Wealth International, Limited (trustprofessionals.com) : Where There’s W.I.L., There’s A Way

W.I.L. Finance Digest for Week of December 8, 2008

This Week’s Entries : This week’s W.I.L. Offshore News Digest is here.


An interview with Barry Ritholtz: Getting ready for a “significant” rally.

Barron's interviews Barry Ritholtz, editor of The Big Picture blog. Ritholtz was bearish long before the market topped out, so that means he deserves a shot at calling the bottom. This he is unwilling to do as yet. He does note that whenever the stock market has become as oversold as it is currently a major rally has uniformly ensured. It is just that sometimes, e.g., after the 1929-30 rally, lower lows have then followed -- much lower, as we know, after the 1930 top.

For the past five years, Barry Ritholtz has been entertaining, educating and elucidating readers of his blog, The Big Picture. Among the noteworthy calls that the savvy lawyer and sometime-trader has made: identifying a credit bubble a few years ago, and a recommendation to short AIG back in February, when the share price was flirting with $80. It is now about $1.80.

Lately, the 47-year-old Ritholtz, with his business partner, Kevin Lane, has had a chance to put some of those ideas to work at FusionIQ, a firm that manages nearly $100 million in separate accounts. Amid the wholesale destruction on Wall Street, Fusion has produced single-digit gains on its long-short portfolios, and has kept the average losses on its long-only accounts to single digits. Ritholtz, whose book Bailout Nation is due early next year from McGraw-Hill, can be trusted to call ‘em as he sees ‘em. To find out what the contrarian is now warming up to, read on.

Barron’s: What is your global outlook?

Ritholtz: In 2006, I was probably the most bearish guy on the Street. Now at a table of industry people, I am the bullish guy. We have cut this market in half. That does not mean it cannot go lower. We are in a medium recession. If this turns into a deeper, more prolonged recession, all bets are off.

Are we are testing a real low here?

There is no doubt we are looking at an extremely oversold market. But by the end of the week, that oversold condition could be worked off. There is upside here for a trade. Over the past 100 years, we have only seen the relative strength of the S&P 500 drop to this level five times, and each time, it has been a major buying opportunity, although not necessarily a major bottom. If you look at 1929, it was a low but it was not the low, and there was a bounce. It was the same thing after September 11 -- from September 21, you had a 40% bounce in the Nasdaq before you went down to make all-time lows.

Will the market drift?

It is flapping up and down. There is a significant rally, 20% or 30%, waiting to happen. But there is also the possibility of a lower low, as we get deeper into the recession, if things take a terrible turn for the worse.

Whenever you are fragile, you do not have the ability to absorb that next blow. My fear is that some economic issue arises and you do not have the resiliency to deal with it. We are economically stretched very, very thin. Things seem to be getting healthier at an ungodly cost, one which we will be dealing with the unintended consequences of for decades. We are really at the fork in the road. Everybody on Wall Street is wondering if we are going to see a year-end rally of any substance, or, if we are heading down to 7100 on the Dow, or 850 on the Nasdaq. [On Friday, those indexes were at about 8200 and about 1430, respectively.]

What say you?

We are waiting for a couple more things to line up: Some clarity on earnings, which we will not have for a while, some sort of resolution on these bailouts, and some sign from the new administration that, unlike the outgoing group, we have a plan -- "Here is what we are going to do about credit, banks, the economy, GM." We would not be surprised to see earnings seriously damaged.

Wall Street is still way too high. They started out the year at earnings of $103 a share on the S&P 500 for 2008, which got them to 1600 on the index. We came in at $65 a share, and that may have been too bullish. The good news is that most of corporate America outside of the financial sector has healthy balance sheets, lots of cash, and is running very lean.

Except for the auto industry.

The auto industry is a whole other story. The auto industry is a story of terrible management, misguided unions, and government intervention.

What is your impression of the bank bailout?

[Treasury Secretary] Hank Paulson is really the imperfect messenger for this bailout. Remember that Paulson is one of the five executives who went to the SEC in 2004 to beg, "Please, let us lever up more. Please let us go to [a leverage ratio of] 30 or 40." It is bad enough that he helped create the crisis. It appears that this whole response is completely ad hoc.

Do you see any guiding principle?

It is, how do you give money to banks who need capital and not say, "By the way, you are cutting your dividend." What is happening instead is they are saying, "Here is money: Give it out as dividends and bonuses." It is unbelievable. There is no clawback. It is unconscionable.

So, what does it take to invest in this kind of world? How do you stay out of trouble?

Always have a stop-loss.

We have a number of internal rules. The most important is that we always have a stop-loss. When the trade is working out, we use trailing stop-loss, meaning that the higher the stock goes, the higher the stop-loss. When the market starts heading south, we get taken out. We screen for short squeezes, and we have found that they are very often present at the beginning of a major move up.

We back-tested [price/earnings ratios] and found they have no forecasting ability. Whenever people do an analysis of a stock, the tendency is to create a snapshot at a given moment. We try to build a moving picture of a stock. For instance, if you know you are in an all-time peak in home sales, and the Fed is in a tightening regime, why own a stock in a homebuilder?

The builders have been pretty beaten down, though.

We are not even close to the bottom in housing.

I have been the biggest bear on housing on the Street for four years now. Housing is halfway through. We are not even close to the bottom in housing. The stocks were always cheap, so it is not a valuation question.

Given the uncertainty in the market at large, what appeals to you right now?

We have been trading the two-to-one leveraged [exchange-traded funds].

One is the Ultra S&P ProShares [ticker: SSO] -- for every dollar the Standard & Poor's 500 moves, it moves two dollars. And there is also Ultra Triple Q ProShares [QLD], the Nasdaq 100-version of the SSO. The flip of the QLDs are the QIDs, which are the negative two-for-ones on the Nasdaq. We are starting to look at that. We are now running about 70% cash, which is inordinately high, but some of the names we are watching, and have owned in the past, are NuVasive [NUVA], a medical-device company, Stanley Works [SWK], a great infrastructure story, LG Display [LPL] and Luminex [LMNX]. Industries we like are infrastructure, defense, biotech and medical devices.

Why ETFs?

We are normally bottom-up stockpickers. But when we are looking at all these individual stocks and war-game them, we end up saying there is this risk and that risk. Here is an example: JPMorgan [JPM] is probably the best house in a bad neighborhood. It had a nice run, then it pulled back. Do we want to own JP Morgan? What is the risk? They have already acquired Bear Stearns. They have to be looking at Goldman Sachs. They have to be looking at putting the house of Morgan back together. If that happens, what happens to the stock price of JPMorgan? You could lose 15%, 20% overnight. Every time we look at individual stocks, we end up with that analysis.

Some of the financials are starting to look attractive.

We spent a lot of the year running a good chunk of cash. Some of that is discipline; a lot of that is staying away from things that are really trouble. The trade that caused so much trouble for people -- long financials -- we are at the point where some of the financials are starting to look attractive.

Would you give us a name?

Citigroup [C] at $5. The interesting thing about Citigroup is that if there is anything that is legitimately too big to fail, Citigroup is it. If you think the consumer and retail sector are having a hard time, imagine if Citigroup were allowed to go belly-up. People would hunker down in their homes and stop buying all but the necessities.

I did not really buy that Bear Stearns was too big to fail, although there was the argument that they could take JPMorgan down. Citibank is one of those things that cannot be allowed to go belly-up. It is enormous. It is the equivalent of AIG.

What else do you like?

We like infrastructure, plays like Stanley Works, and we expect there will be some stimulus to build ports, bridges, and expand the electrical grid. Defense is another sector we like, though it is less so of the Boeings and more of the specialty-defense names, like AeroVironment [AVAV], which makes small, pilotless drones.

There is a list of interesting biotech and medical-devices companies, which are insulated from the economic cycle. We just bought Cubist Pharmaceuticals [CBST], which addresses the anti-infective market. In the same way the Internet bubble gave rise to Web 2.0, Facebook and blogs, the Genentechs of the world and all the developments that took place throughout the 1990s have led to the current new wave of specialized therapeutics. Over the next 10 years, we are going to see a universe of breakthroughs based on the previous 20 years' work. The first order of business on January 20 [presidential-inauguration day] is allowing stem-cell research, and that is going to lead to a number of significant breakthroughs. Medical devices and gene therapies are ripe areas. The problem is, they are very volatile and very speculative, and not necessarily safe for the ordinary household.

What stocks are you shorting?

We have been short Jefferies & Co. [JEF] for a while. They are similar to the various asset gatherers: In this environment, it becomes very challenging to hold on to key people. The best guess is, they are suffering along with the rest of the sector, only they do not have the strength or the size to do things that a Goldman Sachs or a Morgan Stanley or Wachovia can.

What about gold?

Gold is really quite interesting here, as are the gold miners.

