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August 21, 2007

Future Shock

So much for being worried about inflation.

Two days after St. Louis Federal Reserve President William Pools said "there is no need for the Federal Reserve, unless there is some sort of calamity taking place, to make a decision before the next meeting," the Fed dramatically and unexpectedly lowered the rate at which it lends money to institutions by 50 basis points to the cheers of stock lovers everywhere. In kind, the Dow rocketed 233.3 points on Friday and NASDAQ was up 2.2%. Positive to be sure, but not nearly as powerful as the 5% rise that the market experienced when the Fed intervened in October 1998 to reignite the market after the Long Term Capital debacle.

Look, we're bulls and wouldn't want to second-guess the Fed as we clearly don't have all the facts, but we aren't jumping for joy even though the stocks in our portfolio jumped.

Why?

It's not because we are overly concerned about inflation. It's hard for me to see secular inflation in a world that has the megatrends of globalization, the Internet and outsourcing at work — effectively keeping a lid on long-term price pressures.

My issues with the Fed stepping in today are:

1) I don't like the Fed throwing life preservers to the banks and hedge funds as it reinforces the "heads I win — tails you lose" behavior that created the mess to begin with. Having a Countrywide Credit (NYSE: CFC, $21.43 - Not Rated) fail would be a disaster of the highest proportions (and they would truly be the victim) but philosophically, rescuing financial players that were putting on 9 to 1 leverage leaves me with a bad taste in my mouth; I always remember the saying "if you are smart enough, you don't need leverage — if you are not smart enough, you really don't need leverage."

2) We are already suffering with a weak dollar — the Fed reinflating could cause even less confidence in the dollar looking ahead.

So, enough of my "Monday Morning Federbacking" — the reality is that the Fed's move is the likely catalyst to have stocks resume their march upward. The "future shock" of the turmoil we have gone through will undoubtedly result in slower economic growth (and maybe even a recession), and looking ahead, potentially a lower dollar.

This is actually great news for our investment thesis of the increasing appeal of companies that have true organic growth. The too weak dollar has other negative consequences but it does make U.S. products cheap in the global marketplace.

Valuations for equities remain compelling with an earnings yield on the S&P 500 of 6.6% versus the 10-year note's yield of 4.68% — a 42% undervaluation for stocks.

Investors are nervous evidenced by the high put to call ratio for stocks and record short interest. From a supply/demand standpoint, investors continue to pour money into equity mutual funds with $6.5 billion inflows last week and $21.6 billion the past month. Companies, flush with cash, are aggressively buying back stock.

I remain a bull.

Posted by Michael T. Moe at 05:32 PM | Comments (0)

August 13, 2007

Mr. Market Meets Mark to Market

Panic isn't a pretty thing to watch. Accordingly, the TV in my office is usually off and in the past four weeks I've hidden the remote control switch. From time to time when I walk past our trading desk where the shrieks from CNBC can't be avoided, I quickly remove myself from harm's way to be productive, as opposed to being sucked into the noise.

As much as the specific circumstances are usually different, human nature is wired in a way that is predictable.

Markets have been manic since there were markets - the current crisis has the timeless villain of excess leverage combined with the fact that investors have no way to "mark to market" the value of their investments. Should it be valued 10% below or 90% below the last trade? When nobody knows, you get what we got - wholesale panic.

When I find myself in times of trouble, it's not "Mother Mary" who comes to me but the wisdom of legends such as John Templeton, Peter Lynch and Warren Buffett. "Mother Warren" - provided some commentary on Mr. Market in his 1987 shareholders report which I thought is as useful now as it was then:

Mr. Market

"Whenever Charlie and I buy common stocks for Berkshire's insurance companies (leaving aside arbitrage purchases, discussed later) we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We do not have in mind any time or price for sale. Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate. When investing, we view ourselves as business analysts - not as market analysts, not as macroeconomic analysts, and not even as security analysts.

Our approach makes an active trading market useful, since it periodically presents us with mouth-watering opportunities. But by no means is it essential: a prolonged suspension of trading in the securities we hold would not bother us any more than does the lack of daily quotations on World Book or Fechheimer. Eventually, our economic fate will be determined by the economic fate of the business we own, whether our ownership is partial or total.

Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.

Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behavior, the better for you.

But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. As they say in poker, "If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy."

Ben's Mr. Market allegory may seem out-of-date in today's investment world, in which most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising "Take two aspirins"?

The value of market esoterica to the consumer of investment advice is a different story. In my opinion, investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace. In my own efforts to stay insulated, I have found it highly useful to keep Ben's Mr. Market concept firmly in mind.

Following Ben's teachings, Charlie and I let our marketable equities tell us by their operating results - not by their daily, or even yearly, price quotations - whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it. As Ben said: "In the short run, the market is a voting machine, but in the long run it is a weighing machine." The speed at which a business's success is recognized, furthermore, is not that important as long as the company's intrinsic value is increasing at a satisfactory rate. In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price."

