Markets and Culture

Recent Data Weak But The Economy is Still On Track

2013-04-13T05:23:00.000-07:00

The markets have been concerned over the state of the economy recently. The double whammy of a set of weaker Institute for Supply Management (ISM) reports and disappointing payrolls numbers have had the the bears coming out. Although the direction of the market is not really my concern – I’m market neutral -- the direction of the economy is of great interest. There is more reason to be bullish than bearish on the economy. If you are one of those investors that thinks stocks go up with the economy, then now is not the time to lose your nerve.

Now payrolls?

It doesn’t take much to get television journalists shouting, and the last decade has given them more than their fair share of things to worry about. The fact that this fragile psyche also exists in the corporate world shouldn’t really surprise anyone. Discerning investors need to adopt a calmer perspective.

I’m going to start with non-farm payrolls. The key point to understand is just how volatile these numbers are. Moreover, they are subject to significant revisions. In fact, it is rather bizarre that the most followed dataset in the US economy is also one of the most unreliable. I blame Alan Greenspan because he would always refer to it as being the best indicator. This article expresses some of the general underlying issues. The truth is that the payrolls data is usually unreliable from point to point. It is much more useful to take a longer term view.

For example, here are three month averages for the total non-farm payrolls taken from the Bureau of Labor Studies.

There is nothing really unusual about mini troughs and peaks, but overall job growth is still strong. It hasn’t been strong enough to fully gain back the jobs lost in 2008-2009, but that is another matter. We are discussing the direction of the economy.

Furthermore, a quick look at the American Staffing Association Index shows that the index is currently stronger than it has been for over five years.

On a micro level, Robert Half International (NYSE: RHI) always gives good color on conditions. In the company's latest set of earnings, Europe was declared as remaining weak, but its US staffing branches were reported as seeing good demand, particularly in technology and accounting. However, it also stated that the share of temporary jobs (as opposed to permanent) in this cycle was double that of previous recoveries. This may be great news for Robert Half, but it also goes a long way to explaining the sense of ease that is reported over employment conditions in the US.

ISM-ism

The tendency is to look at the ISM data on a monthly basis and then put it out of context. The recent numbers were superficially disappointing, but I think they represented more of a natural correction than any kind of trend change.

Here is the manufacturing data from the Institute of Supply Management for new orders, employment and the headline PMI data.

Note how periods of political uncertainty cause a temporary slowing of orders, which then snaps back as the pipeline build-up gets cleared, following which there is a natural mini correction. I would argue that we are in a period like that now (which has been exacerbated by the sequester), but history suggests that the economy will keep growing -- albeit at the slow pace it has been in recent years.

Investors also need to appreciate that any number above 50 for the index indicates growth. Furthermore, the employment index (it is much harder to turn off employment plans than it is to go slow on new orders or inventory) is still rising well in 2013.

On the micro level, the short-term weakness in the ISM data in December was picked up in the reporting of something like MSC Industrial Direct (NYSE: MSM). Its end demand lacks visibility and is subject to sudden short term changes. Indeed, it reported that its markets were in near ‘paralysis’ in December, and this mirrors the temporary weakness in the ISM data. Furthermore its commentary in its recent results revealed a bifurcation within the metalworking sector. Aerospace and autos are doing fine but general industrial engineering is still soft, with customers delaying activity. Nevertheless if the stock sells off aggressively I think it could be worth a look. Its sales are subject to short lead teams, and if you think the ISM data will improve then this will eventually feed through into MSC's numbers.

Moreover, if we look at General Electric’s (NYSE: GE) recent set of earnings, the surprise was on the upside. Of course, its revenues are a lot more internationally focused than MSC’s will be and its strength in the quarter is an indication that the temporary weakness was really about the US and political considerations, rather than any kind of global drop off in manufacturing. The interesting thing about GE is that--although we know there is pressure on global public spending--it is exposed to areas of government spending (emerging market health care, utilities, transportation etc) that are still being invested in. If the recent results confirm this then the stock is worth a look.

The bottom line

I don’t think the recent data is any cause for significant concern unless it is confirmed by another few months weakness. Short term thinking never did anyone any favors in investing, and the underlying trends for the US economy remain positive. Looking out for stocks that might get beat up with undue short term pessimism seems a good approach to me.

Why It Is Best To Avoid Glamour Stocks

2013-03-22T05:45:00.001-07:00

This article is going to give you a great piece of investment advice, and not in the sense that it is going to give you any buy or sell ideas over a stock. In any case any serious private investor shouldn’t be making investment decisions solely based on the words of a journalist, broker or finance adviser. It’s all well and good to take advice, but the key is to do your own research and make your own decisions.

There Are More Things in Heaven and Earth

And there are more ways to do this rather than invest in Apple (NASDAQ: AAPL). You should know this. Your broker should know this. Your advisor should know this. In short everyone should know this. Well if that is the case why does an inordinate amount of discussion take place over the stock? The answer is simple. It’s probably the best known brand in the world and everybody has an opinion on the iPhone. Herein lies the problem. The stock attracts a huge amount investor recognition, and both private and professional investors seem obsessed with trading this stock. That’s just the way it is. You can analyze the company to death but the direction of the share price is more about sentiment over the iPhone’s future market share than it is about the current fundamentals. Its stock price seems to be a kind of vote over the iPhone.