Gold is really quite interesting here, as are the gold miners. We own no gold now, and we own no gold mines, but we are watching them. The question is, at what point does this deflationary cycle roll over to the point where things start to get better?

We were among the loudest inflation hawks for the past few years. When oil was $147 a barrel the joke was, which was going to hit $6 a gallon first, premium gasoline or skim milk?

In March, we said we are through the worst part of the inflation cycle and now we should see deflation as the economy starts to roll over. And that is pretty much playing out. The bugaboo with all that is you just had the Fed triple its balance sheet. The Bernanke printing presses are running full speed. That ultimately has to hurt the U.S. dollar. It ultimately has to be inflationary.

Has gold bottomed?

I do not know where gold bottoms. We recommended gold for the first time in 2002 or 2003. It was strictly an inflation trade, thanks to Greenspan. And then when the GLD gold ETF first came out, we recommended that. Gold has a date with $1,500 somewhere in the future [up from $763 an ounce now], but whether it makes that move from 700 or from 400, I have no idea. You just cannot print that much paper and debase the currency and not see some sort of reaction.

Anything else look interesting?

We always tell people when things are really good you have to make emergency plans. You know, the time to read that card on the seatback in front of you is not when the plane is heading down. When things are really awful like they are now, that is when you start making your wish list. I have never owned Berkshire Hathaway [BRK], but if it was cheap enough I would buy it.

A level, please?

$85,000 to $95,000 [versus $98,000 recently].

Where else might you be deploying some of that cash?

One client said to me, "I am tired of hearing bad news. I do not care what it is, what can you tell me that is good?" I told him to make a list of things he has wanted to own, but has been afraid to buy or unable to because of the cost. I do not care if it is art, trophy properties, vacation homes, collectible automobiles or boats. Figure out what you are willing to pay, and I can all but guarantee you that by the time we are done with this deflationary cycle, many of those objects will be available at your price. I would not be surprised if, when everything is said and done, a lot of these things are off by 50% or worse.

Thanks, Barry.


When the S&P 500’s dividend yield topped that on Treasurys for the first time since 1958, where were the headlines?

Ken Fisher has been loudly and incorrectly bullish this whole year, finally demonstrating that he is fallible. Today, consistently, he is more bullish than ever, and the stocks he recommends are admittedly compellingly cheap. As for his observation that the S&P dividend yield exceeds the of Treasuries for the first time in 50 years, we are not big buyers of the idea this means anything special. First off, maybe it is just a return to the way things were back in more sensible days. Second, Treasuries are the latest asset bubble. Their yields are unsustainably low. Nor is the S&P's yield particularly high, using absolute historical yields as a yardstick.

The economy is receding, but not as fast as the media tell you, with their headlines about layoffs and store closings. This combination of facts is bullish. I was far too bullish, however, in my September 29 column. It referred to this period as a reverse bubble, where only the bad in everything is noticed. Indeed, the bad has been noticed -- and incorporated into stock prices and credit default prices. Between that column's publication on September 10 and when this one went to bed on November 25, the MSCI World Index fell 31.5%.

The bearish headlines have gotten bolder, and the panic has gotten worse (notwithstanding the late-November rebound). So I am even more bullish now. Stocks are an even better buy. The S&P 500 is going for 12 times earnings (after nonrecurring items) for the 12 months ending October 31. This at a time when 10-year Treasurys yield only 3.08%.

On November 14 the headlines screamed, "October Retail Sales Down -- Worst Ever Recorded." Stocks buckled. But virtually no one noticed that the "recording" had started only in 1992. Since then we have had just one recession. The same reporting failed to mention anywhere that October sales, excluding autos, gasoline and building materials, which everyone already knew about, were down only 0.5%, which was hardly remarkable.

Simply nowhere in the mass media have I seen it reported how strong 3rd-quarter earnings were. Roughly 2/3 of firms reported higher earnings through November 25. Also, 2/3 reported earnings stronger than analysts' latest expectations. Yet we only heard about the laggards. Excluding financials, 67% of companies reported earnings better than the year before, and 68% exceeded expectations.

On Oct. 13 the S&P 500's dividend yield was 3.74%. That means it exceeded the yield on the 10-year Treasury note for the first time since 1958. Did you see a headline about that?

Business inventories are at record lows for the start of a recession, and that fact should make the recession milder. These times will pass. Because stocks are so cheap, a big bull market will emerge. I do not know when. Depending on your willingness to take risk, you could own bigger, safer stocks or smaller, riskier ones. The riskier ones are likely to bounce more in the bull market. Here are five stocks, a mix of blue chips and speculations.

The Swiss firm Logitech(13, LOGI) is a small but leading company in PC peripherals like mice, trackballs, keyboards, Web cams, headsets and network music systems -- with particular clout in cordless devices. Consumers will spend heavily on connectivity as we exit the recession. For the fiscal year ending next March 30, profits should be up 5%. The stock is down 65% this year, leaving it at eight times 2008 earnings and one times revenue.

Cisco Systems (15, CSCO) is bigger and safer. Who would think you could buy the world's leading supplier of data-networking equipment and software for 10 times 2009 earnings? When the rally comes, Cisco should participate fully.

Even safer, Britain's GlaxoSmithkline (34, GSK) is cheaper than competitors like Johnson & Johnson, Pfizer and Roche, with a price less than two times revenue and a dividend yield of 6%. It is also less than 10 times this year's earnings. That is too cheap for the world's 2nd-largest drug and vaccine maker -- and easy to be patient with.

The tougher times are, the more folks talk. Especially in France. France Telecom (26, FTE) is no growth play, but it is very cheap, and France overall is doing better than the rest of Europe right now. With half the cell phone market in France and material exposure in Britain, Spain and Poland -- a span of 112 million subscribers -- this company should do well as a hedge if you fear my optimism is wrong. At 9 times 2008 and 9 times 2009 earnings, one times revenue and with a dividend that yields 10% (albeit at some risk of a cut), this stock sells at a price only a pessimist can justify.

Book publisher John Wiley & Sons (30, JW.A) is small, with sales of $1.7 billion, but low in risk, well managed and consistently growing. Its revenues derive from a portfolio of established books in scientific, technical, medical and finance fields. The company is selling for 10 times its likely earnings in the fiscal year that ends next April. Historically, its forward price/earnings ratio has been more like double that number. I have a bias, since Wiley publishes my books. You would have a hard time making the case that it is a weak company.


Steve Hanke's always provocative Forbes column appears only sporadically. In a favorite past column he noted the futility of devaluing a currency to reduce trade deficits, for the very good reason that it is a logical impossibility given the accounting identity that the deficit must equal borrowings from foreign sources. Thus, you cannot reduce the trade deficit without increasing the domestic savings rate. Right now the issue of loss of U.S. jobs due to imports has temporarily been overwealmed by larger events. Expect it to return sooner or later.

Hanke does not believe the current deflationary environment will last anywhere nearly as long as the 5 years the inflation-protected U.S. T-Notes are evidently forecasting. He evidently doubts it will last a year, given the Fed's "money pump" overdrive. Most of this current column consists of an interesting cataloging of history's most virulent hyperinflationary episodes.

In October the Producer Price Index sank 2.8%, its biggest 1-month drop since the Labor Department began measuring it in 1947. At the same time, the Consumer Price Index fell by 1%. It is no surprise that everyone in the U.S. is talking about deflation. Indeed, the bond market is pricing in deflation. The fact that the yield on 5-year Treasurys with no inflation adjustment is 2% while that on 5-year Treasury inflation-protected securities is 2.4% implies that the bond market expects annual average inflation to be a negative 0.4%.

That is an objective, market-based forecast, but I think it is wrong. Yes, the deleveraging of the economy has set loose deflationary forces. However, the Fed has put the money pump into overdrive, and it is hard to see any way in which deflation could be a headline-grabber for many more months, let alone five years. U.S. Treasury-indexed securities remain a buy.

Deflation is not on everyone's mind, however. Zimbabwe's suffering citizens are caught up in the 21st century's first hyperinflation. In March 2007 Zimbabwe's inflation rate passed 50% a month, a good threshold for defining "hyperinflation" and equal to 12,875% a year. Since then, it has gotten much worse.

The cause of the hyperinflation is a government that forces the Reserve Bank of Zimbabwe to print money. The government finances its spending by issuing debt that the RBZ must purchase with new Zimbabwe dollars. The bank also produces jobs, at the expense of every Zimbabwean who uses money. Between 2001 and 2007 its staff grew by 120%, from 618 to 1,360 employees, the largest increase in any central bank in the world. Still, the bank does not produce accurate, timely data.

The last official inflation statistics, for July, are hopelessly outdated. Money-supply data are even worse; the most recent figures are for January 2008 -- ancient history.

