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A Dose of “Anti-Depression”

(Guest Commentary by Rick Konrad – February 19, 2009)

Dear Subscribers and Readers,

For those who had wanted to learn more about picking stocks, evaluating companies, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary.  Rick is a regular guest commentator and usually writes for us every third Wednesday of the month.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick will put the current US and global recession into perspective – with an emphasis on the importance of being able to think independently, especially during times of great uncertainty.  Rick will also offer his thoughts on what industry will emerge from this downturn stronger than ever.  Without further ado, following is a biography of Rick:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “Waiting for the Fat Pitch” for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog.  You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.

"Whenever you find yourself on the side of the majority, it's time to pause and reflect." -Mark Twain

The New Year has brought little joy to most of us on the long side of this market. The sentiment shift is remarkable. Braggadocio among portfolio managers on the cocktail circuit a couple of years ago centered on obscure little “story” stocks, companies that were ripe for takeover by activists willing to take them private, or Chinese or Indian stocks that provided an opportunity to grow with a rapidly growing economy that purportedly was de-linked from the rest of the world. Investment horizons seemed far off if at all contemplated.  Current boasting generally involves disproportionate levels of cash in accounts or claims to have shorted everything financially related. Horizons have been truncated to periods slightly beyond settlement date. Investors' sentiment appears to have gone from “get me even” to “get me out.”

In fact, the word “depression” has become commonplace. Google Trends provides a quick and useful barometer of the terms that people are searching. In looking at the last twelve months of Google searches under the terms “depression,” “crisis,” and “recession” one finds that the word “depression” has the highest incidence in these searches followed closely by “crisis” and lastly by “recession.” Clearly, the focus of most people appears to be the recurrence of depression. Here is a graphic portrayal of these results.

In fact, in a recent Wall Street Journal article, President Obama was chastised by economist Bradley Schiller for his rhetorical use of the word “depression.”  As he writes in the February 13th edition of the WSJ:

President Barack Obama has turned fearmongering into an art form. He has repeatedly raised the specter of another Great Depression. .. As he tells it, today's economy is the worst since the Great Depression. Without his Recovery and Reinvestment Act, he says, the economy will fall back into that abyss and may never recover.

He cites labor statistics which are disturbing but nevertheless, not akin to the depression experience:

Consider the job losses that Mr. Obama always cites. In the last year, the U.S. economy shed 3.4 million jobs. That's a grim statistic for sure, but represents just 2.2% of the labor force. From November 1981 to October 1982, 2.4 million jobs were lost -- fewer in number than today, but the labor force was smaller. So 1981-82 job losses totaled 2.2% of the labor force, the same as now.

Job losses in the Great Depression were of an entirely different magnitude. In 1930, the economy shed 4.8% of the labor force. In 1931, 6.5%. And then in 1932, another 7.1%. Jobs were being lost at double or triple the rate of 2008-09 or 1981-82.

He goes on to describe the dimensions of GDP contraction in a depression versus our recent experience:

Other economic statistics also dispel any analogy between today's economic woes and the Great Depression. Real gross domestic product (GDP) rose in 2008, despite a bad fourth quarter. The Congressional Budget Office projects a GDP decline of 2% in 2009. That's comparable to 1982, when GDP contracted by 1.9%. It is nothing like 1930, when GDP fell by 9%, or 1931, when GDP contracted by another 8%, or 1932, when it fell yet another 13%.

Repeated warnings about financial apocalypse do little to bolster investor confidence or to lift consumer expectations. Yet, though none of us can assign a zero probability to depression, the likelihood of such an outcome seems very low, particularly given the coordinated actions of central banks and treasury departments around the world and giving some thoughtful consideration to the dimensions of the statistics stated above. Considering the recent Japanese GDP release, economic news remains quite devastating.

It is bad out there. The economy is getting worse, consumers and some business still need to de-lever and worst of all, housing remains a mess. Consumer debt as of the end of the third quarter represented 96.4% of GDP. US business debt represented some 48.8% of GDP. But the US does have a better balance sheet than most of the rest of the world. Non performing loans in the States represent about 1% of total loans. In Japan, this figure is some 2.4%, in Europe, just under 2%. Corporate sector debt in the US is about 40% of equity as compared to Japan at 97% and Europe at about 75%.

An excellent paper by Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard looks at the US sub-prime financial crisis in the context of 18 post World War II banking crises in industrial countries is worthwhile reading. Protracted crises have occurred in Spain (1977), Norway (1987), Finland (1991), Sweden (1991) and Japan (1992) and resulted in major declines in economic performance for an extended period. Here is the link

As bad as it is, this is not a Great Depression or G.D. II as some have coined it.

Why not?

  • Interest rates were tightened between 1929 and 1932.
  • Fiscal policy was tightened from 1929 to 1932 as Hoover and Congress attempted to balance the budget.
  • Fiscal stimulus did not occur until 1933 and peaked at 5.4% of GDP
  • Money supply shrank by a whopping 33% from 1929 to 1933.

Contrast this with the current period:

  • Fed funds are essentially zero
  • Fiscal policy is anything but tight and balancing the budget is far from anyone's mind
  • Fiscal stimulus between the new $787 Billion and what remains of TARP represents about 8.0% of GDP.
  • Mr. Bernanke sent the helicopters…M2 is growing at about a 22% annualized rate.
  • The Fed has doubled its balance sheet.

Help is coming from unlikely sources such as the IRS. Globally, we are seeing tax cuts on home sales in China, stimulus programs in Thailand, and Japan. Even Dubai has announced that it will increase spending by 11% this year. In Germany, there is agreement to begin Europe's largest fiscal stimulus of some $67 B or €50B over two years. Clearly, there is a global program of reflation to attempt to restart a critically wounded credit cycle.