Of course if you have strong views on the subject then go ahead and invest, but if you don’t then stay away because this stock invariably attracts hot money. Whatever you do, don’t buy or sell this because you feel obliged to have an opinion on it.

Icahn vs. Ackman, Who Will Win?

The battle over Herbalife (NYSE: HLF) has fascinated commentators and investors, and for good reason. The story invokes our love of the thrill of a high stakes game between two individuals driven by a mutual dislike. Ackman holds a conference to outline the reasons behind his very aggressive short position. Icahn later buys the stock and very publicly lambasts Ackman claiming that Herbalife could be the mother of all short squeezes. The fact that all of this is being played out so publicly tells you all you need to know.

These guys are surely trying to influence other investors to join in this game. And a game it is. This isn’t so much about the underlying fundamentals as about who is going to get the most investor votes and force the other to climb down.Who really knows what will happen and how this will play out, so why get involved in this game? It’s a lot of fun to discuss and debate the ongoing developments, but this is not the kind of situation that serious investors should be involved in.

My Advice?

My idea is simple. Call your broker or investment adviser, ask about these two stocks and if he spends half an hour gushing over them with trading advice and exhortations to take a position then politely close the phone and start thinking about finding a new adviser.

Investing is hard. It requires a relentless commitment to research and a disciplined and methodological approach. Unfortunately these aspects of investing are far too easy for private investors and professionals to discard. Private investors are encumbered by a lack of time but for professional investors there is no such excuse. It’s all too easy for professionals to focus on glamour stocks or the most popularly discussed situations. They bring instant recognition and they get their investors talking and trading. Moreover investors expect their advisers and fund managers to ‘have a view’ because to not do so would be to be out of the ‘smart money’ loop. When will this nonsense stop? When will investors stop handing over money on to advisers on the back of their opinions on one or two glamour stocks?

The Law of Small Numbers

The nonsense doesn’t stop there. Consider the law of small numbers or the understanding that a larger sample of data gives a more accurate measure of performance than a smaller set. This is the reason why the number of patients goes up with later stage clinical trials. Pharmaceutical companies generate much more accurate data with later stage trials, and approval decisions are based on them and not on early stage data with a relatively small sample. With this in mind, why do investors trust fund managers on the back of their performance over one year or with a data point of one?

Two classic examples of this tendency are the hedge fund managers Andy Zaky and John Paulson. The former achieved fame and investment funds due to his analysis of one stock. No prizes for guessing it was Apple! And no bonus for working out that Zaky went on to lose investors significant sums of money as outlined in this article. As for Paulson, he achieved fame and investment thanks to his outstanding performance during the recent financial crisis. While this deserves applause, it still does not represent a long term track record of performance; but that didn’t stop investors giving him huge sums of money. The result is that he has had a lousy couple of years, and Morgan Stanley is now reported as telling its clients to redeem their investments.

The Bottom Line

The moral of the story is to avoid highly popular story stocks or short term records with limited data to back up an investor's performance. Investing is a hard grind and it requires a lot of hard work. It is easy for the investment industry to focus on high profile stocks and applaud and promote themselves on the back of a good year or two, but serious investors should not allow themselves to get seduced into investing with them.

How To Profit From Obesity

2013-03-21T08:42:00.003-07:00

Funnily enough, I think that long term investors should be investing in the long term. In this article I’m going to discuss obesity, its prevalence and suggest some of the stocks that might be bought and avoided as a consequence.

Obesity Prevalence

Everyone loves looking at a national league table in order to compare and contrast, and the evidence from the OECD is clear: The US, Canada, Mexico and the UK are right at the top of the developed world obesity league. There are other countries like Hungary, Greece, Estonia and the Czech Republic that have higher than OECD average obesity rates. But there are two unique features that these countries have in common with each other but not with the UK and US.

Firstly, in the US and UK there is a tendency for women to have notably higher rates of obesity than men whereas in the other higher obesity countries (apart from Mexico, Chile and Ireland) the rates tend to be similar. Second, there is a tendency for women in the UK and US to be obese earlier on in life and stay that way.

Before looking at the chart demonstrating these points please understand that the data was pulled from two separate sources and for slightly different age groups so it is not directly comparable. No matter, the important point is the trend. The US data was sourced from the Centers for Disease Control and Prevention while the European data comes from the EU, and the US data is for the 20-39 year old range.

The key is that there is no great quantum leap within obesity rates between young and old in the UK and US, while the evidence suggests that in other European countries women tend to experience a ‘natural’ step up in weight gain as they get older. UK and US women seem to get obese at an earlier age.

To demonstrate this I’ve tabulated the ratio of overall female obesity rates and divided them by the 18-24 year old rates. A low ratio indicates the tendency for women to be obese at an earlier age and stay that way.

Based on the data above I think it is safe to assume that the US ratio would be similar to the UK. Note that Romania, Greece, Hungary and Poland have high ratios. They are countries where women are slimmer earlier on.

Why the Focus on Women?

Before the complaints come in I should explain that I am focusing on women (even though global trends with men and women are pretty similar) in order to highlight some remarkable data. According to the OECD data, US women are noticeably more obese then the men, but it is not even comparable to the huge divergence in the UK.