In the absence of good official numbers, I have developed my own hyperinflation index for Zimbabwe. I derive it from market-based price data starting in January 2007. The index tells us that Zimbabwe's annual inflation rate recently peaked at 80 billion percent a month. That means around 6.5 quindecillion novemdecillion percent a year -- or 65 followed by 107 zeros. To get a handle on it, realize that it is equivalent to inflation of 98% a day. Prices double every 24.7 hours. Shops have simply stopped accepting Zimbabwean dollars.

Where does this place Zimbabwe in the hyperinflation record books? Episodes of true hyperinflation are rare. They occur only when the money supply has been fed by an unconstrained printing press. No hyperinflation has ever been recorded when money was based on or convertible into a commodity. The first hyperinflation happened during the French Revolution. There were 28 other hyperinflations before Zimbabwe's, all in the 20th century.

The U.S. has had none of them. It came closest during the Revolutionary War, when it churned out Continental currency to pay the bills. The peak monthly inflation rate then was 47.4%, in November 1779. During the Civil War greenbacks were printed to finance the fighting, and inflation peaked in March 1864 at a monthly rate of 40%.

The accompanying table [see article] shows the six alltime worst hyperinflations. The famous German episode was only the 4th-most virulent. It was not even close to the Yugoslav experience under Slobodan Milosevic. Mugabe's mess now tops Yugoslavia's, and if it continues to grow at its current rate, it will overtake Hungary's world record in little more than a month.

Many think this will be the blow that finally topples Mugabe's 28-year dictatorship. Do not count on it. Yugoslavia's hyperinflation peaked in January 1994, but Yugoslavs suffered for 7 more years of high inflation until Milosevic reluctantly conceded defeat after the September 2000 elections. Bet on seeing Mugabe stick around for a while yet, unless old age (he is 84) or assassination gets him. Also bet on a return to at least mild inflation for the U.S.


The terrified flight from equities has given stocks a great margin of safety versus bonds.

Regular Forbes columist and mutual fund manager John Rogers is your basic and classic value investor. He looks for stocks selling at a discount to his estimate of their intrinsic, or private market, values. Our main issue with his past recommendations is that his stocks have been selling at too small discounts to their intrinsic value estimates to warrant being buys. We took this as an indication that there was little value to be had in the market at the time, and we appreciate that no matter how skeptical Rogers may have been, an equities money manager -- unlike an individual -- cannot expect to get away with going into a 50%+ cash position.

As one would expect, stingy discounts are no longer an issue. Some of the discounts calculated by Rogers here for very good companies are astonishing, assuming his subjective calculation judgements are reasonable.

We do disagree with one of of Rogers's lines of reasoning put forth here. He finds the S&P 500 earnings yield compelling at 8% versus the 10-year T-Bond yields of 4%. However: (1) You want to use long-term earnings power for stocks in this calculation, not trailing or always inaccurate forward forecast earnings. (2) T-Bonds are in a bubble and those yields are riding for a reverse-fall. This is paradoxically an example of the kind of relative value reasoning that often hurts value investors, where they figure if you cannot find anything absolutely cheap then at least buy stuff that looks good by comparison to everything else -- which is overvalued and thus serves as a poor yardstick. E.g., look no further than the "cheap" financial stocks many value investors were buying last year. To paraphrase Peter Lynch, if a value investor spends 15 minutes a year figuring whether the overall market is cheap, that is probably 10 minutes too many.

I am bullish. That might surprise you if you recall my writing in January that "we may be seeing a return of the slow, agonizing periods we saw in the 1970s." But as the market has changed -- and not exactly slowly -- my perspective has changed, too. The Standard & Poor's 500 fell 39% between January 28, the date of that column, and November 21. There came to be almost universal agreement that the global economy is in big trouble. Panic set in. That is when I see opportunity.

Warren Buffett, who is buying right now, advises us to be greedy when others are fearful and fearful when others are greedy. Is that simple-minded? No, it is just a recognition of the fact that the crowd can become irrational, producing valuations that anyone not caught up in the frenzy can see are too high or too low.

Between January 1, 1973 and September 30, 1974 the S&P fell 43% (all our returns include dividends). At the end of the period the index was trading at 7 times trailing earnings, less than half the historical average of 16. Three-month and 10-year Treasurys were both yielding 8%. You buy bonds to get the yield and stocks to get the earnings. At the time, $100 worth of bonds would get you $8 in yield; $100 of the S&P would get you $14 in earnings. So stocks were obviously better. Had you invested $100 in them at that point, you would have wound up after 10 years with $368 (including dividends), equivalent to a 16% annualized return.

Then there was 1987, when the S&P lost 20% on just one day, Oct. 19. By the end of that year the index was trading at 14 times trailing earnings (after nonrecurring charges), for an earnings yield of 7%. Three-month Treasurys yielded 5.8% and ten-year ones 9%. You weren’t getting the urgent buy signal of late 1974. Still, if you plunged into stocks in December 1987, you built $100 into $469 in ten years, a 19% annualized return.

Where are we today? As of October 31 the S&P was trading at 12 times trailing earnings, while 3-month Treasurys are yielding 0.4% and 10-year ones 4%. A stock portfolio thus yields earnings of 8%, double what you get on the T bond. Because people have become very risk averse, many think that is not a sufficient margin of safety, but it surely is to me.

Maybe you have been convinced by the doomsayers that the economy is as bad as it was in the 1930s. I am not. People are projecting their worst fears far into the future even though regulators and governments around the world have united in an unprecedented way to end the credit crisis. Americans have shown that they believe the new President, Barack Obama, will be able to handle the economic trouble. That will lift spirits around the country and the world and ultimately prompt a far more optimistic outlook.

I have looked through my portfolios to find a few attractive holdings with P/Es that jump out, and I will start with Nordstrom (8, JWN), a purchase I made recently. Two clouds hang over the company: The question of the long-term viability of department stores and the weakness in consumer spending. However, Nordstrom's well-heeled shoppers believe strongly in its brand and top-notch customer service. It may have a few tough quarters ahead, but they will not permanently impair its business. I think a share will earn $2 in the fiscal year ending January 31, 2010 and you can buy it for four times that amount. Nordstrom is now trading at a 79% discount [!] to my estimate of its intrinsic value.

Anixter International (24, AXE), a long-term holding of mine, has been beaten down badly in the last few months. It is the world's biggest distributor of cable, wire and fasteners. It has a better, smoother delivery system than anybody else and great economies of scale. As you would expect in a slowing global economy, its business dropped late in the third quarter, even though the vast majority of its work is maintenance-related, and Wall Street hammered it for missing the quarter. Its forward P/E is 4.6. I believe its long-term worth is $52.

Finally there is Jones Lang LaSalle (21, JLL), a global real estate services firm. Part of its business is transactional, representing owners or occupiers when they lease, buy or sell commercial real estate. With these transactions drying up, the crowd has panic-sold the stock, based on just one side of the business. Surely that crisis will end. Meanwhile, the firm also manages commercial real estate and runs real estate investment portfolios, both with steadier, fee-based income streams. The market has knocked down JLL to a forward P/E of 4.4 and a 77% discount to the $92 that I think it is worth.


Media stocks have gotten crushed lately but have a history of snapping back early in a recovery. Finding likely winners means tossing out traditional measures of value.

Another must-read entry in the Forbes "Beyond the Balance Sheet" series. Newspapers were once canonical "Warren Buffet stocks," with their high free cash flows and the protected market positions of their underlying businesses. Then came the internet and everything changed, to coin a phrase. Semi-monopolies no more, they can still be decent businesses if well run. You just have to buy the stocks with eyes open. Other combinations of increased competition and industry maturity have effected cable, mobile communications, internet, and other print companies as well.

The number of media stock valuation techniques we have seen approximates the number of media stocks. Widely varying balance sheet characteristics, operating margins, cash flows, and whatnot have made standard earnings multiple comparisons pretty much useless. Enterprise value (usually market value of equity plus book value of debt less cash) per subscriber, or per "eyeball" with internet companies, has had its consistent proponents, but this article makes it clear that that can conceal as much as it reveals. Instead it compares a variety of valuation approach results across the media industry for the different subsectors. A must-read for anyone interested in fundamental value analysis, not just media stocks.

As the stock prices and earnings of many industries have collapsed this year, it has become next to impossible, using traditional measures, to separate the good long-term values from the bad.

Nowhere is that more the case than in the media business. Many of the industry's stocks have retreated to levels last seen a decade and a half ago; the broader market rout has wiped away merely a half-decade of gains. Making media stocks even more enticing: a record of bouncing back early in economic recoveries.

In this edition of Beyond the Balance Sheet, Forbes presents media-specific metrics to cut through the fog and offer a glimpse of possible long-term winners. [Accompanying set of tables here.]

