the power than nickel based, allowing cars to travel up to 40 miles on a single 8-hour charge. Need to travel more than 40 miles? No worries, a dual gas engine will cut on, getting you to where you need to be.
Depending on how much your local electricity supplier charges, it would cost you around $2.50 to fully charge a lithium ion hybrid. Also, even if the electricity supplier is burning fossil fuels to produce the needed charge, they are still releasing less carbon emissions than regular gas powered cars.
A Breath of Fresh Technology
The latest car technology to hit the world's markets involves an air compression engine. An almost unimaginable idea, this engine uses air compression tanks to push the pistols instead of the explosion of gasoline/air mixtures in a traditional internal combustion engine.
The car's appearance is small and not that attractive, but at $2.00 to fill a tank good enough for a 125 mile trip, it might be worth it. Like hybrids, they also have a dual gas engine for speeds over 60kph. A high-pressure air pump could fill up the car in 3 minutes while a built-in air pump could refill the tanks in four hours using a simple household outlet. The internal pumps will also refill its tanks while running on gas -- making it a somewhat renewable energy product.
Indian carmaker Tata Motors (TTM) and French-based Zero Pollution Motors are the first companies to commercially produce this technology. Deals have been made in more than a dozen countries. The Mexican government signed a deal to buy 40,000 of these for taxis in Mexico City.
Air compression cars ... [a]t least not for now ... are simply too small and lightweight to pass U.S. crash tests. But this technology has potential -- not to mention the fact that it is easy on the environment.
Hybrid sales were estimated to increase by 11% for 2008. Yet sales are down 1.9% compared to last year through the month of June. However, total car sales are down 10.1% due to a choppy economy and high fuel prices. And even though demand has waned a bit, carmakers still have been unable to meet America's demand for hybrids. Simply put, 2008 hybrid sales would be higher if it were not for inventory shortages. ...
It is no question that hybrids will be a success. In a recent poll conducted by Edmonds, 35% say they are currently shopping for fuel-efficient cars while over 50% say they will shop for another vehicle if gas reaches $5 per gallon. With only 0.388 sold per 1000 people, there is plenty of room for growth. A 10% tax break on a hybrid is a nice incentive as well.
The largest factor to the shortage is battery supplies due to poor planning and limited resources. The battery packs, which are the most expensive part of hybrids, could be a huge gainer in the markets.
GM's recently announced lithium-ion contracts with both German-based Continental AG and Compact Power Inc, a subsidiary to LG Chem of Korea. With numerous other major automakers racing to get lithium battery hybrids out, lithium ion providers will be in demand. These companies would be worth keeping an eye on in the near future.
With amount of money companies and governments are putting into these projects, it is likely we could see a promising industry to boom in the future. Hopefully, it will sustain not only the economy, but the environment as well.
COAL KEEPS THE LIGHTS ON IN AMERICA. CAN WE MAKE IT CLEANER?
This article is basically a promotional piece from Penny Stock Sleuth writer Greg Guenthner. Penny Stock Sleuth is published by Agora Publishing, who are promoters par excellence ... so to speak. Nevertheless, it is an interesting update on where we are in efforts to make coal burn cleaner, i.e., do not count on it just yet.
By a wide margin, the United States has the largest coal reserves on the planet. The coal supplies in the U.S. account for 95% of its fossil fuel reserves and a whopping 60% of the fuel reserves in the world, according to the American Coal Foundation.
Yes, coal prices have continues to rise across the globe. But of course, this pales in comparison to the continued run-up in petroleum, which has virtually paralyzed the wallets of many oil-reliant Americans.
The idea of a coal shortage is virtually unthinkable. We have roughly 275 billion tons of recoverable coal, enough for us to burn for the next 2 1/2 centuries if we needed it. So while the next generation might not have the oil to run their cars and trucks, the lights at the house will stay on thanks to coal power.
If this were the end of the story, coal would be sitting pretty. But the black rock is under attack from governments, scientists and ordinary citizens throughout the world. And with no end in sight, our main source of electricity is in serious jeopardy.