A quick breakdown of the stats for the UK demonstrates the point:

There is clearly some factor responsible for UK and US women being more obese at an earlier age. As for UK men, if you go back to the second chart their ratio works out to be bang in the middle.

I can't give a definitive verdict but allow me to humbly speculate that both countries have a similar income distributions with net worth skewed to upper deciles, and both have strong feminist influences in the media and within their welfare states. I think the solution involves a little bit more than getting Jamie Oliver to run around and introduce more broccoli into school meals.

How to Profit and Avoid Loss?

The current bugbears are of course the fast food restaurant chains and the snack & beverage companies. The highest profile of which are McDonald’s (NYSE: MCD) and Pepsico (NYSE: PEP). Indeed, not a day seems to go by without someone jumping on the bandwagon and criticizing these companies. The central argument seems to be that they offer cheap carb laden foods that poorer people (who tend to be more obese) are minded to eat. I have a serious issue with this kind of criticism. There are many other countries in the world that have lower GDP income levels and high fast food penetration rates, but they are not subject to the same levels of obesity.

Of course it is so easy to criticize these companies rather than have the courage to at least try to delve into the underlying causes of obesity. Let me put it this way: A city like Budapest (Hungary) is saturated with fast food joints. Now if McDonald’s shuts down tomorrow will there be mass anorexia among the young? I think not because I believe the key determinant of obesity is the willingness to lose weight, and that is guided by the social acceptability of being obese or not. However, I’m not optimistic that politicians will share my view anytime soon so I suspect McDonald’s and Pepsico are faced with these kinds of unfortunate challenges in future.

Another impact is on health care. The correlation between weight gain and diabetes is well documented, and companies with large diabetes franchises look set for strong growth in the years ahead. The big two players are Sanofi (NYSE: SNY) and Novo Nordisk (NYSE: NVO). I’ve discussed Sanofi in more length linked here and for those interested in more pure diabetes plays there is some discussion linked here. Novo has the broadest range of products in the marketplace including injectables like Victoza, which helps to lower blood sugar levels in Type 2 patients.

However, the big battle is being fought over Novo getting its long acting insulin (Tresiba) approved and into the market so it can compete with Sanofi’s leading insulin Lantus. Both companies have had setbacks recently with Tresiba requiring more detail from the FDA and Sanofi’s Lxyumia (intended to be used in combination with Lantus and help extend the franchise beyond Lantus’ upcoming patent expiry) not being able to initiate Phase III trials this year as previously planned. Nevertheless if you want a diabetes play, these are the stocks to start looking at.

Another area worth looking at is Bariatric surgery, and I think Covidien (NYSE: COV) is an interesting candidate. Its minimally invasive surgical (MIS) solutions see this type of surgery as the biggest single profit driver. Furthermore, MIS represents the key growth area of the firm and will be even more so when it completes the split from its pharmaceuticals division. There is some discussion of Covidien linked here. My point is a simple one; if there is more obesity then there will be more Bariatric surgery.

Investing in the Spending Trends of the Wealthy

2013-03-20T12:00:00.001-07:00

I have a quick trivia question. What share of US net worth does the bottom 60% of the US hold? Stop for a second and think about the answer. The correct answer is just 4.2% while the top 5% of the US owns nearly 62%. Now consider an average superstore in an average mall (such a thing doesn’t actually exist but assume it does) and accept that spending correlates strongly with net worth (it does) this would mean that just 5 out of a 100 shoppers is doing the bulk of spending. Meanwhile 6 out of the 10 are doing just 4% of the buying. Now hold that thought.

A Realistic Way to Think About Spending

The reason I am engaging the reader in this kind of thought framing is because it is the reality whereas it is so easy for us to fall into the delusion of misattributing spending trends thanks to the language we use. Analysts and commentators use words like ‘mass’ and ‘luxury’ to describe the retail market. They are useful concepts and I am not in any way arguing that the top 5% only buys luxury goods! However the point is that we should think about retail trends in terms of who is doing the spending rather than just assuming that the conditions of the majority (80% of the US only holds 15.1% of net worth) dictate overall spending.

In order to graphically demonstrate income distribution I’ve broken out the numbers graphically below. All numbers in this article come from research carried about Edward Wolff.

I’ve put the bottom 40% but even then it is hard to see! The top 5% is broken out and as you can see comprises almost 62% by 2007.

A Bifurcated America?

Indeed the trends appear to be slowly getting worse and I’m sure the economy of recent years has accelerated them. For a host of reasons –most of which I can’t go into here- I think that this will continue. My central point is that there appears to be a growing bifurcation in America and it is just not about money. Lifestyles are also bifurcating and at the heart of the reasons for it lie two ideas which I think are mistaken but widely accepted as truth by the constituent groups that holds them. On the one hand one group seem to think that the US lives in a pure meritocracy and taxes and government expenditure are a disdainful burden on them that is intended to punish their success. On the other, another group seems to believe that all men are born with equal attributes and abilities and the purpose of Government policy is to rectify any ‘unnatural’ imbalances via redistribution of resources. This is part of the reason why the US has such large public debt. You can’t reduce a debt by paying less and spend more, yet that is the ‘happy’ consensus that US has been living in for years.

The result of this mess is that the wealthy are getting distrustful of the merits of the public sector while the poorer segments are developing a dependency culture. Moreover the cultural ties that bind America are splitting.