In publishing, for example, News Corp. and Meredith support $1.50 and $1.63 of debt, respectively, for each dollar of operating earnings (EBITDA). But Meredith (fiscal 2008 revenue: $1.3 billion) has only $13 of debt per reader, versus $865 for News Corp. (For debt, we add in unfunded pension obligations and prorate the result for publishing's share of company revenues.) Some of this discrepancy can be explained away by the fact that News Corp., a newspaper publisher, puts more pages per month in front of its readers than Meredith, a magazine publisher. But even allowing for that, Meredith is far less leveraged.

Analysts typically evaluate cable companies by cash flow from operations (roughly speaking, net profits plus depreciation plus other noncash charges, like deferred taxes). Tuna Amobi, a media analyst at Standard & Poor's, argues that a more telling measure is enterprise value per subscriber. Enterprise value is what it would cost you to own a business: market value of common, plus debt, minus cash.

There are several advantages to looking at price per subscriber. One is that it does not have the volatility of profit numbers. A recent Comcast report, for example, displayed a nice boost in cash flow, yet a quarter of it came from a lightened tax burden. Next, price per subscriber is the number that an acquirer of a cable system would put foremost. Finally, the price differences highlight cable operators with untapped potential in terms of upgraded services (or just jacked-up prices).

Cablevision looks like a bargain at 3.2 times cash flow, a 21% discount to the industry's 4.0 average. But at an enterprise value of $5,000 per subscriber, Cablevision shares look pricey. To put it another way: This cow is already being milked.

At 6.6 times cash flow, DirecTV's multiple is twice Cablevision's. But DirecTV sells for less than 1/3 Cablevision's enterprise value per subscriber. True, satellite providers usually lag cable rivals in services like local channels. But at a 50% price-per-subscriber discount to peers, DirecTV looks cheap.

Valuations based on earnings or sales can be especially misleading with Internet firms. The high growth rates they enjoy early on, and which analysts tend to project into the future, can drop off suddenly. Yahoo looks cheap at 2 times sales, versus Google at 4.4. But Google is better at converting revenue into profits (net margin 24%, versus 13% for Yahoo) and also better at converting visits into revenue. Google derives $1.85 in sales from each unique visitor annually, versus Yahoo's 91 cents.

For those interested in media's plentiful high-yield debt, Charter Communications' April 2009, CCC-rated notes look interesting—albeit speculative. They have a 10% coupon, trade at 89 cents to the dollar and carry a yield to maturity of 46%. Although the cable provider's stock has fallen from $5 to 19 cents over the last 18 months, JPMorgan Chase highlights in an investor note Charter's better-than-expected margin gain in the third quarter and growing subscriber base. Caveat: The bank reiterated a neutral rating on the shares. For more junk bond options, see the table.


Newspapers used to keep ad rates intact in a recession. Web ad rates are plunging and may never recover.

Years after the original dot-com boom went bust, a new round of internet entrepeneurs sought to build companies which made use of the greater functionality that more powerful computers, increased bandwidth, and evolving standards -- aka "Web 2.0" -- has provided. However fancy the interface of your latest and greatest website, however, as before and always the essence of the business model must be to convert page viewers into revenues and profits.

You can sell a service, which is often problematic with a public which has become accumstomed to lots and lots of freely-provided things on the Web. Or you can sell advertising space on your pages, a la the old television station model. Thus the ubiquitous and often insistent banner ads on so many Web pages. As with TV show ratings one can measure gross Web page/site viewers. Unlike with TV one can directly measure interest in the advertised product or service by counting the number of click-throughs and then, modulo some measurement slippage, the number of those who ultimately buy. With measurement comes accountability, which gets reflected in the bid price per viewer or click-through.

Banner advertising may be a bonanza for a particular site, but logically it is just advertising and thus competes with other outlets, and will be directly driven by the vibrancy of the consumer sector of the economy. The current feedback? Banner viewers are not worth as much as they used to be, having fallen 42% on average over the last two quarters by one measure. Read on for more details.

If you are an internet entrepreneur and think your superhot Web 2.0 company is going to become the next Google, or your Web media company a 21st-century Time Inc., here is a bit of advice inspired by recent headlines: Think twice. Literally.

Among the many dislocations of the current economy is the slowing of the growth in spending on Web advertising. While traffic is good and plenty of ads are being served up, the price of generic, run-of-the-site ads is falling.

PubMatic, which tracks online ad rates, reports that the price of a banner ad on an entertainment Web site fell from 57 cents per 1,000 viewers at the start of the year to 33 cents by October. That is a 42% decline in two quarters. Some categories fared better than others, but none showed an increase.

This is far different from what happened in earlier media downticks. Newspapers, for example, by and large kept their advertising rate cards intact during recessions, giving up revenue in the short term in order to preserve their pricing once the recovery came.

Perhaps rates for banner ads will improve at the end of the current downturn. But perhaps not. There is an awful lot of inventory. (Pay-per-click search ads are a slightly different story, but Google has a lock on most of them.)

That this will be a source of pain to many people should be obvious. The list starts with magazines and newspapers trying to supplement declining print revenue by moving to the Web. They have known for some time that an online reader is not worth as much as one from the print world. In a bad piece of alchemy, print dollars turn into digital dimes.

Also needing to rethink things are Web entrepreneurs. For all their lofty talk of connecting people, many Web companies are actually in the prosaic business of selling ads, especially social media companies like Facebook, Digg or Twitter that give away a core service for free. Their default strategy has always been to race to acquire eyeballs, which could be eventually monetized through ads. That supposition needs to get tossed with ad rates on a one-way trip to the basement. "It is a fallacy to say that just because a site has a lot of traffic, it will also be getting a lot of revenue," says David Hallerman, a senior analyst with Emarketer, a media research outfit.

A cautionary tale involves MySpace, which, according to Hitwise, gets 4% of all Web traffic. MySpace owner News Corp. [NWS] does not break out the numbers, but the unit that includes MySpace and other online divisions lost $101 million in the quarter that just ended, on revenue of $719 million. Even Gannett [GCI] does better than that.

So what about Google, where annual revenue is pushing $20 billion? Does that company not show that someone with a good idea will end up doing just fine? No, because Google had not one but two good ideas. First, it had a clever way to improve search by counting links into a site. Next, it hit on AdSense, its method for auctioning off the right to place ads next to relevant search results.

Which is where the "think twice" at the start of this comes in. You cannot just have a great idea that will gain a lot of users. Unless you are going to charge money for your service, you also need to attract advertisers in a way that is as tailored to your site or service as AdSense was to Google. Generic banner ads just will not do.

Facebook assumed that as a social network it could make money by letting customers know when their "friends" had bought something online and then charging advertisers. But when it switched the feature on this year, users revolted at being turned into human billboards, and Facebook backed down. The imputed $15 billion valuation of the site (based on Microsoft's nibble last year) looks too high now.

This is not to say that there are not ways that smart, elite Web sites can do well. Top-tier media properties have a special relationship with their readers that is worth something to advertisers. Federated Media, which handles ads for 150 sites, designed a special campaign for BMW that invited people to use a drawing application on Facebook to color in their cars. Some 9,000 Facebook members took part, and the campaign won accolades from Web media analysts. Still, efforts like that cannot be replicated at high volumes for little or no extra cost.

The moral is that you can still make money online, but it will be harder than you ever imagined.

An amusing article from Slate, "I Hate You, Blue-Tux-Wearing Viagra Guy!", details recent encounters with advertising on the Web.


On the dangers of confusing brains with a bull market.

In the 1960s conglomerate boom, managerial geniuses with more brains and fashion-cognizance than sense acquired companies hand over fist, on the theory that it would be a shame to let all those businesses soldier on without the benefit of their sage oversight. Their inflated stock prices, puffed up by easy credit, provided the currency for realizing their ambitions. Heavy use of debt was still frowned upon then. At this point let us note that these proto-financial engineers at least had pretensions, however ungrounded, of adding value to the operations of their acquisitions. The gut-and-run turnover artists and asset flippers would have to wait a good decade and a half to make their appearance.

Following the bust, financial engineering entered a bear market which lasted through the 1970s. Then in the 1980s LBO geniuses bought a lot of those conglomerates and did quite well divesting the underperforming parts, and selling the slimmed-down core back to the credulous public. The LBO boom was fueled by easy credit and a reinvigorated stock market, which was fueled by easy credit. The phrase "easy credit" keeps coming up. What a coincidence.

The 1980s, '90s, and 2000s featured credit growth rates that could have come from a McDonald's burger menu: big, large, and super-colossal. John Kenneth Galbraith observed that financial genius is leverage and a rising market. Circa 2006, 25 or so years of nonstop credit inflation had produced so many financial geniuses that there were hardly any financial peons left to lord it over. Sam Zell, enter center stage.

We actually saw Zell speak in the mid-1990s. He was salivating at the prospect of scooping up bargain-priced properties following the mini-property bust of the early 1990s. ("Mini" by today's standards that is, but still big enough to put the final nails in the coffin of the savings and loan industry.) It was clear that he thought pretty highly of himself, and that he was the restless sort. In practice, this is not a good combination when left to run on its own without adequate supervision. In Freud's schema: Too much id, not enough superego.