The prolific use of coal as a power generating fuel is causing massive damage to the planet in the form of carbon dioxide emissions. This is not a political statement -- it has been proven over and over again by scientists and accepted by governments and the United Nations. Today, oil we burn in our vehicles and use for power generation is the #1 source of CO2 emissions. However, half of the excess CO2 civilization has contributed to the air is from coal. And as you are aware, oil use will most likely decrease from this point forward due to supply and pricing constraints.
It is clear that coal is the dirty, cheap energy culprit the world needs to fix. President Bush and both major-party candidates in the White House race have advocated the development and use of new coal technology that would reduce CO2 emissions. And politicians on both sides of the isle have supported efforts to develop clean coal technology. Unfortunately, a viable solution is decades away.
Take carbon capture technology, for instance. Carbon capture techniques are designed to take the CO2 emissions from power plants and inject them into the rocks or other geological formations. This process would keep the harmful CO2 emissions from entering the atmosphere.
While it looks good on paper, industry analysts believe this technology is at least 10 to 15 years away from commercial use. Others are questioning whether CCS will ever become viable. A New York Times article from earlier this year asks precisely that, describing the government yanking support from an Illinois site that was supposed to pioneer the technology. The article continues, citing utility projects in Florida, West Virginia, Ohio, Minnesota and Washington State that have been canceled or postponed. The piece continued with even more evidence that questions the program's viability ...
Two important conclusions must be drawn from this evidence. First, we see no reduction in the volume of coal used to generate power in the foreseeable future. It is also clear that a truly viable CO2 reducing solution needs to present itself ASAP. Green laws sprouting up across the E.U. and the U.S. will require a change.
Electricity demand in western states continues to rise. Power distributors are desperate to keep up with demand. Add to the mix strict environmental laws and you are looking at a world of hurt for the Western United States.
INVESTING IN WASTE MANAGEMENT
Another promotional piece from a Penny Stock Sleuth writer, on an industry worth tracking ... but not always worth owning. Suffice it to say that we thing the case made is a bit overstated for the waste management industry. Waste Management, Inc. was one of the original great growth-by-consolidation stories, but it has had its ups and downs since reaching maturity. Like all such stories, when they reach a slower growth middle age they stop being "one decision stocks" and require more discrimination about buy-in points.
In a world full of lawyers, brokers, accountants and any other white-collar profession you can think of, we sometimes forget about the miners, brick makers and garbage men. ...
You probably hear it once a week ... The sound of a diesel engine, the loud reverse beeps, and the crash of a dumpster being unloaded on to the back of the massive garbage truck. That is the sound of you cashing in. The waste management industry here in the U.S. is a $50 billion-per-year operation. We throw away over 200 million tons of solid waste every year, or 4.4 pounds per person per day. That is a lot of trash, and it costs a lot of money to get rid of it.
Now with gas prices hitting new highs weekly, many waste collection companies are now implementing fuel surcharges. The costs are passed on to you. But waste collection alone is not necessarily the best place to put your money. You see, even they are paying more. Gas prices are not the only cost going up.
There are fewer and fewer places to put all this trash. So even with a recent surge of recycling, if you own a landfill, you are probably making a killing. It costs waste removal companies anywhere from $45 to $125 per ton to unload it at a landfill. That works out to between $27 to $75 per cubic yard of airspace. That is an awful lot for a cubic yard of air just to store your trash, but waste removal companies have to pay it.
Another "The world is running out of X" story.
Today, we have the one company that can take advantage of these high prices. But before we get into to that, there is an important reason why you should invest in garbage now ...
As you have heard again and again, during recessions, people stop spending money when it is not absolutely necessary. But no matter how bad this year turns out to be for many stocks, waste management companies will still get theirs.
Just look in your kitchen cabinets right now. We are sure you have tons of cereal boxes, soup cans, and plenty more packages of this and that. All of it will soon be trash. Everyone's kitchen looks like that. No matter how depressed the housing situation gets or how low the stock market may go, we still go through a bunch of trash.
Let's take a look at the last major recession and what happened to the industry leader, Waste Management, Inc. (WMI): [see chart]. Between 1990 and the first half of 1991, the market fell flat. But as you can see, Waste Management, Inc., which was similar to the size of our company today, took off. Investors recorded 800% profits, while everyone else in the market got crushed.
