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Evaluating Industries and Competitive Advantage

(February 8, 2009)

Dear Subscribers and Readers,

Let us now begin our commentary by reviewing our 7 most recent signals in our DJIA Timing System:

1st signal entered: 50% short position on October 4, 2007 at 13,956;

2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

3rd signal entered: 50% long position on January 9, 2008 at 12,630;

4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

6th signal entered: 50% long position on June 12, 2008 at 12,172, giving us a loss of 3,891.41 points as of Friday at the close.

7th signal entered Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 3,582.41 points as of Friday at the close.

One of the industries that are still deleveraging and that we have been monitoring is the restaurants industry, or more specifically, the casual dining industry.  Our thesis is this: Similar to the consumer electronics (i.e. Best Buy vs. Circuit City) and the specialty retailing (or specifically, in bed and bath products, as in Bed Bath & Beyond vs. Linens & Things) industries, the ongoing deleveraging – forced by the decline in consumer discretionary spending – will eventually be beneficial to the survivors, as the survivors will be able to enjoy higher pricing power and as operators will be less aggressive in expanding and opening new casual dining concepts for years to come (they will also be less able to obtain financing).  According to the market research firm NPD Group, the number of restaurants declined by 0.1% last year, with fast food outlets increasing 0.5%, casual dining increasing 0.3%, and family dining and fine dining restaurants declining by 2.8% and 7.5%, respectively.

Within the casual dining industry, last year's 0.3% increase in the number of restaurants is truly shocking, especially in light of the closing of the Bennigan's and Steak & Ale chains (granted, many restaurants only revised their expansion plans after the Lehman bankruptcy and the September to October crash in the equity markets).  To top it off, the new owner of the bankrupt Bennigan's chain has indicated that it plans to reopen its company-owned restaurants and to continue to franchise new ones.  For Bennigan's new owner, startup and ongoing financing costs will be relatively low, in light of the bankruptcy restructuring, and since the physical restaurants and equipment are already in place. So while Bennigan's should fare relatively well this year, the same thing could not be said for struggling casual dining chains such as Ruby Tuesday (in fact, Ruby Tuesday has indicated it would close 40 restaurants this year, and 30 more over the next several years).  Wall Street analysts are now predicting a 3% to 8% (4,500 to 12,000) decline in the number of sit-down restaurants this year, with the largest shakeout coming in the casual dining industry.  One company I like – both for its long-term competitive advantage and for its growth prospects – is Cheesecake Factory (CAKE).  But until I see more closing and liquidations in the casual dining industry over the next 6 to 9 months, I would hold off on buying it or any other stock in the industry, despite the decent valuations.

I now want to discuss the topic of deleveraging with regards to the financial sector.  As PIMCO and others have chronicled over the last few years, the “shadow banking system” (as coined by PIMCO's Paul McCulley) has been responsible for much of the credit/liquidity generation over the last five years.  As a result, the Fed's latest plan to “unfreeze” the securitized market through its $200 billion Term Asset-Backed Securities Lending Facility will be a welcome development, even though it has been pushed back from its intended start date sometime this month.  That said, there is no time to lose, as commercial banks have started to seriously tighten credit availability.  The following chart showing the significant deceleration in year-over-year growth in loans and leases held under bank credit must be very disturbing to the Fed and US Treasury:

Year-Over-Year Change in Loans and Leases Held Under Bank Credit(January 1948 to January 2009) - 1) List of Recessions: July 1953 to March 1954 Sept 1957 to March 1958 January 1974 to March 1975 July 1981 to November 1982 July 1990 to March 1991 March 2001 to November 2001 2) Four of the last six recessions over the last 60 years were preceded by a significant plunge and a subsequent dive to the zero line in the growth of loans and leases held under commercial bank credit. Up until October, there was not much evidence that commercial banks were shrinking their balance sheets dramatically, even though the spike in credit spreads and continuing write-downs were indicating that the *shadow banking system* has been actively shrinking its collective balance sheet.  3) Growth has now declined to only 3.18% . Get ready for a depression if the Fed does not move now!