Zell's timing then was great. He made billions of dollars sticking to what he was good at: property "vulture" investing. In early 2007 he sold his collection high-end office buildings, Equity Office Properties, to the Blackstone Group -- a private equity company which had too much stupid money cash burning holes in its pockets. (The cash came courtesy of institutions, advised by consultants, who were mesmerized with idea that private equity was some "alternative asset class" that magically produced higher returns with lower risk -- a rich man's subprime mortgage portfolio.) The transaction looked like your classic "money moving from strong/smart hands into weak/dumb hands" at the top of a bull market. Indeed, the Zell's timing was as perfect as could be.

Truly smart money at this point would take a long breather and patiently bided its time waiting for bargains to reappear. Zell should have gone on vacation for a while, either on a meditation retreat or to some place that offers you a fair return on your entertainment dollar, like Monte Carlo. But Zell was too smart and restless for that. And therein lies another tale ...

What is the difference between Smart Money and Dumb Money? Twelve months, the popping of a credit bubble, and about $800 million.

In the run-up of asset prices, which ended about a year ago, everyone was a genius. Hedge-fund managers felt wise for borrowing large sums of money and buying stocks, commodities, or pretty much anything that went up. Private equity barons bought companies, issued debt to pay themselves dividends, and were hailed as master investors. Heck, even millions of homeowners felt like Einsteins for refinancing at lower rates. And hardly anyone was deemed smarter than Sam Zell.

The Chicago-based real estate investor, nicknamed the Grave Dancer for his delight in picking up dead businesses and reviving them, built Equity Office Properties, a collection of high-end office buildings. In February 2007, Zell was lauded as a genius for unloading the company in an all-cash transaction valued at about $38 billion (Blackstone put in $6.4 billion in cash and borrowed the rest), after a frenzied bidding process. But Zell was not content to take his winnings and stow them under the mattress. Having benefited from the dumb-money culture -- people willing to pay high prices for leveraged assets in the hope and expectation that they would be able to sell them to other debt-fueled buyers at even higher prices -- Zell loudly plunged right back into it. (Regular readers of this column should expect to hear more about the culture of dumb money -- I have got an electronic book about it in the works with the Free Press.) In December 2007, Zell closed on the $8.2 billion acquisition of the Tribune Co., putting in $315 million of his own money and borrowing much of the rest. Make no mistake about it, the Tribune Co. was a classic dumb-money play, and not just because its main assets were declining newspapers.

A big part of the dumb-money culture was the rising sense that hedge-fund managers, asset flippers, and financial engineers -- because they had made a lot of money from cheap credit -- could apply their genius to industries in which they had little expertise. Frequently, however, that strategy did not go much beyond financial engineering or selling assets -- which depended, in other words, on the plentiful availability of cheap credit and credulous buyers. If hedge-fund maestro Eddie Lampert could not remake Sears into an effective retailer, investors thought, he could at least bolster shareholder value by buying back shares or by selling the real estate underlying the stores. That has not quite worked out. Hedge-fund manager Dan Ackman set up a vehicle to amass a huge stake in retailer Target. His bright idea: Target should sell its stores and lease them back.

It was plain from the beginning that Zell did not have much of a strategy for reversing the revenue decline at the newspapers. And the failure to realize that a slowdown in real estate and autos -- the credit crunch had started a half year before the deal closed -- would reduce revenues sharply was an act of colossal stupidity on Zell's part and on the part of the bankers who made the era of dumb money possible. (Andrew Ross Sorkin has a good rundown of the fees earned by Citigroup, Merrill Lynch, and Morgan Stanley for their roles in this debacle.)

Zell loaded up the company with nearly $13 billion in debt, which required interest payments of nearly $500 million in the first half of 2008. The plan, such as it was, was to pay down debt not with operating cash but with asset sales. One problem: Most of the assets were themselves dumb-money assets -- trophy properties such as the Chicago Cubs, office buildings, and big-city newspapers that could not support a lot of debt on their own and whose purchase would require easy credit. In May 2008, Zell managed to sell Newsday to Cablevision for $650 million. In September, it sold a chunk of CareerBuilder.com for $135 million. In June, Tribune put the company's headquarters buildings in Chicago and Los Angeles on the market. So far, no takers. The hope to stay current on debt payments rested on selling the Chicago Cubs, perhaps the greatest Midwestern trophy property of all. But the credit crunch decimated the net worth of many of the potential buyers, and lenders fell by the wayside. Having failed to find any greater fools, Tribune filed for bankruptcy Tuesday (December 9).

A mistake analogous to the one of believing one's own public relations happens in bubbles. Smart people get lucky as well, and then believe it was all their doing. Humility is a virtue that is good to cultivate preemptively, otherwise it will cultivate you.

In all fairness we should point out that Zell was not that dumb. His $315 million equity stake in Tribune has gone to money heaven, but unless he has done something else imprudent we are not aware of his net worth is largely intact. He took most of his money off the table. We still say he would have gotten more entertainment value by blowing his $315 million in Monte Carlo.


The company has a cult-like following among value-oriented investors who like its investment style – and results.

Leucadia National's Ian Cumming and Joseph Steinberg have been effective as they are secretive. A conservative estimate of Leucadia's current book value of $14 a share contrasts with a split-adjusted value of 11 cents in 1979 -- an annual growth rate of over 18% even after the recent major hit from the markets' declines. (The historical annual growth rate calculation was 20% before the declines.) Notably, this was all done with minimal leverage. Cumming and Steinberg are sometimes compared with Buffett, but except for the minimal use of leverage Leucadia's investment style is quite different -- versus the pre-1990 Buffett, anyway. Leucadia's managers do not shy away from capital-intensive commodity operations, if they can get a stake cheaply enough.

The company's proponents note that the stock has rarely traded below book value in the past decade, more typically trading at 1.5 to 2 times book. So if you buy the stock at around book value you are, in theory, getting the exceptional investment acumen of Cumming and Steinberg for free. Another stock to add to the value investor's watch list, it looks like.

Leucadia National may be the closest thing to what Berkshire Hathaway was 20 years ago, before Berkshire became so large that Warren Buffett needed investments of several billion dollars to move the needle.

Run for 30 years by a secretive duo, Ian Cumming and Joseph Steinberg, Leucadia has invested in a wide variety of stocks and a diverse group of businesses. It has generated impressive returns and developed a cult-like following among value-oriented investors who like its investment style -- and results. Buffett is a fan of Leucadia, although Berkshire does not own the stock. Leucadia's book value, which stood at $23 a share on September 30, is up from just 11 cents in 1979, an annual growth rate of more than 20%.

Leucadia (ticker: LUK), however, has fallen 60% since Sept. 30, to about 17, leaving it way below its May peak of 57 and slashing its market value to $4.3 billion. Investors fear that Cumming, 68, and Steinberg, 64, have lost their touch, owing to declines in many of Leucadia's key equity holdings, including Australian iron-ore producer Fortescue Metals Group (FMG.Australia), securities firm Jefferies (JEF), Canada's Inmet Mining (IMN.Canada) and auto-finance outfit AmeriCredit (ACF).

Many of the company's other investments are suffering, including Cresud (CRESY), an Argentine agricultural and real-estate company, and Leucadia's 10% stake in a hedge fund run by William Ackman of Pershing Square that owns a single stock, retailer Target (TGT). Leucadia probably has lost half of the $200 million it put in the fund last year.

Fans argue that Leucadia is oversold, noting that it rarely has traded below book in the past decade and in recent years typically has commanded 1.5 to two times book. The stock could hit $30 in the next year if the company's equity holdings turn around and if Steinberg and Cumming take advantage of the current financial distress to display their old stock-picking magic. Says one Leucadia holder: "I don't think that they suddenly took stupid pills." Given market declines since Sept. 30, Leucadia's book value has now probably fallen closer to $20 a share.

Steinberg and Cumming, who could not be reached for comment, focus on minimizing Leucadia's tax bill. The company now has $1.6 billion of deferred tax assets, indicating that it expects to shield some $5 billion of future profits from federal income taxes. Strip out that tax asset to reflect no future gains, and estimated book falls to around $14 a share. "It is a worst-case assumption. You are not paying much above that for the stock," says a recent Leucadia investor.

Book value also may be understated because of conservative valuations for real estate and other assets the company owns, plus a potentially lucrative agreement with Fortescue that pays Leucadia 4% of net revenues from its Australian iron-ore mine for more than a decade. The deal could produce more than $100 million of annual profits for Leucadia, assuming ore prices do not collapse.

Leucadia's operating businesses, including plastics, wood products, pre-paid phone cards, as well as a Napa Valley winery and the Hard Rock Hotel & Casino in Biloxi, Mississippi, do not generate much profit. Investors tend to value the company on book value, rather than earnings, because most of its worth lies in investments.