So even if we head into recession, waste management is still the place to be ...
Perhaps a place to be ...
STARBUCKS, THE “CORE,” AND CONVENTIONAL MORTGAGES
The fancy coffee chain’s problems are emblematic of the deep problems facing the U.S. economy.
Doug Nolan summarizes the fundamental problem facing the U.S. economy, as personified by Starbucks's announced plans to close 600 stores: There has been far too much investment ("malinvestment," as the Austrian economists call it) in the consumer sector and far too little in the capital sector. The retrenchment in the former is sure to be wrenching. If it were just a matter of investors writing down the value of their investments in consumer-related and consumer-driven enterprises that would be bad enough. But the highly leveraged and intertwined nature of the whole debt structure means that cascading defaults are inevitable. This is the first system-wide threat of this nature and magnitude since the 1930s. Good luck to us all.
This week's [ending July 4] announcement that Starbucks plans to close 600 stores and fire 12,000 employees is emblematic of the major restructuring that lies ahead for the deeply maladjusted U.S. bubble economy. Throughout the real economy, businesses that had previously luxuriated in robust profits during the credit and asset inflation-induced boom now see earnings and cash-flows rapidly erode. During the boom, Starbucks aggressively spent on capital expenditures, while expanding its employee base, product offerings, and real estate commitments. "Money" was easy, revenues were easy, and growth was easy.
For the economy overall, the enormous expansion of mortgage (and other) credit poured spending power throughout, especially in the "services" sectors. This purchasing power was "multiplied" by additional borrowings by the likes of Starbucks and others, as well as by the real estate developers borrowing, building and leasing space to tens of thousands of coffee shops, retailers, restaurants, hotels, casinos, nail salons, health clubs and such. It amounted to a historic borrowing and "investment" boom in building out a massive consumption/services-based infrastructure. Now, with the credit bubble having burst, the economic viability of broad swaths of this economic structure is in question.
Many of us have been scratching our heads for years over the expansion of retail space in the United States -- actual and virtual -- since the early 1980s. We will finally see just how much overinvestment in that sector there has been.
Years of credit, asset price, and consumption-based investment inflation created a deeply ill-structured real economy. Simplistically, the U.S. bubble economy was structured for a particular variety of inflation. As long as Wall Street could inflate mortgage and other asset-based credit, along with real estate and stock prices, additional purchasing power would be created and distributed for spending throughout the economy. Sufficient business and government cash flows ensured adequate household income growth to go along with booming -- and self-reinforcing -- asset price gains. As such, Household Net Worth (asset values less liabilities) swelled by about $4.0 trillion annually for the finale bubble years 2003-2006.
And as the "world's reserve currency," our credit system was able to generate endless new (and mostly top-rated) financial claims that so easily financed our import buying binge. Meanwhile, with business profits generated with such ease in the booming finance, consumption and asset sectors of our economy, the U.S. and global credit booms worked deleteriously to hollow out our nation's manufacturing base. But what difference did it really make if the economy's "output" were goods or services?
For years, we have protested this combination of over-investment in consumption-based infrastructure and the hollowing of manufacturing capacity. And for the longest time, most have scoffed at our analysis and pointed to the rising stock market and generally inflating asset prices as indicators of the efficiency, productivity, and profitability of the so-called New Economy. We warned of the eventual perils of over-borrowing and the lack of household savings, while Alan Greenspan and others argued that it did not matter because we had become so efficient at investing our limited savings. Besides, the world would always seek the superior quality and liquidity of our securities markets.
Yet the optimists failed to recognize that only massive -- and increasing -- amounts of system credit would sustain the inflated boom-time asset prices, household incomes, corporate cash flows, and government receipts that had become essential for levitating the various facets of the bubble economy. The deteriorating quality associated with the massive inflation of our financial claims should have been obvious. And today -- as symbolized by Starbucks -- the required credit stimulus is no longer forthcoming, leaving scores of enterprises throughout the economy attempting desperate measures to cut expenses and maintain viability.