As shown on the above chart, the year-over-year growth in loans and leases held under commercial bank credit has shrunk to only 3.18% in January 2009.  In a close-to-pure commercial banking system (such as what existed before the mid 1990s), such a deceleration, while raising red flags, would not have been a death knell.  Unfortunately, our financial system is no longer a pure commercial banking system.  With the tremendous shrinkage of our shadow banking system – including dramatic balance sheet write-downs by the investment banks, the hedge funds, and sovereign wealth funds, as well as the freezing of the commercial paper and asset-backed markets – the commercial banking system will need to “take up the slack” in order to revive economic growth going forward.  To that end, the first priority of the US Treasury, the Federal Reserve, and the FDIC is to find a way to recapitalize the banking system.  Without a fully functioning banking system, even an $800 billion fiscal stimulus would do little to revive the US economy (as the classic “money multiplier effect” would not hold).  Assuming the Feds can implement an adequate and credible recapitalization plan over the next couple of months, and assuming the Federal Reserve will continue its purchases of mortgage-backed securities and implement the TALF program, we could very well see a stabilization of the North American, Latin American, and Asian financial markets over the next few months.  The US leading indicators will in turn reverse to the upside – which means unemployment will most likely peak (at the latest) by Thanksgiving this year (I am still predicting a peak unemployment rate of 8% to 9%).

Let us now get on with the main topic of our commentary.  In the 4th edition of “Security Analysis” (published in 1962), authors Benjamin Graham, David Dodd, and Sidney Cottle (the main author of the 5th edition), commented that the investment environment has changed dramatically since the 1930s to 1940s, due to: 1)The establishment of the SEC in 1933, resulting in much improved published corporate data, 2) Higher quality corporate annual reports since the end of World War II, and 3) The change in government policy, legislations, and business practices since the end of World War II, which should result in a generally more stable economic environment.  Quoting Graham et al:

The relevant legislation, governmental policies, and business practices of the last two or three decades, have, for the most part, tended toward stability.  It appears, therefore, that – from a cyclical point of view – the economic climate within which business operates has improved materially.  If so, the investment attractiveness of common stocks as a class has risen.  It would be logical, then, for this improved attractiveness to be expressed in a higher multiplier of earnings and a lower dividend yield that would otherwise be appropriate.


The most important single factor determining a stock's value is now held to be the indicated average future earning power, i.e., the estimated average earnings for a future span of years.  Intrinsic value would then be founded by first forecasting this earning power and then multiplying that prediction by an appropriate “capitalization factor.”

The evolution of the “security analysis” profession from a primary function focused on the balance sheet and the company's net asset value to one that is based on future prospects is not unparalleled, of course.  In fact, the booms and bull markets of years past could not have happened without “speculation” (and the underlying optimism) of future earnings.  The main differences were that the “security analysis” field could not have emerged as a profession (unlike the speculators of years past) until the disclosure of better corporate data and until 3 to 5-year earnings could be better estimated.  Warren Buffett and Charlie Munger were one of the first investors to sense this.  The evolution of their investment philosophy would lead to Berkshire's purchase of Blue Chip Stamps in 1970, See's Candies in 1972, and Coca-Cola in 1988, even though these companies were trading significantly above their net asset value at the time.  Still yet another investment legend recognized the importance of investing through an assessment of a company's future prospects.  Aside from achieving impressive returns through his style, Philip Fisher also articulated his process early on through his book “Common Stocks and Future Profits.”  Specifically, Philip Fisher mentioned that an astute investor would need to answer the following “15 points” before he or she should think about buying a stock:

Philip A. Fisher's 15 Points to Look for in a Common Stock

  1. Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years?
  2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?
  3. How effective are the company's research and development efforts in relation to its size?
  4. Does the company have an above-average sales organization?
  5. Does the company have a worthwhile profit margin?
  6. What is the company doing to maintain or improve profit margins?
  7. Does the company have outstanding labor and personnel relations?
  8. Does the company have outstanding executive relations?
  9. Does the company have depth to its management?
  10. How good are the company's cost analysis and accounting controls?
  11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company will be in relation to its competition?
  12. Does the company have a short-range or long-range outlook in regard to profits?
  13. In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders' benefit from this anticipated growth?
  14. Does the management talk freely to investors about its affairs when things are going well but "clam up" when troubles or disappointments occur?
  15. Does the company have a management of unquestionable integrity?

Fisher's writings contained some elements of Peter Drucker (specifically its focus on management issues), but its discussions on competition also foreshadowed the writings of Michael Porter – who would eventually build a whole new school of industry analysis based on his “Five Competitive Forces.”  Specifically, when evaluating an industry, it makes sense to first try to understand its structure – from the size of the industry, to its lifecycle and various competitive forces (these are the five forces), such as rivalry among existing competitors, bargaining power of suppliers, bargaining power of customers, barriers to entry, and threats of substitutes.  As Porter documented, the forces range from intense in industries such as airlines and steel, to mild in industries such as medical supplies and soft drinks, where one could earn high returns on investment.  Taken together, these competitive forces set the profitability of an industry and are thus very important to valuing the industry over the long run.  Other important (but secondary) attributes include the industry growth rate, government policy, technology and innovation, and the role of complementary products and services.