Leucadia also has invested about $100 million for an 87% stake in a medical start-up called Sangart, which is developing a blood substitute now in clinical trials. There have been many failures in this field, but Leucadia hopes that Sangart's product, Hemospan, is a winner.

Many holders simply view Leucadia as a play on Cumming and Steinberg's investment acumen. Both intend to stay on the job for a while; their employment contracts run into 2015. Some Leucadia watchers believe the company will be liquidated or sold when Cumming and Steinberg leave the scene.

Like Buffett, Cumming and Steinberg believe in a strong balance sheet. As of September 30, Leucadia's $8.4 billion in assets significantly exceeded its $2.6 billion in debt and other liabilities. Leucadia had about $500 million of cash and equivalents on 9-30, down from $1.4 billion on December 31. Dividends certainly are not a drain on its cash. This year, there will be none. Last year, the payout was only 25 cents a share.

Unlike Berkshire, Leucadia lacks significant operating businesses. Its focus tends to be on more speculative companies. It has paid $405 million for 32 million shares -- a 28% stake -- in AmeriCredit, which provides auto loans to those with weak credit. Reflecting a tough economy and tightness in the credit markets, AmeriCredit shares are 40% below Leucadia's cost.

Cumming, Leucadia's chairman, and Steinberg, its president, may be the lowest-profile leaders of any sizable public company. Outside of their annual shareholder letter and appearance at the annual meeting, they stay out of public view. There are no earnings conference calls, no investor presentations and no financial guidance. There are no photographs of Cumming or Steinberg in the annual report. Hardly any analysts cover the company because of its complexity and minimal communications.

Leucadia invested in Fortescue in 2006, when founder and CEO Andrew Forrest needed money to build a giant mine in a remote area that would compete with Australian iron-ore titans Rio Tinto and BHP Billiton to supply the voracious Chinese steel industry. Leucadia, which initially invested $400 million, now owns 9.9% of Fortescue. The miner's shares got as high as A$13.15 in May, at the height of the commodity boom, making Leucadia's stake worth $3 billion and pushing up Leucadia stock. Since then, Fortescue has slid to A$2.50 still more than double Leucadia's cost.

Leucadia also has a close relationship with investment firm Jefferies, reflecting in part Steinberg's friendship with CEO Rich Handler. Last year, Leucadia took a 50% stake in Jefferies junk-bond trading unit, in return for $350 million, even though securities firms rarely sell outsiders parts of their trading operations. This year, Leucadia has accumulated a 30% stake -- 48.6 million shares -- in Jefferies itself, at an average cost of $16. But the stock has dropped to around 10, less than 80% of book value.

Jefferies is not immune to Wall Street's troubles -- it laid off about 10% of its staff last week -- but its losses have been relatively modest because it does not take big trading positions. Still, its high-yield trading business has lost more than $80 million this year. Jefferies, a scrappy niche firm, focuses on equity trading and junk bonds, as well as investment banking.

Jefferies is given as a short selection of Barry Ritholtz, in the interview above.

Leucadia now looks like an attractive play on its depressed investments and on the ability of Cumming and Steinberg to find new opportunities. Unless the pair has indeed taken "stupid pills," investors could do well taking a ride with them.


It’s the economy.

No one can have failed to have observed that the younger generation does not treat old-style land-line telephones as a necessity. OTOH ("on the other hand," for those not versed in text message-speak), take away their cell phone and you may as well have removed an arm. Now the older generations are joining the trend. As budgets tighten, people are finding the mobile phone is the necessity and the old-fashioned phone line is a convenience that can be done without.

Those of us who have called the local electric utility many times over the years to report a power outage appreciate the robustness of the land-line network. Vonage and Skype's services are routed through your internet broadband router/modem. No electricity, no service. Your mobile phone's battery cannot be recharged without power. Personally, we will keep at a minimum our basic land-line phone service.

It is not exactly insightful to point out that young people do not feel the need to have old-fashioned telephones, the kind that are tethered to a house via a wire and provided by a descendant of the original AT&T. This week, when I conducted an informal survey of summer interns and the under-30 set in the offices of both Slate and Newsweek, inquiring whether they had telephones in their sorority houses and shared urban rentals, I was greeted with doleful, patronizing, silly-old-man smiles. The few who did have home phones used Skype. One had a phone at home that was part of a triple-play offering from the local cable company. "Nobody uses it." Adults are finding that they do not need the lines in anywhere near the numbers they used to -- and it cannot be chalked up simply to instant messing displacing phone conversations and cell phones displacing housebound phones. The economy is playing its part, too.

At first, as this massive FCC report shows (see the charge on Page 29 of the PDF), the rise of the Internet and the telecommunications revolution of the 1990s was a boon to the wired-phone industry. In the mid-to-late-1990s, even as the number of wireless subscribers exploded (Page 232), the number of access lines provided by incumbent local exchange carriers rose at a rate greater than that of the overall economy, with the number of lines rising nearly 24% from 142.4 million in 1992 to 186.6 million in 1999. Growth was driven in part by millions of people hooking up faxes and adding dedicated lines so that they could dial up to AOL. (Yes, kids, that is how we used to do it in the dark ages.)

Since 2000, however, it has been a different story. Wireless has continued to boom, up from 109.5 million subscribers in December 2000 to 233 million in December 2006, but the number of land lines has fallen somewhere between 4% and 6% in every year since 2000. The result: The number of incumbent local exchange carriers' access lines in 2006 was back down to 140 million, about the same level as in 1991 and off about 1/4 from the 2000 peak. The growth and convenience of wireless have played a role, and so, too, have the rise in broadband Internet access and the availability of phone service from cable companies and outfits such as Vonage and Skype.

But in the past year, a new and unexpected woe has been crushing the land-line business: the economy. In the past, a few quarters of slow growth would not have meant really bad news for basic telephony subscribers. The telephone at home has long been a utility, not a discretionary item. (This FCC telephone subscribership report [PDF] shows that the percentage of homes with telephone service has held remarkably steady in recent decades.) But in this first real slowdown of the wireless age, consumers seem to be saying that home-based telephones are expendable luxuries, like Starbucks lattes or Coach handbags. And it makes sense. Confronted with high inflation, soaring energy costs, and stagnant wages, millions of households are facing choices about which monthly bills to pay and which commitments to maintain. And if it comes down to one or the other, the mobile or the home-based land line, it is clear which is a necessity and which is an option. One lets you make telephone calls only from your house. The other lets you make telephone calls from anywhere, send e-mails, surf the Internet, play music, and take photographs.

Another feature of today's economic climate favors wireless over land-lines: the real estate mess. According to RealtyTrac, foreclosures are booming. In the first half of 2008, there were 1.4 million foreclosures. The company is projecting at least 2 million foreclosures for 2008. When people under financial duress move out of their homes, they are likely to disconnect the land line and find some temporary arrangement (a rental, staying with friends or relatives), which makes it unlikely they will acquire a new land line. What is more, the number of vacant homes is at a record (about 3 million), and none of them needs a land line.

And so this year, the rate of decline of land lines has accelerated sharply. AT&T, which provides wired service in 22 states, just reported its second-quarter results. The wireless sector (72.9 million subscribers) continued to grow, adding 1.3 million net subscribers in the quarter. But revenues in the land-line voice services were down 7.8% from the first quarter of 2007. The information on the number of consumer lines is tough to find. But if you look on Page 25 of the 2007 annual report (PDF), you will see that the number of retail consumer lines fell from 37.12 million in 2006 to 35.05 million in 2007, off 5.6%. In the first quarter of 2008, according to AT&T's 10-Q, the company lost another 870,000 consumer land-line subscribers, or another 2.5%.

The author's analysis of Verizon's financial reports showed similar rates of decline.

At this rate of decline, within a few years the push-button wired telephone with service provided by a Bell company could be as rare and obsolete as a rotary phone is today.


Lest anyone doubt that Fed chairman Ben Bernanke intends to print until he drops, Gary North analyzes Bernanke's playbook and finds exactly that play as option A ... with no option B to speak of. As with all conventional academics, Bernanke has bought into the interpretation of Milton Friedman and Anna Schwartz given in their 1963 tome A Monetary History of the United States: The Federal Reserve's failure to add enough liquidity to the banking system led to all the problems.

Murray Rothbard's interpretation was that excessive liquidity courtesy of the Fed from 1924 to 1929 created the boom that busted in 1929. After that is was basically the government's efforts to avoid the pain which prolonged the misery. Had Bernanke studied Murray Rothbard's 1963 book, he might have had a very different career, North notes: "Perhaps teaching in a community college in North Dakota." Fighting the academic equivalent of city hall is not the way to career success.

In the National Football League, a marginal player dreads the request that he report to the coach and bring his playbook. He figures he is going to be cut from the team. The coach makes sure the playbook does not leave with the player.