What Does This Mean For Stocks?

Of course many of these observations have been made by Citigroup in its investment research on plutonomy stocks, however the stocks I want to discuss are subtly different. Whilst those stocks were primarily about luxury stocks, I want to focus on stocks that are emblematic of the cultural shifts and that are dependent upon them continuing. For example the wealthy bought Louis Vuitton bags in the 60’s and they do so today but, what about other differentiating trends in wealthy peoples spending habits?

Let’s focus on lifestyle. Take Lululemon Athletica (Nasdaq: LULU) and Whole Foods Market (Nasdaq: WFM). The former appears to be a business without any significant moat and therefore susceptible to margin erosion as rivals threaten to introduce cooler yoga gear. Indeed a quick look at the figures from Yahoo finance indicates that there is a 27% short interest in the stock. While I sympathize with such an approach and find some of the company’s pronouncements over the cultural importance of its yoga pants to be comedic, I would caution against being too negative. It is not pitching itself into the mass market but rather at the kind of wealthy health conscious lady with significant spending power. Her spending priorities are not governed by the same kind of economics as the rest of the athletics gear market.

As for WFM a relatively small number of its customers make up a huge amount (around 20/80) of its revenues. Moreover as long as the trend towards healthy living and differentiation from the eating habits of the rest of the nation continues then I think WFM can convert shoppers to its offering. WFM doesn’t just offer a healthy option, it offers a tangible differentiated lifestyle choice and wealthy people in the US appear willing to pay for this in itself.

Similarly take something like the Boston Beer Co (NYSE: SAM). Beer is as far from a ‘luxury’ stock as you will ever get but SAM does offer premium craft beers and this market is growing significantly in excess of the mass market beers. All it requires is a notable shift in purchasing behavior from the top 10% of the US and there will be a notable marginal shift in demand. Given that SAM has such a small market share it is not hard to see the company continuing to generate double digit revenue growth.

Another area in which we can expect the wealthy to continue to spend is in personalized health care and cosmetic surgery. Stocks like Myriad Genetics (Nasdaq: MYGN) and Allergan (NYSE: AGN) are worth a look. The former develops diagnostic tests for people who want to assess the risk of developing certain diseases (typically hereditary). Admittedly it needs to develop revenues outside of its Bracanaysis (breast and ovarian cancer) test but if the trend towards the wealthy spending money on personalized and pre-emptive medicine then its chances will improve. As for Allergan, as long as the trend towards cosmetic surgery increases among the wealthy then it can expect good sales of its market leading Botox product.

Why The Sequester is Good News

2013-03-01T23:26:00.002-08:00

For those investors focused on the big picture I thought I would share a few thoughts on the current situation. I previously discussed some of the worrying structural trends in the US economy in an article linked here, and in this article I want to discuss why so many commentators are getting it completely wrong.

What Went Wrong With the Free Market?

The problem with free market thinking is that it is most visibly and vehemently promulgated by those who are the biggest absolute winners in it: the expensively suited Wall Street professional, the corporate ‘fat cat’ and the propertied wealthy who have done so much better than the rest of the US over the last 20-30 years. Of course such caricatures of America were tolerated and even admired by the rest of the country as long as the economy prospered and blue collar America could participate in the dream of having a better standard of living than its parents.

The rest listened to the wealthy and their exhortations over how the modern democratic capitalist state was a new meritocratic utopia where everyone had opportunity. And although they never fully believed the wealthy, they accepted it was better than living under communism and they were grateful for their chance.

I emphasize meritocracy because it has the wonderful byproduct of obviating the necessity for any form of collective responsibility: a convenient state of affairs for the uber wealthy and a large part of the reason why the wealthy genuinely don’t want to pay more taxes.

Of course the principle of meritocracy went completely out of the window in 2008 and along with it went the free market ideology so beloved by Wall St. The idiotic, reckless and in some cases corrupt bankers were rewarded with a collectivist scheme of redistribution. They were bailed out and saved by racking up public debts in the name of saving the system. If the meritocratic free market really had its way than the senior bankers would be senior burger flippers by now. As John N. Gray put it to me when discussing the issue ‘unfairness is the price you pay.’ Indeed.

What We Learnt and What We Should Learn

Of course what we learnt from all of this is that, as George Soros always said, there is nothing inherently stable or self rectifying about free markets. And if he is right then there is no pure meritocracy or free market in the real world. I suspect the Occupy Wall Street and Tea Party movements share the same disaffection with how the recession was dealt with. I suspect they both want to get back to the American dream of opportunity through self effort.

Putting all these things together it is easy for a free market enthusiast to retreat into his shell. It is easy to give up. It is easy to forget that social mobility occurs better in freer economies. And it is also easy to forget, in my opinion, that the corporate sector has far more checks and balances in it than the public sector does. My argument is not to defend free markets just because it is a doctrine argued by the very same people who made a mockery of it with the bailouts, but rather to point out why and where it does work.

What Corporations Do and Government Don’t Seem Able To

Allow me to flesh out this point by comparing how the corporate sector functions (when it is not interfered with by bailouts) as opposed to the Government.

Let’s go back to 2001 and recall that the recession then was largely caused by over investment or rather misallocated capital. Corporations spent too much and generated over capacity, particularly in the technology sector. Now look at how the corporate sector has adjusted to this ever since.