When evaluating a company within a specific industry, the analyst must also evaluate its “competitive advantage” relative to other companies within the industry, in addition to evaluating the state of the industry.  Porter asserted that to create a competitive advantage, a firm must configure itself to do something unique and valuable.  The firm must ensure that, were it to disappear, someone in its network of suppliers, customers, and complementors would miss it and no one could replace it perfectly.  Second, competitive advantage usually comes from the full range of a firm's activities – from production to finance, from marketing to logistics, all acting in harmony.  On a superficial level, the analyst could evaluate competitive advantage within an industry by comparing ROEs or ROICs across comparable companies within the industry, but these are all lagging indicators (even though they may be useful in the sense that they will tell you whether management and the company's workers have made the appropriate decisions in the past).  On a deeper level, the analyst must catalog and examine the costs of each activity within the company, and compare the costs relative to the competition.  The analyst then must analyze how each activity affects the customer's willingness to pay.  Combined, this will give the analyst an idea whether an activity is generating a competitive advantage for the company, or whether it is destroying “value added.”

As the country's financial system regain its footing over the next 6 months, and as the US, Chinese, Euro Zone's, UK, and Japanese fiscal stimulus programs worked their way through the global financial system, serious security analysts should again spend their time on the analysis of industry and competitive advantages, as opposed to focusing on macro factors (which they really know nothing about).  For serious investors who want to buy individual stocks in their portfolios, I would highly advocate such a serious approach, starting with the writings of Philip Fisher, Warren Buffett, Michael Porter, and then proceeding to the S&P Industry Surveys, the Encyclopedia of American Industries, the Encyclopedia of Global Industries, trade periodicals, and of course 10-Ks, 10-Qs, and earnings call transcripts. For those who don't have a solid valuation background, I highly recommend buying the CFA Level II materials (or even better, take the CFA exams) and buying the book “Investment Valuation” by Professor Aswath Damodaran (I highly recommend the book even though it tilts to the theoretical side).

Let us now discuss the most recent action in the U.S. stock market via the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from July 2006 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports(July 2006 to February 6, 2009) - For the week ending February 6th, the Dow Industrials rose 279.73 points, while the Dow Transports rose 238.05 points. With the latest rally in both Dow indices, tthe Dow Industrials is now nearly 10% and the Dow Transports 7.1% above their November 20, 2008 lows - and things are now looking much more favorable for both the domestic and the global economy. As with last week, any action int he next week or so will be driven by the actions of the Obama economic team, including talk of a RTC-style fund to absorb toxic assets or a system-wide *backstop* of banks' balance sheets. The Obama fiscal stimulus is not enough - and neither can the US rely on the Europeans or the Japanese to lift the global economy out of recession. With the immense amount of capitulation and very compelling valuations across the world - I still believe we are in the midst of one of the greatest buying opportunities of our generation, but should the latest plans fail to stem the liquidation in financial stocks once and for all, there's a chance we could break the November 20, 2008 lows in all the major indices. For now, we will maintain our 100% long position in our DJIA Timing System, but will continue to be cautious on the stock market until we see some definite policies from US policy makers.

For the week ending February 6, 2009, the Dow Industrials rose 279.73 points while the Dow Transports rose 238.05 points.  With both the Dow Industrials and the Dow Transports closing above their November 20, 2008 lows, things are now looking much more favorable for both the domestic and global economy, assuming that the Feds' bank recapitalization scheme and stimulus proceed successfully through the Congress this week.  With the market waiting for a system-wide bailout of the US banking system, the stock market is still a crossroads, though.  As I mentioned before, the US financial system (in the form of banks' shares, corporate spreads, and securitized spreads) has been screaming for assistance.  With the further tightening of the commercial banking system, now's the time for the Feds to be much more proactive and to find a systematic solution, once and for all.  Once that is settled, I expect a sustainable rally in the stock market to develop (and for a significant increase in bank lending).  Again, while there are still landmines in various emerging market countries (such as most of central and eastern Europe) and individual stock investments, I urge subscribers to take a longer-term view and to try not to time the market on a day-to-day basis, given the most compelling valuations in the US equity market in decades and the emerging innovative/Schumpeterian growth forces that will inevitably be unleashed in the next 5 to 15 years.  We remain 100% long in our DJIA Timing System.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The latest four-week moving average of these sentiment indicators declined from -9.0% to -13.3% for the week ending February 6, 2009.   Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending February 6, 2009, the four-week MA of the combined Bulls-Bears% Differential ratios declined from -9.0% to -13.3%. No doubt, the latest rise in bullish sentiment has reversied to the downside (which is bearish for the stock market in the short-run). However, this indicator is now very oversold. Moreover, most of the upcoming week's market action will again be news-driven. Until we the systematic-wide bailout and Obama's fiscal stimulus plan are finalized, sentiment can indeed get darker, but for now, we will remain 100% long in our DJIA Timing System.

