Friday, April 27, 2007

Economic Worries and Marathon Running

It is easy to take a dim view of equity markets when we read today's economic report showing US GDP slowing to a lethargic 1.3% pace for the first quarter, well below the expectations of most economists at 1.7%.

It's a good time to remind people of what I view as truism, the economy per se has nothing to do with the stock market, the biggest factor is what price you pay and what level of profitability you are attaching yourself to. You will find I refer to this truism quite frequently, most recently here.

It's easy to get bogged down in the noise, to get spooked by the media's fear-mongering. or news creation Sub-prime mortgage failures prompt curiosity much like rubber-necking a car accident. For the individuals or families, they represent a financial train-wreck and a horrible event. In aggregate however, even with one quarter of last year's originations being sub-prime, and even with defaults potentially hitting 20% rates, we are still looking at only 5% of mortgages that are afflicted. It is also easy to forget about the number of homes that are actually owned "free and clear" a figure that encompasses most of the baby boom generation.

As a value investor, I have little regard or time for most economic forecasts. Avoiding trouble (aka preserving capital) is first and foremost on my agenda. Some of my friends are far better at developing an aggregate stock market view. Let me cite a couple of them that I recommend highly. They have been kind enough to allow me to write occasional guest commentary for them.

Henry To of views markets as somewhat overbought, but remains bullish on a market that remains well-supported by private equity buyouts and insider buying as well as numerous other factors that he provides his faithful subscribers.

Another friend, David Korn of remains bullish as well citing bullish insiders, as well as a host of evidence from sentiment indicators. I recommend both of these subscriptions as ways to improve your financial acumen from writers who are far better equipped than I to provide aggregate viewpoints.

Elsewhere in the blogosphere, I have found Interactive Investor Blog's recent post to be quite interesting.Q In a well-balanced post that cites bears such as Barry Ritholz in "The wall of worry now looks like the Great Wall of China " he also cites the very optimistic Ken Fisher, the Forbes columnist, money manager, and yes, Forbes 400 list.

Fisher's optimism is predicated on the spread between earnings yield and government bond yields in markets around the world. In what sounds like a physics argument relating to potential energy, he writes:

" At the beginning of the year the forward earnings yield was 2% higher than the 10 year government bond yield in the US and over 3% in the UK, France, Germany and Japan, yet over long periods the spread between the two has been close to zero. The theory is that when one asset pays more than another, money will flow to it and prices will rise."

Fisher continues,

“This is the beginning of a process that no-one has ever seen before,” says Ken, “In the past, when the earnings yield has been above the bond yield it’s either been in a single country… Or it happened for a very short time. This is the first time in modern history when the earnings yield has been above the bond yield all around the world.”

I am not sure that I am quite this optimistic. Nevertheless, I find it very odd that corporate balance sheets in general have failed to adequately respond to continued low rate opportunities. In a recent screen of S&P 500 non-financial names that I did, fully 30% of the companies had cash plus cash equivalents in excess of total debt. A year ago, the result was similar at about one-third. Looking at all North American companies covered by Reuters, there were 4,334 companies that passed this very far from robust screen. Financial leverage is only appropriate for companies that generate returns on investment above the cost of debt and can do so through cyclical ebbs and flows. Like the fellow who has discovered a hammer and thinks the world is covered in nails, financial engineering by blindly buying back stock willy-nilly can be a prescription for disaster.

Bottom-line, don't let economic aggregate numbers influence your investment thinking. The upside to any turbulence created by such releases is that fear or conversely, bravado creates opportunities.

In looking back at a week of earnings releases, (and remember it is only looking forward that makes you money) I am gratified by results at companies we hold such as 3M (MMM), Aetna (AET) , Harman (HAR), NCR (NCR), National Instruments (NATI), Microsoft (MSFT).

What a strange hodgepodge of businesses, you may think, but several characteristics define attention to return on invested capital, a discipline in running the franchise, and a return of capital to the shareholder.

Some years ago, I trained and completed the New York marathon. Though distance running is portrayed as being very solitary, successful training was easiest when you ran with a partner. The same is true for successful investing. Don't let the short-term economic stats worry you, find yourself some decent businesses to partner with for the long run.

Disclaimer: Either I, my family, or clients own a current position in the securities mentioned in this post.


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