From 2001 onwards they diligently built up assets over liabilities and they didn’t rack up debt in order to do it. Even now the net worth of corporations is surely at an all time high while the debt/net worth ratio was lower than in the 90’s for the last ten years save for recession-affected 2009.

The non-financial corporate sector is good at adjusting to market discipline. In fact the problem now may be that corporations are too reluctant to spend. All of which means that Johnson & Johnson (NYSE: JNJ), Microsoft (NASDAQ: MSFT), ADP (NASDAQ: ADP), and Exxon Mobil (NYSE: XOM) have a higher credit rating than the US Government. I suspect Apple (NASDAQ: AAPL) would do too if it had the need to issue credit!

I’ve included GE and McDonald’s by way of comparison. Apple isn't included because it has no debt.

ADP Debt to Total Assets data by YCharts

What Is the US Government Doing?

So while corporations are adjusting to realities, here is what the US Government (and it is not alone) is doing.

US Federal Government Revenue as % of GDP data by YCharts

These are the hard numbers. This is the truth. And with every recession the situation is getting worse, and so is the debt.

It is not enough for Wall St to drone on about a meritocracy while they merrily save themselves from market forces and despise higher taxes and, it is not enough for Main St to carry on pretending that the fiscal trend is sustainable.

Something has to give here, and public spending as a share of GDP must be reduced in order that the US never gets itself in this situation again. Simply put, the Government is not good at managing finances because its members are not subject enough to an efficient form of accountability. And so, I repeat the same question. If a recession comes in the next few years--and I do not have a black swan warning system--then how will the US pay for it?

It strikes me that the Sequester is not the enemy of the US, it's part of the hope. Racking up debt for future generations is surely not an option anymore.

Why the US is No Position to Deal With Another Recession

2013-02-24T00:49:00.003-08:00

Occasionally some of my friends ask me why I am hedged and market neutral in my investing. My answer is always the same. I invest for the long term, and the macro-environment remains very dangerous right now. I am confident in my ability to pick a portfolio that can outperform the market, but I can’t predict what is going to happen in the global economy, and the evidence is that the key players are not dealing with the problems at hand. Moreover, trends in economics and society are severely threatening the West’s future prosperity. With this in mind I thought I would outline the reasons why and then suggest a sector likely to outperform.

Government Debt

The lessons of the last recession are still not properly being learned. In fact, I don’t think they ever will be because the causes of it are so deeply ingrained into the nature of capital markets that they will inevitably repeat themselves in the future.

However, some things have changed. For the sake of brevity I will mention three things.

First, take a look at the following chart. This is data sourced from the IMF that outlines government debt/GDP. The shaded areas represent recessions.

United States Government Debt data by YCharts

My point here is that whenever the US entered previous recessions it always had the leeway to raise government spending (and consequently debt) in order to counteract the cyclical slowdown in the private sector. So what happens if there is another recession in the near future? The US Government (actually the US taxpayer) does not appear to be in a strong position to deal with it. In addition, borrowing rates are likely to be much higher, and if history is a guide then the cyclicality of the next recession is likely to increase thanks to globalization synchronizing the global economy.

Employment

Second, I don’t like the structural nature of unemployment in the cycle. Don’t get me wrong, I’m a great believer in the idea that employment will pick up this year but we need to put this into context.

Here is a chart that does that. This represents the percentage of jobs regained from those lost in the previous recessions . All data is non-farm payroll from the BLS.

Note how weak the current recovery is with only 62.7% of the jobs lost now regained, and these numbers do not include assumptions for new entrants into the labor market. Furthermore, note how with each recession it takes progressively longer to regain jobs.

The US has structural unemployment issues, and this is placing a burden on public finances and also on the way of life that post-War America came to understand as normal.

Demographics

The third issue is demographics. I’m going to lean on Charles Murray’s Coming Apart and highlight the differentials in marriage and divorce rates between poorer and wealthier segments of America. Things appear to be okay at the top, but marriage rates have imploded at the bottom while single parenthood rates have exploded at the same time. I’m aware these subjects are contentious but allow me a few brief words.

The great Aristotelian religions (Judaism, Christianity and Islam) survived and became so, because at the heart of them lies the nuclear family and respect for private property. I argue that we have never before been in an economic environment where the nuclear family has faced such a sustained onslaught from social commentators, sociologists, the media, divorce courts, and good old fashioned social engineering ‘do-gooders’ fixated on the idea of restructuring gender relations. You don’t have to agree with me on the causes (I stress feminism causing social pressure against marriage), but it is indisputable that the nuclear family is breaking down in America, and this is unchartered territory for the economy.

I would also argue that when a working class man loses the incentive or opportunity to form a family, he then loses a large part of the incentive to work. Similarly when he loses the opportunity to work (see above) hypergamy ensures that his options in the sexual marketplace are limited. These two issues are symbiotic and create significant economic problems, and it’s time the mainstream media started talking about these issues rather than discussing Kim Kardashian’s new hair cut.

Throw in an aging demographic and you have an economy that is gradually morphing itself into one that will have significant problems should it be hit with another recession.