The finance, automotive and airline industries are also notable for having come to rely on a very different inflationary environment than the one we face these days. And today's unfolding retrenchment will place only further downward pressure on business profits, household incomes, asset prices, and government receipts -- forcing additional spending restraint and deeper retrenchment. At the same time, this self-reinforcing retrenchment will create only greater financial strain on an already impaired credit apparatus, ensuring even greater credit troubles and tighter financial conditions, especially for the business sector.
And to attempt a response to the above question: What difference did it really make that our economy's "output" was services rather than goods? It made a huge difference. At the end of the day -- at the conclusion of the credit boom -- a finance and consumption-based economy is left with enormous financial claims backed by woefully inadequate wealth creating assets. During the boom, Starbucks could earn seemingly endless profits by selling $4 lattes. The stock price went to the moon; financial wealth was abounding. Now, with discretionary spending being sharply reduced by the confluence of sinking asset prices, tightened credit, and inflating energy and food prices, the enterprise value of Starbucks and scores of other businesses has been greatly diminished. Worse yet, for the economy overall, there is little in the way of real economic value remaining for billions of "output" Starbucks and other services providers created over the long boom. Only the financial obligations (the original asset-based borrowings) remain, while the market is increasingly suspect of their true state of underlying quality and value.
And the harsh reality is that Starbucks is a microcosm of scores of enterprises that have come to comprise the Core of the U.S. Bubble economy. The economic viability of so many businesses -- and even industries -- will be in jeopardy in the unfolding credit and financial landscape. The stock market is still in the early stage of discounting the unfolding credit and economic bust. And I will reiterate that we expect the unfolding economic adjustment to be of such a magnitude as to be classified as an economic depression as opposed to a more typical recession.
June 27 -- Bloomberg (Simon Kennedy):
"U.S. and European central bankers are intensifying pressure on counterparts in emerging-market countries to step up the fight against inflation. Federal Reserve Vice Chairman Donald Kohn yesterday urged countries where 'rapid' economic growth is elevating prices to respond. Hours earlier, Bank of England Governor Mervyn King said global monetary policy looks 'a little lax.' Bank of France Governor Christian Noyer said the day before that 'coordinated, resolute action' is needed to encourage more exchange-rate flexibility as a way of tackling inflation. The comments reflect concern among central banks in major industrialized economies that their own campaigns against inflation will be undermined by a failure of others to combat price pressures. Demand in emerging markets is already propelling the cost of commodities such as oil, tin and corn to records. 'The bulk of inflation is coming from emerging markets,' said Stuart Green, a global economist at HSBC ... 'The concern in developed economies is that inflation is rising because of pressures outside of their remit and that monetary policy overseas is too loose.'"
"The reasons for the trajectory and persistence of increases in prices of food and energy this year, as global growth has moderated, are not entirely clear. The upward trend in prices of food and energy over the past several years, however, importantly reflects the pressures posed by rapidly growing demand in developing economies against relatively inelastic global supplies of commodities." Fed Vice Chairman Donald Kohn, June 26, 2008.
"We are living through the unthinkable ... The list of casualties is very different. What has suffered most is the credibility of the most sophisticated financial systems in the world." Mohamed El-Erian, PIMCO Co-CEO, June 25, 2008
Now that inflation manifestations have shifted from asset prices to energy, food and general consumer prices, the finger pointing has begun. I am compelled to return to my old "Core" versus "Periphery" analysis. As Mr. El-Erian is suggesting, the "Core" of the global credit system is in the process of being discredited. [Pun apparently intended.] To be sure, the world is increasingly loath to accumulate additional "Core" risk assets. Especially in the case of dollar financial claims, this major devaluation and, increasingly, revulsion is tantamount to a major inflation in the pricing of energy, metals, food, and myriad resources that are in increasingly global short supply.
This supply shortage is related to at least two now powerful dynamics. First, there are the booming emerging economies at the "Periphery" -- booms largely fueled by unfettered credit systems and acute inflationary forces unleashed initially by runway credit excess at the "Core." And, second, there is today's acute speculative excess in almost anything energy and resource related. This is also a consequence of dysfunction at the Core, namely the massive U.S. current account deficits and resulting rapidly expanding global pool of speculative finance coupled with the discrediting of Wall Street Finance. There is today much too much global liquidity (running away from sophisticated financial instruments while) chasing too few global resources whose supply is not easily expanded ("inelastic").