While the four-week moving average of our popular sentiment indicators could sink to a more oversold level, subscribers should note that this week's market action will be news-driven, given ongoing jitters about the Western banking system and fourth quarter earnings reports.  For now, we should continue to be cautious, but given the (almost) inevitable bank recapitalization plan, the compelling global equity market valuations, the sheer amount of global investable capital sitting on the sidelines, and the easing in the money/credit markets, I still believe we are in the midst of the biggest buying opportunity of our generation.  For now, we will remain 100% long in our DJIA Timing System.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator for the stock market.  Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:

ISE Sentiment vs. S&P 500(May 1, 2002 to Present) - Since its most recent high on January 8th, the 20 DMA of the ISE Sentiment has quickly corrected, and is now near a two-month low.More importantly, the uptrend in bullish sentiment is no longer intact, suggesting that both sentiment and the market is now biased towards the downside. However, relative to levels over the last five years, both the 20 and the 50 DMAs are at oversold levels, signaling that bullish sentiment is bottoming. With the immense liquidation in the global stock market in the last four months, my sense is that the selling pressure in the US stock market has peaked, but until we get some concrete signs of a systematic-wide bailout, we could see more weakness in the short run.

Since its most recent high on January 8th, the 20 DMA has corrected quickly to the downside.  More ominously, it has now declined below the 50 DMA, signaling that investors are now getting more bearish (which usually leads to short-term weakness in the stock market).  That said, the 20 DMA of the ISE Sentiment Index is now at a somewhat oversold level – suggesting that the market could be bottoming out (or have already bottomed early last week).  As I have mentioned before, as long as one is under the age of 60 and is in a reasonable state of health, I believe US equities are still a great long-term buy at current levels.

Conclusion: As the world waits for the almost-inevitable bank recapitalization scheme (in many ways, recapitalizing the commercial banking system is much more important than passing the $800 billion fiscal stimulus), subscribers should start thinking about what individual stocks to buy, and in what industries, etc.  To that end, it is important to find a good framework to evaluate your targeted companies' competitive advantage, and their industries – as well as finding the right tools and resources.  Hopefully, I have provided you a “flavor” of what is required (at the very least).  Before we can go on and focus on selecting individual stocks, however, it is important to note that we are not out of the woods just yet.  As the above chart shows, commercial bank lending has fallen over the last few months. Given the ongoing troubles in the commercial paper and asset-backed security markets, it is imperative for the Feds' bank recapitalization scheme to be finalized as soon as this week.  Combined with the $800 billion fiscal stimulus, and assuming that the Euro Zone, China, and the UK would continue to ease their monetary policies, there is a good chance that the stock market will finally embark on a sustainable rally.  Again, within one's global equity portfolio, I highly recommend an overweighting of US equities and emerging markets at the expense of international developed (mostly Western European and Japanese) equities for the next 12 months.  Given the immense amount of cash sitting on the sidelines (including the amount of cash assets on commercial banks' balance sheets), any official government “backstopping” of the US banking system would create an immediate incentive for fresh lending.  Such a move would also bring a lot of risk capital back into the financial markets – starting with the corporate bond market, and moving on to the high yield and equity markets.  However, subscribers should be very selective if buying individual stocks, given the ongoing deleveraging phase in the OECD economies.  As I mentioned before, subscribers will also need to be very careful with buying “yesterday's winners,” as the stock market's “favorites” tend to change in a new bull market.

Assuming a system-wide bailout of the US banking system is announced, I expect a dramatic easing of global liquidation pressures, although there are still further “shoes to drop” – primarily in Central & Eastern Europe, and in the commercial real estate market.  For those with a long-term timeframe, the stock market still represents the greatest buying opportunity of our generation.  I am still constructive on US and Chinese equities.  Unfortunately, I am no longer overweight in Japanese equities, as both the Japanese government and corporate CEOs have shown continued reluctance for structural reforms.  We will stay with our 100% long position in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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