The volatility we're experiencing is actually our friend if we can avoid the noise and focus on long-term value. Another Buffettism - "be fearful when others are greedy and greedy when others are fearful" - it's clear that fear is the dominant emotion in the market today.

Part of the reason that there is so much volatility is that so much capital has been committed to hedge funds and private equity funds.

Hedge funds needing to seek short-term alpha and private equity's need for abundant, esoteric, and cheap debt to fund investments has created a lethal Molotov cocktail that has resulted in today's turmoil.

For the week, believe it or not, all U.S. indices that we track were up, led by the Russell 2000 advancing 4.4%. The theory goes that the Russell 2000s relative lack of liquidity aided it as investors were dumping stocks more aggressively in the larger, more liquid names. The S&P 500 and NASDAQ were up 1.4% and 1.3%, respectively, and the Dow was up 0.4%.

Strikingly for the week, $9.8 billion of inflow came into equity mutual funds last week despite all the volatility. $21.6 billion has come into equity funds in the past month.

It's times like these that test your convictions - but remain bullish for growth stocks. Fundamentals are good, relative growth is great, valuations remain compelling, and there is a persistent demand imbalance.

Posted by Michael T. Moe at 07:18 PM | Comments (0)

August 06, 2007

Give Us Some Credit

The best parties always seem to end badly.

When the champagne is flowing and the band is playing all the right songs, nobody wants to go home. People forget they have to get in their car and get up in the morning, anybody who reminds the guest of this fact is thought to party poopers.

The Global Liquidity Bash which provided almost free money to a wide array of participants helped fuel roaring home prices and LBO's galore has entered the post-hangover phase. Several months ago, anybody could borrow money at low rates - today "the bar" is closed for just about everyone.

On Friday, Bear Stearn's CFO (NYSE: BSC, $108.35 - Not Rated) said it was the worst credit market he had seen in 22 years. American Home Mortgage looks like it's going toes up. Buyout kings are looking for cash to complete their deals. And Adjustable Rate Mortgages - A.R.M.s - are going higher, affecting 50% of the homeowners who have felt smart until now.

Risk was badly mispriced and now there will be consequences. Treasury Secretary Hank Paulson has said this is healthy for our healthy economy. In any event, it should be an interesting Fed Meeting on Tuesday.

The credit correction has led to a stock correction which has seen the Dow off 6.2% from its peak, the S&P 500 fall 7.8% from its high, the NASDAQ drop 7.7% and the Russell 2000 fall 11.7% (and is now down 4.2% for the year).

Despite being up 3 of 5 days, stocks fell for the week with the former leader Russell 2000 down 2.9%, the NASDAQ was down 2%, the S&P 500 was down 1.7% and the Dow was off 0.6% for the week. Advancers trailed decliners 6 to 11 on the NYSE and 5 to 11 on NASDAQ. Of particular note to the three straight weeks of a tough tape was that companies making new highs were 232 versus 1529 making new lows.

While we think that the credit crisis is real and will likely impact the stock market in the immediate term - this too shall pass. Companies are in good shape with record levels of cash. Earnings growth for the S&P 500 looks like it will end up at around 9% versus the 4% expected when the quarter began. The 10-year note is currently selling at 4.68% with an earnings yield on the S&P 500 of 6.6% - implying that stocks are 30% undervalued. Company executives understand this with insider buying at record levels. Cash inflows remain robust with $1.8 billion of inflows last weeks, $26.7 billion of inflows for the second quarter on top of the $75.6 billion of inflows in the first quarter.

The volatility we are likely to see in the coming weeks should give us an opportunity to be well positioned for the resumption of the Global Growth Bull Market we have been in for the past 12 months. Slower overall economic growth will make companies that have higher organic growth more appealing to investors. Strategists are calling for investors to focus on large cap growth companies that have maximum exposure to the global marketplace - we think that makes sense but we believe the greatest bang for the buck is to be looking for new leaders.

We've seen in recent weeks even with the melt down in overall stocks, new consumer companies like Chipolte (NYSE: CMG, $97.90 - Not Rated), Under Armour (NYSE: UA, $64.71, Accumulate - Price Target: $70) and Crocs (NASDAQ: CROX, $58.62, Buy - Price Target: $72) bolting to new highs driven by great numbers (earnings growth drives stock prices). The big winners are going to be created in what I'm calling the "innovation economy" which has evolved from the "knowledge economy".

The Innovation Economy is focused on creating solutions to the biggest problems in the global marketplace - education, the environment, Internet security, terrorism, an aging population, dependence on foreign oil. Companies that create effective solutions for these major issues will be well rewarded

Posted by Michael T. Moe at 02:35 PM | Comments (0)