I find it rather incredible that U.S. and European policymakers are increasingly pointing blame and calling upon their emerging economy cohorts to aggressively combat inflation. With the U.S. today stuck with intractable $700 billion current account deficits and European credit systems still churning out double-digit credit growth, the Periphery is not the root cause of today's escalating global inflationary pressures. The global credit system has run amuck, a process that evolved from years of credit and speculative excess generated by, and tolerated at, the Core. It is today unreasonable to expect the Chinese or Asians generally to bring their booming economies to their respective knees to fight global inflation anymore than we can expect the Fed to tighten the economic screws to the point of balancing our current account and punishing the destabilizing speculators.
Today's inflationary dynamics have been developing for decades. Only discipline and stability at the Core of the global financial system would have stemmed the strong inflationary bias of contemporary electronic fiat "money" and credit. But the Core was instead egregiously undisciplined and unstable, setting the stage for the type of runaway inflation we are now experiencing. The Core came to love and rationalize asset inflation and consumption. The Periphery was forced along for the ride and happy to oblige.
And now we find ourselves in the midst of another leg down with regard to the credibility of U.S. (and, increasingly, British) financial assets and economic structures overall. And while recent market tumult has not had the intensity of March's acute de-leveraging, the ramifications of recent developments are more problematic. For one, the markets are now coming to grips with the reality that much of the massive apparatus of various types of credit insurance is insolvent and has little chance of recovery. While the nature of these companies' obligations may not require bankruptcy filings in the near-term, the market nonetheless recognizes that much of the future protection guaranteed by these companies/financial players has become worthless.
The "monoline" insurers do not have the resources to fulfill their huge future obligations. The players behind the credit default swap (CDS) marketplace do not have the wherewithal to fulfill their unfolding obligations. And the mortgage insurers do not have the resources to pay their share of the rapidly escalating costs of a historic real estate bust. And if the mortgage insurers are indeed bust, the GSEs have a major dilemma. Not only do they have very large exposures to these firms, the entire "conventional" mortgage market is at great risk to any insurance-related dislocation. If much of the "private mortgage insurance" industry loses it capacity to write new policies -- or if this insurance is no longer trusted by the agencies or the marketplace -- this would be tantamount to a major tightening in the thus far bullet-proof "conventional" mortgage market. Or, said differently, if significant down payments come to be required for GSE-related mortgages the effects will be felt immediately in neighborhoods all across the country -- not to mention the acutely vulnerable consumption-based U.S. bubble economy.
THE MURDER OF U.S. MANUFACTURING
U.S. manufacturing was killed by a multitude of foolish short-term-profit motivated decisions by inept and overpaid U.S. management.
The Doug Noland analysis directly above gives us a kind of bird's-eye perspective on the decline of U.S. manufacturing: Grossly misconceived government policy encouraged current consumption and discouraged the capital reinvestment that any prosperous economy thrives on. (All the debt accumulation, financial engineering, etc. derives from this backdrop.)
As they say, markets make opinions. This Martin Hutchinson mid-June piece gives us a more micro-level view on the same issue. A generation of consultants and business theorist rose up to explain why everything that was happening should be happening, and why it would continue forever. By the time the later prediction was shown to be wrong it was awfully late in the day. Besides a huge credit mess to clean up, the U.S. has a manufacturing industry that is a pitiful shadow of its former self. GE's announcement that it is getting rid of its appliance division -- which originally was synonymous with GE itself -- is the latest in a line of such actions indicating such.
GE's announcement a week ago that it would accept offers for its appliances business marked the death-knell of yet another U.S. manufacturing business, one among so many in U.S. manufacturing's long and seemingly unstoppable downtrend since 1980. That decline may seem an inevitable historical trend, and Wall Street's analysts would claim that the U.S. economy can prosper just fine without it. Yet impartial analysts of the putrefying corpse of U.S. manufacturing capability are forced into an inescapable question: Did it die of natural causes or was it murdered?