How to Outperform

Of course it doesn’t have to be all doom and gloom. The global and US economy could go through another 10 years without a recession, gradually reduce debt burdens and offer a better quality of living for all. However, in both polar scenarios there are some things in common. One of them is that health care costs need to be reduced, and companies that help to do this will have plenty of upside potential.

In this regard the generic drug manufacturers like Actavis, Mylan or Teva are set yo benefit. Increasing generic penetration rates is a good way to reduce costs and I have no doubt governments will be pressured to do this in future. Another area of opportunity will be from medical device manufacturers that offer tangible cost reductions. I think Covidien’s (NYSE: COV) Minimally Invasive Surgery (MIS) solutions are a good example of this. MIS offers patients better outcomes and consequently reduces patient stays; it saves money.

Another area that could reduce health care costs is affordable human genome sequencing . The leading players here are Life Technologies (NASDAQ: LIFE) and Illumina (NASDAQ: ILMN), and if they can make sequencing affordable then health care costs could come down as individuals will be able to identify and detect indications that can be treated earlier and therefore save costs.

In conclusion, there are plenty of dangers out there, and I will stay hedged for the foreseeable future, but there are still areas of the economy that will outperform irrespective of the long term outcome.

Which Region Will Do Best in 2013?

2013-01-16T02:52:00.000-08:00

t’s the New Year, and it’s always a bit of fun to peer into the crystal ball and see bits of refracted images of table cloth below you while a crook asks you for some money. Ernest predictions of your future life follow (usually prompted by a fleeting glance to see if you are wearing a wedding ring or not) and after a few optimistic words, charlatan and dreamer part company. In a similar vein I shall attempt some geographical predictions for 2013!

China's Economy in 2013

Forgive me for not being inclined to forget everything I’ve learned about economics and markets, but the last time I looked at economies under collectivized control they did not have a particularly good track record. In other words, I’m not convinced that China’s attempts to stimulate its economy back to 7.5%+ growth is going to work as many are hoping it will. Moreover, the indications are that this is not going to be like the 2008-09 stimulus plan and this can be taken as a de facto admission that the previous plan was inefficient. So what next?

I think it better to consider China as an odd proposition. On the one hand, continued gains from private sector inspired productivity improvements, while on the other the government’s currency management (buying US dollars, selling yuan) has threatened the creation of a localized asset class bubble in housing. Pencilling in ‘same again’ GDP growth for China seems a sensible policy to me, but who knows? China can always generate growth (but future problems) by throwing money around.

If I am right about China then don’t expect the mining and resources sectors to do particularly well this year. I appreciate that Caterpillar and Joy Global were beaten up in 2012 over this issue, but these things can go on longer than many suspect. I like to invest with a bit more certainty. Things appear to be getting better for them lately, but if China disappoints then their earnings prospects will be downgraded in the future.

US Strengthens

I think the evidence suggests that the US economy is improving but is suffering from near term difficulty engendered by its politicians. I’m not entering a political debate here. Suffice it to show this chart and remark that neither party has a particularly good recent record with either reducing spending or encouraging social cohesion.

The whole ‘fiscal cliff’ debacle is a red herring. It will get resolved and America will go on, but at some point the whole idea of trading off an increasingly unequal society for a larger public sector has to be reconciled. The public sector isn’t very good at doing these things and its growth encourages vested interests to game resources in their favor. Rant over. The US will do okay in 2013.

I think that US consumer focused stocks are still a good way forward. Within retail I favor the high end and some specialty stores. However, the real story lies with the ongoing recovery in housing, employment and credit issuance. When net household wealth rises, it encourages spending and lending. I would look for the financials like Capital One Financial (NYSE: COF) or American Express (NYSE: AXP) to experience improving conditions. There is some more analysis on the issue here. Charge-offs continue to decline in the US and there are signs that the consumer has stopped deleveraging. Financials can start to lend more as consumers spend.

European Economy in 2013

Europe will surprise to the upside. You heard it here first. I’m increasingly becoming less scared of companies with heavy European exposure. Why?

Europe has been weak for a while, and I would expect yearly comparisons to be a lot easier; companies have had plenty of time to adjust to the dictum of North-Good, South- Bad. Moreover, Italian 10 year Government bond yields have come down to around 4.5% and Spain’s are at 5.25% as I write. The EU has made great strides in restoring confidence, and it is making efforts to install systematic rigor to its government's spending. Europe is hopefully heading to the kind of monetary discipline that the Bundesbank enjoyed for so many years. It is still tough, but things are getting better and I'd like to see Greece thrown out of the Euro Zone, though its debt is not such a big issue for Europe provided the markets understand this. Do not be scared of European exposure.

With this in mind perhaps it’s time to look at some European stocks or at least companies like McDonald's? It has some issues in China right now but Europe is still its largest profit center and any upside surprise from Europe would drop favorably into its bottom line.

The Bottom Line

Of the three regions, China’s 2013 is likely to be the hardest to predict. I think the risk is on the downside. The US looks set for a slow grinding recovery and it truly is a stock picker's market, but I'm not complaining. I love such conditions. As for Europe, don’t be surprised if we surprise you.

Happy New Year!

Why Follow Investment Gurus?