A coach's playbook has a series of self-contained plays. Their importance is not based on their sequence in the book. They are implemented by the coach in specific situations. They may not work in any given game. If they do not, the team loses the game.

Alan Greenspan never had a playbook, as far as we know. His famous Fedspeak was designed, not to conceal the plays from investors, but rather to conceal the fact that he had no playbook.

Ben Bernanke is different from Greenspan. He has a playbook. He has spent his career studying Milton Friedman's now-dominant 1963 interpretation of the failure of Federal Reserve Policy, 1930–33, in not reversing the Great Depression. The FED did not inflate, Friedman said. This was in contrast to Murray Rothbard's 1963 interpretation of the same era. He argued that the FED did inflate, 1924–29, which created the boom that busted in 1929. Had Bernanke studied Murray Rothbard's 1963 book on Federal Reserve policy as the cause of the Great Depression, he might have had a very different career, perhaps teaching in a community college in North Dakota.

He is not fluent in Fedspeak. Who is? So, he has a different strategy. Lay it out in deadly dull Profspeak. Add footnotes. Deliver the speech to the National Economists Club, an association of men and women who have mastered Profspeak. No problem.

But there was a problem. Bernanke stole one of Friedman's analogies. Friedman did not lecture in Profspeak. He was so confident that he was right, all the time, that he spoke in plain English. He dared anyone to challenge him. Few people did. I did it only once. It was always a high-risk procedure.

The analogy Bernanke stole was the analogy of a helicopter dropping paper money. Bernanke said in his speech that this was a famous analogy. But it was not famous outside of academia. Bernanke's speech gave it currency (as punster David Gordon would say). Here is what Bernanke said.
Even if households decided not to increase consumption but instead rebalanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.
Am I exaggerating? Hardly. Bernanke gave this speech on November 21, 2002. On November 8, he had given a different speech at a conference at the University of Chicago to honor Friedman on his 90th birthday. As always he delivered an academic speech: a long, tedious summary of Friedman's 1963 book, A Monetary History of the United States, which is most famous for its section on the Great Depression. (Poor Milton. What a birthday present!) Here is what Bernanke -- along with the entire guild of academic economists -- derived from that book.
... the central bank of the world's economically most important nation in 1929 was essentially leaderless and lacking in expertise. This situation led to decisions, or nondecisions, which might well not have occurred under either better leadership or a more centralized institutional structure. And associated with these decisions, we observe a massive collapse of money, prices, and output.

What was lacking? Leadership! Also, a more centralized institutional structure. Does this sound like Friedman? You bet it does. On central banking, Friedman was a conventional fiat money economist, a defender of the banking cartel. No gold coin standard for him!

Bernanke ended his speech Happy Birthday with this:

Regarding the Great Depression. You are right, we did it. We are very sorry. But thanks to you, we won't do it again.
You bet they won't!

What can you bet? Your economic future. Ladies and gentlemen, place your bets!

The playbook is buried deep in his November 21 speech, "Deflation: Making Sure 'It' Doesn't Happen Here." The speech began with a statement of fact.
Since World War II, inflation -- the apparently inexorable rise in the prices of goods and services -- has been the bane of central bankers.
He then lists the explanations for inflation offered by economists. One of them is accurate: "an 'inflation bias' in the policies of central banks." It was hidden in plain sight.

This is always Bernanke's strategy: hide the needle of truth in a haystack of academic qualifications, verbal hedging, and footnotes. He is not fluent in Fedspeak. His strategy works just as well.

He states as fact what clearly is not factual.
... during the 1980s and 1990s most industrial-country central banks were able to cage, if not entirely tame, the inflation dragon.
The inflation calculator of the Bureau of Labor Statistics indicates that goods costing $1,000 in 1980 would have cost over $2,000 in 1999. The cage was way too large for my taste.
Although a number of factors converged to make this happy outcome possible, an essential element was the heightened understanding by central bankers and, equally as important, by political leaders and the public at large of the very high costs of allowing the economy to stray too far from price stability.
Over the next four years -- maybe longer -- these words will come to haunt Dr. Bernanke.

Then he moved from a discussion of inflation (rising prices) to deflation (falling prices).
With inflation rates now quite low in the United States, however, some have expressed concern that we may soon face a new problem – the danger of deflation, or falling prices.
This in retrospect is strange. Who was worrying about deflation in 2002? From the day he became Chairman until the day he left office, Greenspan had warned publicly against inflation. Then the FED inflated. Why this shift? Was Bernanke trying to shift the debate to the opposite issue? No. He was heading it off at the pass.

He began with the definition of inflation common to all schools of economic opinion except the Austrian School: rising prices. Inflation is the opposite of deflation. Here is how he defines deflation: "Deflation is defined as a general decline in prices, with emphasis on the word "general."

He does not define inflation as a rise in the money supply, with the effect being rising prices. To define it this way would identify the source of rising prices: The central bank and the fractional reserve commercial banking system.

Bernanke then identified unnamed sources. He also pulled off one of the greatest slight-of-tongue routines in academic history.
The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand -- a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.
Did you spot it? It is here: "side effect." Falling prices are a side effect. A side effect of what? Falling aggregate demand. What causes falling aggregate demand? He never said.

Here is where long, tedious speeches perform public relations miracles. They put listeners to sleep. That is their purpose.

He then moved in near-prophetic fashion to the American economy in late 2008.
However, a deflationary recession may differ in one respect from "normal" recessions in which the inflation rate is at least modestly positive: Deflation of sufficient magnitude may result in the nominal interest rate declining to zero or very close to zero. Once the nominal interest rate is at zero, no further downward adjustment in the rate can occur, since lenders generally will not accept a negative nominal interest rate when it is possible instead to hold cash. At this point, the nominal interest rate is said to have hit the "zero bound."
It is widely believed today that the FED will reduce the federal funds rate to zero within the next few months -- maybe sooner. Ever since October 29, it has been 1%, down from 1.5%. So, what happens when the rate is zero bound? Will banks stop lending to each other overnight?


Then will they stop lending? No. Banks will not stop lending until they stop taking deposits. Every time a bank takes a deposit, it is announcing: "This deposit will be lent at a higher interest rate than we are paying." Banks are not in the charity business.

The day your local bank stops taking deposits, you should start to worry about the Great Depression 2 we hear so much about. You should start taking currency out of the ATM.
To take what might seem like an extreme example (though in fact it occurred in the United States in the early 1930s), suppose that deflation is proceeding at a clip of 10% per year. Then someone who borrows for a year at a nominal interest rate of zero actually faces a 10% real cost of funds, as the loan must be repaid in dollars whose purchasing power is 10% greater than that of the dollars borrowed originally. In a period of sufficiently severe deflation, the real cost of borrowing becomes prohibitive.
The cost of borrowing became prohibitive. Really? The U.S. government had no trouble in the 1930's getting investors to lend it money at rates well under 1%. So does today's U.S. government. No problem!

Will banks lend to private businesses? Maybe not. That is the real problem we face today: the siphoning off of capital by the U.S. government. Economists call this the crowding-out effect. Most of them deny that it exists. Let us see, if a dollar is invested in T-bills, it is not invested in business. But that is not crowding out. No, no, no. It is something else. What, exactly? They never say, just as Bernanke never says what causes falling aggregate demand.
Although deflation and the zero bound on nominal interest rates create a significant problem for those seeking to borrow, they impose an even greater burden on households and firms that had accumulated substantial debt before the onset of the deflation. This burden arises because, even if debtors are able to refinance their existing obligations at low nominal interest rates, with prices falling they must still repay the principal in dollars of increasing (perhaps rapidly increasing) real value.
What? Dollars increasing in real value? What is this? Americans have seen this only once since 1937: in 1955.
The financial distress of debtors can, in turn, increase the fragility of the nation's financial system -- for example, by leading to a rapid increase in the share of bank loans that are delinquent or in default.
This is beginning to sound remarkable prescient. Did Bernanke see what was coming? Did he finally grasp the Austrian School's monetary theory of the business cycle? After all, the FedFunds rate was 1% when he delivered this speech.
Closer to home, massive financial problems, including defaults, bankruptcies, and bank failures, were endemic in America's worst encounter with deflation, in the years 1930–33 -- a period in which (as I mentioned) the U.S. price level fell about 10 percent per year.
True. This was why, in 1934, the government created the Federal Deposit Insurance Corporation. This is why banks are not allowed to go bankrupt. Bankrupt banks shrink the money supply. Taken-over banks do not.
Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has "run out of ammunition" -- that is, it no longer has the power to expand aggregate demand and hence economic activity.
"Run out of ammunition." Where have I heard that before? There is a familiar ring to it.
It is true that once the policy rate has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory. The central bank's inability to use its traditional methods may complicate the policymaking process and introduce uncertainty in the size and timing of the economy's response to policy actions. Hence I agree that the situation is one to be avoided if possible.
We are now almost there. Two more meetings of the Federal Open Market Committee, and we will be there. Then what? The playbook tells all.