For the last 30 years, Wall Street's insouciant attitude appears to have made sense. U.S. manufacturing has slowly declined, as operations have moved to lower-wage centers in the Third World. However the U.S. economy as a whole has continued to thrive, as financial services doubled its share of GDP and grew to provide 40% of the earnings on the Standard and Poor's 500 share index. Prosperity was heavily skewed towards the very rich, but the majority of Americans continued to enjoy a general, if halting improvement in living standards.
The collapse of the financial services bubble has however called into question three of Wall Street's most cherished beliefs about manufacturing:
The inevitability of manufacturing's decline is in some ways the most interesting question, which has not been addressed much elsewhere. Most large-scale events of this nature appear inevitable in retrospect, yet if examined in detail can be shown to have been triggered by a series of decisions that could have gone the other way.
- First, Wall Street believes that financial services and other services can take the place of manufacturing, and that the United States can remain a prosperous economy thereby.
- Second, it believes that manufacturing tangible products is an intrinsically low-skill and uninteresting operation, so that the U.S. would do much better to specialize in "symbol manipulation."
- Third, it believes that the decline in U.S. manufacturing was and is inevitable, so that decline would have happened whatever strategies management had adopted, and whatever resources and attention it had devoted to manufacturing activities.
Management decision-making like most human activities is a slave to fashion: Whichever guru has captured the attention of business academics and the business press at any given time is likely to have an inordinate influence on management decisions. In the 1920s through the 1950s, the production engineering of Frederick W. Taylor was fashionable, and the United States built the first mass-production economy. In the 1960s, MBA-credentialed top management was thought able to run anything, and so both conglomeration and strategy consulting came into fashion. From the early 1980s, it became received wisdom that all organizations could usefully be "downsized" and that the traditional corporate welfare protection of employees was wasteful. All these theories had their virtues. The reality, however, is that they cannot all be universally true since they are largely mutually incompatible.
In the 1970s the new and very fashionable Boston Consulting Group introduced the "strategy matrix" under which businesses were divided into stars, cows, dogs and question-marks, according to their growth prospects and profitability. Stars, the businesses with the highest growth prospects and profitability, were to be nurtured and given resources; dogs, of low profitability and low growth were to be closed down; and question-marks, of high growth but low profitability, were to be given modest resources to see whether they turned into stars or dogs. The whole operation was to be paid for by milking the "cows," those businesses of low growth but high profitability. Cows, as their name suggests would be denied capital investment, since such investment should not be wasted on low-growth situations. Instead their cash flow would be milked to provide capital investment for the stars and the more favored question-marks.
There were several problems with this mechanistic, clever-clever approach to business management. One was that the businesses' typology could not be identified accurately. Which businesses were treated as "stars" was more a matter of the business cycle and doubtless of office politics than of the long term underlying reality. A second, even more fundamental problem was this: Cows that are milked and not fed quickly turn into dogs. Businesses that are treated as not part of the company's glorious growing future quickly wither on the vine, as new opportunities in those business areas are missed. Their profitability starts to decline and quickly the cash flow that was their corporate raison d'être disappears.
When examined dispassionately in the light of posterity, it appears that far too many of these "cow" businesses were manufacturing operations which were milked for cash flow that was diverted into more fashionable businesses in the service sector, particularly in finance. Westinghouse, for example, one of the most important names in electric equipment until 1980, had split up and left manufacturing altogether by 2000. To be fair Westinghouse management had a good excuse. One of their leading and most successful businesses had been the construction of nuclear reactors, an activity that disappeared in the 1980s owing to political cowardice in the face of environmentalist harassment.
General Electric, however from 1981 to 2001 run by ultra-fashionable "Neutron Jack" Welch, epitomized the failings of the era. It under-invested in many of its manufacturing businesses, entered into a blizzard of divestitures designed to boost its short term earnings, played games with its pension accruals and built a gigantic financial services empire of low quality businesses in which it could never be a leader. It also ruthlessly eliminated its middle management and overpaid its top management -- winners in the corporate office political game. GE was a much admired operation in Welch's later years. It is less so now, and if the bloated global financial services business returns to a historically normal size may finally be seen to have been a disaster.