2013-01-14T02:48:00.000-08:00

One of the most seductive things for a private investor is reading an article by an investment guru or pundit that writes or screams about trading a certain stock or asset class. In addition, I frequently see articles that monitor their positions and what they buy and sell. It’s all so easy. You just follow a guru-who has no doubt put in a lot of research--and you make money. It’s so simple and you can just sit back and let them do all the work. Alas, it’s not so easy and here is why.

Why You Shouldn’t Take Gurus Too Seriously

I’m going to summarize the main arguments and then flesh them out.

Real time observations: Are you able to monitor exactly when they enter and exit positions? And when they change their minds?
Deliberate obfuscation: It’s a nasty zero sum game world out there, and some people deliberately want you to trade opposite to them. Think of Jim Cramer and his infamous ‘moron longs’ observations.
Track record: Are these guys actually any good? What do you really know about their track record and do they consistently make money or is it just a year or two of good numbers when the market favors their strategy? Why is it so hard to find a track record for some of these guys?
Timing: Are you in the position at the right time or is the guru the only one making money?
Portfolio positioning: Do you understand how the position works within their overall portfolio or are you looking at it in isolation?

It’s all very well reading the myriad reasons why someone wants to buy something, but what about when they want to sell? What about when conditions change and a disciplined ‘guru’ then suddenly changes his mind? I doubt he is going to email you personally to let you know. Moreover, let’s say that you learn that one of them has just sold his entire position in, say, Costco. You get all excited and dump your entire holding but what if he sold his because he wanted to shift into Wal-Mart and Target on a relative value basis? This doesn’t mean he’s expressing anything negative about Costco. On the contrary, it could be positive, but it just means he prefers other stocks in the sector.

Moron Longs and Jim Cramer

It should not be lost on investors that there are lots of scurrilous people out there who spread rumors and counter-rumors in order to manipulate investors and sometimes it is in the opposite direction of which way they are actually trading.

In recent years there have been examples of financial institutions setting up products in order to sell investors and then short them or their constituents. Similarly, it’s so easy for an investor who wants to sell a position to try to encourage others to buy it so he can get his exit cleanly. Always ask why someone wants to tell you about his position.

What is Ken Fisher's Track Record?

Okay, I confess I have a bee in my bonnet about this. Investment management lives off numbers, performance and results. There is no end to the metrics that have been devised in order to monitor these things mathematically. Well in that case, why on earth is it so difficult to find a track record for many of these guys? I doubt anyone markets more than, say, Ken Fisher but I suggest Googling around and trying to find a discernible long term track record for the guy. Similarly, some investors are great in certain periods but they may not perform in others.

I learn this lesson to my own regret. Now I respect Warren Buffett more than most investors and have written about his long term track record here, however, there are certain types of stocks that I have learned to avoid with him. A few years ago I recall buying H & R Block (NYSE: HRB) and Iron Mountain (NYSE: IRM) and feeling good because Buffett held position in the stocks. The logic seemed clear. HRB had a natural moat with its tax services and was expanding into Wal-Mart locations. It was cash generative and had obvious long term prospects. Similarly, Iron Mountain’s document storage was a long term recurring revenue generator and a service that certain industries could not do without. It all made sense. Right?

Well HRB turned out to be on the cusp of losing market share to Intuit thanks to its do-it-yourself software and cloud offerings. IRM discovered that electronic storage can replace much of the need for document storage. Lesson learned. Buffett is not that hot in industries susceptible to technological changes. Maybe this is because of his famous aversion to buying technology stocks?

Following Hedge Funds Shorting Herbalife?

This argument is simple. It is all very well to follow a guru ‘with a view’ but you have to be in the position at the right time. For example let’s look at GameStop (NYSE: GME), Herbalife (NYSE: HLF) and Nu Skin Enterprises (NYSE: NUS). I wouldn’t buy these stocks if you paid me to, but I would be very cautious about shorting them despite the amount of negative feeling that some ‘gurus’ have over them.

Here is why.

HLF data by YCharts

As much as I dislike Nu-Skin and Herbalife, the fact is that until a notable hedge fund manager comes out and states his negative case over the stock you could find yourself losing money. The reason is that so many nervous shorts hold these positions and worried buyers stay away. Therefore any positive news sees them rising and the shorts close out. You can see this with GameStop.

In addition, investors need to be in the position before the guru speaks, but how do you know when he will do that? And why short a stock after the big move down. The few big down moves took place over a few days in the year!

Portfolio Positioning

This is probably the most important aspect. Investors buy stocks for all sorts of reasons, and you need to understand how a stock works in a portfolio. So, for example, what is the point of talking about a short/long position in a stock if a hedge fund manager is long/short another stock in the sector with a relative value pairs trade. Similarly, some managers buy stocks in order to thematically hedge against overweight positions in their portfolio or they buy them in order to try some form of corporate action. The reasons are myriad and investors should not look at one position in isolation.

How to Be a Better Investor

2013-01-01T09:40:00.002-08:00

It’s Christmas shopping time: No doubt us obsessive investors will be thinking about gifts and contemplating buying the latest book designed to convince us that a certain investor or other has the panacea to investment or management problems. Whether it is a book on ‘master investors,’ the latest Buffett biography, ‘Business Secrets of the Pharaohs,’ ‘Why Mayan Civilization Collapsed: A Technical Analysis’ or other such nonsense, you can be sure they will be out in book shops near you. Well, in the spirit of Christmas, it’s time to throw my opinions over for free.