Bernanke's playbook is governed by Friedman's prescription: Do not inflate more than 2% to 3% per year unless there is a depression on the horizon, and then inflate without limit until the crisis goes away. Bernanke followed this playbook from his inauguration on February 1, 2006 until the fall of 2008, when events began to look ominously like 1929. He is now using pages from the section on "hail Mary" plays.
However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. As I will discuss, a central bank, either alone or in cooperation with other parts of the government, retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero.
The central bank can take steps to inflate, despite a FedFunds rate of zero.
As I have already emphasized, deflation is generally the result of low and falling aggregate demand. The basic prescription for preventing deflation is therefore straightforward, at least in principle: Use monetary and fiscal policy as needed to support aggregate spending, in a manner as nearly consistent as possible with full utilization of economic resources and low and stable inflation.
This is being done today. The U.S. government has officially increased the debt by $700 billion (plus $150 billion of pork). The FED has increased its balance sheet by a trillion dollars. The government has taken over Fannie Mae and Freddy Mac loans totaling close to $5 trillion. Congress did not vote on this.

There will be plenty of opportunities for the FED to inflate its way out of this. Why must it do this? Because Prof. Irving Fisher said to.
Irving Fisher (1933) was perhaps the first economist to emphasize the potential connections between violent financial crises, which lead to "fire sales" of assets and falling asset prices, with general declines in aggregate demand and the price level. A healthy, well capitalized banking system and smoothly functioning capital markets are an important line of defense against deflationary shocks. The Fed should and does use its regulatory and supervisory powers to ensure that the financial system will remain resilient if financial conditions change rapidly.

Fisher was the first modern macroeconomist. He was the inventor of today's definitions of inflation and deflation. By 1933, he was bankrupt, having run through his own fortune -- he had invented the Rolodex -- and his wife's sister's fortune. He had announced in September 1929 that the stock market was not going to fall. He was wrong.

Irving Fisher is the patron saint of central bank policy in the same way that John Maynard Keynes is the patron saint of modern deficit fiscal policy. Fisher was wrong in 1911, wrong in 1933, and wrong today. Yet he is the most influential economist of our day ... still. This is why we are in big trouble.

What is in store for America? Monetary inflation on a scale not seen since World War aaaaaII.
As I have mentioned, some observers have concluded that when the central bank's policy rate falls to zero -- its practical minimum -- monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken. Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero. ...

What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
Then Bernanke gave us two of his key plays from his playbook. Nobody paid any attention. They pay attention now.
To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system -- for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities.
I therefore suggest that you take him seriously.
If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.
He was only halfway through his speech at this point. But you get the idea. He ended with his now-famous words:
A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.
He ended his speech with these words: Nevertheless, I hope to have persuaded you that the Federal Reserve and other economic policymakers would be far from helpless in the face of deflation, even should the federal funds rate hit its zero bound.

We are now reaching the point of the helicopter drop. If the FED does not reverse its policy of buying bad debt with new money -- high-powered money, as Friedman called it -- we will get mass inflation before the next Presidential election.

Bernanke told us what he would do. Over the last six months, the FED has done it.

It will do more. Worse.


Formula for surviving a bear market: Stick to companies with histories of strong sales and earnings growth.

This year has been humbling for many a turn-of-the-century mutual fund superstar. After beating the market for years on end, iconic stock pickers like William Miller of Legg Mason Value Trust and Mason Hawkins of Longleaf Partners have been catching falling knives.

Not William Frels of the Mairs & Power Growth fund. While the 40% loss his $1.6 billion (assets) fund suffered through November 20 is nothing to retire on, it is a far sight less ugly than the S&P 500's 48% plunge over the same period (Miller is down 65% and Hawkins 61%). Over the nine years Frels has run his fund, it has returned 3.3% annually after fees (currently a modest 0.68%) versus -6% for the S&P 500.

The Frels formula is simple. He shuns initial public offerings, turnarounds, foreign stocks and cyclicals, like airlines and railways. He focuses on large companies whose sales and profits are growing faster than the economy and that boast what he sees as a solid chance of posting more of the same. Then he waits until he can buy them at a price/earnings ratio that is low relative to his estimate of the company's growth prospects over the coming three to five years. ...

Frels likes to invest in enterprises whose managers he has met face-to-face. He holds only around 45 stocks and turns over a mere 5% of them a year. That is 1/18 the industry average. Frels' fund has owned Minneapolis-headquartered Target since shortly after the retailer went public in the early 1960s (and was known as Dayton's).

The article concludes with a table consisting of blue chips or quasi-blue chips such as Johnson & Johnson (they do not come much bluer than that) and Donaldson.

Mutual Life Insurance Companies: Stodgy and Proud of It

Stock options were supposed to align company managers' interests with those of the shareholders. It has not worked out that way, unless hidden dilution and going all out to hit a short-term share price target is what shareholders had in mind. We suspect that managements ethically inclined to orient their actions to serve the shareholders do not need additional prodding in the form of options, while options give those not so inclined another tool with which to feather their nests.

Like non-option issuing corporations, mutual life insurance companies were supposed anachronisms. The idea promoted by Wall Street was to convert to corporate form, giving policy holders shares to replace their ownership beneficial interests, and then let the miracle of being public take its course. Except that in a credit mania that too did not work out so well. The public life insurers joined their fellow financial companies and bet their surpluses, and some of their reserves that were supposed to pay off claims as well, in a typical panoply of dodgy credit instruments.

A result, which surprises even us, is the publicly traded insurers are joining the bailout begging line, while not one mutually owned rivals has asked for anything. Distance from Wall Street and prudence evidently go together.

Mutual Life insurers are stuck in the mud. If you have pizzazz, you work for a stockholder-owned insurer. That was the refrain from stock insurers a few decades ago.

Without the shareholders' lash to whip them into shape and stock with which to buy rivals, policyholder-owned insurers were sure to get crushed by publicly traded rivals. So went the argument, and so began a flight from mutual ownership that included such stalwarts as Equitable, Prudential and Metropolitan.

Who's sneering now? The mutuals that refused to switch over. The stocks of publicly held life insurers have fallen 63% this year. They had a little too much pizzazz, in the form of corporate bonds, mortgage securities and risky bets on annuities.

With their survival on the line, publicly traded insurers are scrambling for cash by cutting dividends and issuing new shares (diluting existing investors), begging regulators for a relaxation of capital requirements and lobbying Washington for a cut of the $700 billion Wall Street bailout.

Their mutually owned rivals have not asked for a dime. Their statutory surpluses (the regulatory counterpart to book value) have held steady or even increased. Some are announcing plans to pay out near-record dividends to policyholders.

"We're Main Street. Not Wall Street," brags an ad from mutually owned New York Life.

It is a sign of the times that this slogan would be considered, let alone used.

Forbes Collectors Guide 2008

Typically electic and entertaining set of articles in this year's guide.

Cuckoo for Cocoa?

We usually pay little attention to the soft commodities like orange juice and cocoa, as intriguing as their stories sometimes may be. Cocoa has lately resisted the commodities carnage, rallying 18% off its lows before giving back some of the gains. We do mean "carnage." Crude oil is down near $40 a barrel, and corn is under $3 a bushel for the first time in two years. Copper is below $1.50 a pound. We suspect even the most fervent commodities bubble believers of last summer did not see these sized corrections in their crystal balls. We will have to check in soon for what Jim Rogers is saying.

Through December 1, ICE Futures U.S. cocoa had rallied 17.8% from November lows, as exports fell by nearly 50% on harvest delays in top producer Ivory Coast. The rally then melted a bit on estimates of eventual higher output, mixed with a recession that's chipping at demand. (ICE cocoa is sensitive to U.S. dollar direction, as a cheaper British pound will shift buying to the London futures market.)

By Friday [December 5], the futures had given back some gains as the U.S. dollar firmed. March futures settled at $2,141 a metric ton, or 6.7% lower on the week. However, the contract held above the $2,100 support level, underpinned by supply constraints and a threat of dry winds from the Sahara that could reach crop regions. If consumer markets do not turn bitter, March cocoa futures could rise to $2,400 or $2,500, says James Cordier, president of Liberty Trading in Tampa.

Where cocoa goes from here, analysts say, depends a lot on equities' direction, the U.S. dollar, and Ivory Coast crop development. ...

Bears see continued pressure from weaker overall commodities and equities markets pressing cocoa down to the $1,700 to $1,750 level, especially if the delayed crop is large, says Judy Ganes-Chase, president of J. Ganes Consulting ... Declining equities could soften demand as chocoholics reassess their every purchase. "There are very few times when cocoa demand actually falls year to year, but this could be one of them," Ganes notes. Chocolate manufacturers will not buy beans if prices are high and demand is bleak, she adds. They might not have a choice. ...