GE Appliances, GE's home appliance business dating back to 1907, the early years of electrification, was long dominant in the home appliance field. GE Chairman Jeff Immelt has now put GE Appliances on the sale block so that GE could focus on higher margin businesses. The business has attracted interest from China's Haier Group, but is expected to be less interesting to Korea's LG, because LG manufactures appliances of a higher price and quality. A commoditized and fairly uninteresting business, in other words, currently worth around $6.3-6.5 billion, little more than 2% of GE's $290 billion market capital.
However if you look back even to 1994, a medium year that was already well into GE's Welch-inspired transformation, appliances represented 10% of GE's sales and 8% of operating profit. In other words, the business has been steadily starved relative to GE's other businesses, and has turned itself from a "cow" into a "dog".
To see how this happened, think back to the 1950s. Electric appliances were the major growth business of that decade, symbolizing the decade's new affluence. Forecasters confidently predicted that by 2000 robot appliances would be in every household, removing the drudgery of housework once and for all. As a youthful reader of Isaac Asimov's robot stories I shared that confidence -- after all the computerization necessary for robot control systems, which had not existed in 1940, when Asimov wrote the first of his "I Robot" short stories, was already revolutionizing business management by the late 1950s.
Now it is not just 2000 but 2008. So where the hell are the robots? GE Appliances has no such offering. If you buy a GE vacuum cleaner you will still have do all the work yourself. Can it be that the technological optimism of the 1950s was misplaced, and that home robots will never exist, or will be invented only in the far distant future? You would certainly think so from looking at GE's catalog of products.
However it turns out that GE is simply behind the curve. The iRobot Corporation of Bedford Massachusetts, founded by keen Asimov readers from MIT in 1990, manufactures fully robotized vacuum cleaners as well as some pretty neat robotized mine-clearing equipment for the military. iRobot's standard model runs around $300, less in real terms than an ordinary vacuum cleaner would have cost you in 1980. iRobot's total sales are only $250 million, which GE would no doubt class as a rounding error, but dammit the company does not have GE's brand name or distribution network.
Had GE had the sense and innovative skill to develop robot vacuum cleaners, can anybody doubt that that product group's sales would today be several billion dollars, with appropriately high margins? It is thus clear that by starving GE Appliances of investment and, more important, of research dollars, and devoting the company's efforts to financial services, "Neutron Jack" and his cohorts have deprived the U.S. of a major new business and deprived us overworked consumers of a major labor-saving technology (unless we are lucky enough to find out about iRobot or its few small-company competitors). GE has commoditized its appliance business, forcing down prices by manufacturing in ever cheaper-labor parts of the world. Instead it should have been enriching that business, opening up new opportunities for products that could be sold at higher prices and higher margins and provide more value to the consumer.
The sad story of GE Appliances is a paradigm of what has gone wrong in the U.S. economy since 1980. No, manufacturing did not need to leave the United States. U.S. manufacturing was killed by a multitude of foolish short-term-profit motivated decisions by inept and overpaid U.S. management. The other questions can also be answered. Manufacturing is not intrinsically a low-skill and uninteresting operation, it involves skills at the highest possible level and can readily employ high-wage workers -- after all LG's workforce in South Korea are these days very far from being subsistence-level Third World proletariat. Finally, the U.S. cannot survive through financial services and tech startups alone. It needs to reinvest in manufacturing or it will find itself unable to support an advanced-economy living standard for the mass of its population.
Yes, Virginia, you could have had both robots and the Internet. The 1950s dream of an infinitely prosperous United States full of household robots and other high-tech wonders was not a fantasy, it was there for the taking. Only political and business incompetence prevented us from achieving it.
Well, OK, throwing in the "political" puts some of the blame back where it belongs. What Hutchinson fails to mention is that with all the funny money sloshing around the system, managements that wanted to act rationally with regard to the long-run profitability of their firms would end up being booted out by some takeover artist backed by said funny money. The micro followed the macro, even if the wholesale selling of souls was unseemly.
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