Fooled by Topiary

Any discourse on this subject can’t avoid a reference to Nassim Taleb. In truth, most investors owe a debt to him for his popularization of the idea that most of these tomes are merely selling observations of ‘certainty’ on events which are in fact random in nature. I’m greatly sympathetic to this view. For example, if you want to analyze what makes great investors do you only analyze the traits of ‘the greats’ or do you analyze a huge cross sample and see which traits appear to lead to some of them being great?

Let me put it this way. Assume Buffett, Soros and Chanos love doing topiary on the weekends. Conclusion: doing topiary makes you a great investor! However, you can analyze 1,000 investors (including plenty of losing investors) and discover that doing topiary on the weekends actually causes negative overall performance.

In other words, I don’t think a narrow analysis of a few great investors’ traits is a legitimate pursuit. It’s a bit like looking at say Exxon Mobil or Chevron and the huge run up they both had from 2003 to 2008 and then concluding that the management was fantastic because they may have all favored topiary when in fact it was largely due to the price of oil. If you buy these stocks, you are de facto taking a position in oil.

And don’t get me started on hindsight or survivorship bias!

Stop Analyzing the Pro’s

The other problem that private investors (and authors for that matter) have is that most of the track record is in the professional arena. This is an issue because professional investors are necessarily solely focused on generating risk adjusted returns. I’ll explain.

Private investors can take no solace in the track record of professionals. Essentially the investment industry works on a couple of working principles which it has learned empirically over the years. It took the work of behavioral psychologists Kahneman & Tversky to rationally express these principles or heuristics, but the investment industry has always lived by them.

A loss is psychologically weighted double that of a gain
Investors overweight near term performance

The first point plays out because asset managers are terrified to deviate from industry benchmarks on the downside because they will lose their blessed assets under management (AUM), and there is little benefit to be gained in trying to beat their peers because upside is not as strongly rewarded.

The second point is that investors tend to overweight short term performance, and the industry knows this so there is nothing wrong (for the industry) in chasing myriad risky strategies which produce short term outperformance but then blow up when conditions change. After all, the important thing is to get AUM and tie it up. This is why asset managers tend to have a stable of different types of funds. When one is hot they market it more and then investors duly reward them with AUM. Of course the problem is that that manager may have taken on excess risk to get the numbers. But who cares? Asset managers make money by managing assets after all.

In this sense it is exactly the same principle with what went wrong with the financials. Risk went out the window in many cases and if it wasn’t for the largess of the Government and taxpayers money, the likes of Goldman Sachs (NYSE: GS), JP Morgan (NYSE: JPM) and AIG (NYSE: AIG) wouldn’t be around today. It’s tough to blame them for the whole crisis because so few saw it coming, but then again if conditions collapse for a topiary supply company then they go bust. Who ever heard of a bank going, errr, bankrupt? My point here is that these organizations don’t appear to be run with a cognizance that they might fail, therefore the only game in town is (still) to go for profits irrespective of the risk.

I would urge great caution in following professional investors too closely unless they have demonstrable track records of making money over the long term. I would also suggest investors avoid tomes in technical analysis which in fact turn out to be capturing some facet of market conditions that worked for a while only to then fall apart as they changed.

So What to Do?

My only suggestion if you want to be a better investor is to look at your internal thought processes. You will find no end of information, views and data on stocks. In my humble opinion what makes a good investor is the ability to disseminate this mass of information into something coherent and then pick out the salient drivers that are going to guide the stock price. In the end all you want is the stock price to go up while not taking on too much risk. The latter stipulation usually requires a level of humility (diversifying to accept that fact that you might be wrong) that is often missing in professional investors touting for AUM.

No matter, it shouldn’t detract private investors from trying to define clearly what they think is the key driver of the stock price and then analyzing whether they are good at doing this or not over the long term.

As for the Christmas book shopping, I would advise Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay. Any lingering doubt that investing requires humility and the need to avoid selective reasoning should be eradicated after reading that marvelous book.

UK Government's Share of GDP

2012-12-29T04:23:00.001-08:00

Ever wondered what the UK Government share of GDP spending was?

Well here it is.

And it doesn't make pretty reading. The truth is that New Labour managed to orchestrate the double whammy of increasing social tension at the same time as increasing public spending. In addition I would argue that- in many cases- the latter engenders the former.

It is a sad state of affairs when the argument is always framed to the contrary. In other words that there is a natural 'trade-off' between increasing social cohesion by spending more public money and vice versa.

It strikes me that it's time for the Left to start discussing public spending proposals that are not propelled by an ideological conviction that more spending equates to a better society or that it can equalise income disaparity by doing it. No one tried harder- or with a greater sense of moral purpose- than Gordon Brown and look at the result?

It's also time for the Right to stop pretending that we live in a meritocracy and that public spending is some sort of cancer that its more privilieged members can find a way to avoid. All economies need public spending but it isn't to be viewed as a bone to try and placate the masses or as part of some middle class racket.

The result of continuing this nonsense is a disparate society in which a welfare state dependency culture is created alongside a detached uber wealthy enjoying the fruits of their 'meritocratically' earned work.

The greatest case for capitalism is that it creates real opportunities for social mobility and the advancement of civilisation. It's time to remember this.