While governments and monetary authorities are doing their part to support demand and prevent the collapse of the system, private industry is beginning to restructure and adjust to a more restrictive economic reality. I am encouraged that productivity gains are being maintained despite the downturn. Like the restructuring of the early 80's, the outcome of this is that businesses that survive will have higher profitability coming out of the downturn than would have otherwise been the case. On the trade side of the economy, the de-leveraging of the consumer has had a dramatic impact on imports which are down 7% over last year. With only a 2% fall in exports, our trade deficit is finally narrowing.

I am also grateful that spreads are normalizing for many asset classes. Despite record bond issuance by the US Treasury, 10 year yields are below 3% and investment grade corporate debt issuance is beginning to recover. The commercial paper market is thawing out after a year of decline and CP rates are coming down.  The only positive one can say about housing is that inventory is coming down and housing affordability is near all time highs.

Money remains on the sidelines with money market fund assets now capable of buying out almost 50% of the S&P 500 market cap. On NASDAQ, short interest is two standard deviations above the mean.

Apart from 2001, in the past five recessions (1970, 1974, 1980, 1982, and 1991) stock prices rose 25-30% in the next six months after the market bottomed. As you can see from the table below, this frequently was accompanied by P/E expansion that exceeded the EPS decline.

Year Year-end Price for S&P 500 EPS ($/share) P/E & Change in P/E
1960 58 3.27 17.8  
1961 72 3.19 22.4 +26%
1969 92 5.78 15.9  
1970 92 5.13 18.0 +13%
1973 98 8.16 12.0  
1974 69 8.89 7.7 -35%
1979 108 14.9 7.3  
1980 136 14.8 9.2 +26%
1981 123 15.4 8.0  
1982 141 12.9 10.9 +37%
1990 330 23.42 14.1  
1991 417 19.50 21.4 +52%
2001 1148 45.16 25.4  
2002 880 47.94 18.4 -28%

Datasource: UBS US Equity Strategy

One other dimension of portfolio thinking that should be addressed is the relevance of dividends as part of total returns. Dividends peaked for the S&P 500 in June of 2008 and have dropped off by a highly unusual 10.8% since the peak. This is a 3.8 standard deviation event!  But the “geography” of the dividend cuts tells an important story in and of itself:

Sector Dividend as % of S&P % Change from 6/30/2008 to 1/31/2009
Financials 20.2% -29.1%
Consumer Staples 14.1 +1.3
Industrials 13.6 +5.3
Health Care 12.0 +1.8
Energy 9.6 -1.6
Info Tech 7.1 +4.3
Consumer Discretionary 7.1 +1.7
Telecom Services 7.0 +3.1
Utilities 5.9 -0.8
Basic Materials 3.5 -8.4

Source: NDR Research

Clearly, the damage has been largely confined to the financials though basic materials, utilities, and energy have also had some dividend reductions. Ex-financials, in aggregate, dividends have grown by 1% for the other sectors.

More cuts may be on the horizon. Generally speaking, the number of S&P 500 dividend cuts has peaked after the end of the past five recessions. So far, dividend cuts have been minimal outside of the financials with only 13 non-Financials having cut their dividends. Keep an eye on payout ratios as a percentage of cash flows and free cash flows! Make sure that the dividend stream you are counting on is sustainable!

The essence of capitalism, Austrian economist Joseph Schumpeter warned, is "creative destruction" that undermines economic structures, then replaces them with better ones. Today we know all about destruction. We could use a happy dose of the creative element. Here is a creative sector that I think requires further investigation:

We are spending considerable time in the healthcare sector and looking for innovation in places like the CRO (contract research organizations.) CROs provide product development services to the pharmaceutical and biotech industry. Such services may include drug testing, data analysis, reporting and consulting services among others to move a drug candidate through the necessary FDA regulatory requirements that must be met to seek approval. CROs have developed the infrastructure and expertise to develop drugs more quickly than large Pharma companies can do internally. They allow pharma companies to bring their products to market more quickly while using high quality independent data and avoiding the need to support a costly overhead structure.

The largest CROs such as Covance (CVD) and ICON (ICLR) have global infrastructures that can assist drug companies in recruiting patients and administering the regulatory process in many world locales. The closing of R&D facilities as announced by Merck, Pfizer, and Lilly implicitly suggests that there will be a higher reliance on outsourcing in the future. At this point, more than 80% of pre-clinical development is performed in-house. There is plenty of room to grow.

Much like the auto companies found themselves having to outsource in order to free up capital and reduce costs, I suspect that pharma companies will find themselves looking for ways to improve their productivity. Successful outsourcing companies in the auto industry sustained returns on equity of 20% or better for many years while the Big 3 struggled to earn a 4 or 5% return.

It would not be surprising to see a shift to strategic outsourcing in order to generate better productivity in the industry.

We suggest that names such as Charles River (CRL), Covance (CVD), ICON (ICLR), Pharm Product Development (PPDI), ParExel (PRXL), and Kendle (KNDL) may be a good place to look for value.

We will be following some of these names in future posts of Value Discipline.

Investing opportunities abound in this ugly marketplace. Horizons really have deteriorated into nothingness. Markets sway 2-5% a day based on the day's economic news- often a release of data that is at least a month old. As Buffett said, the market is a voting machine not a weighing machine. Short term consensus views will prevail but longer term, fundamentals in decent businesses always prevail. As Mark Twain said, if you are part of the majority, pause and reflect why you believe what you do.

Keep in mind that stocks will reflect future cash flows not what has happened in the past. Be careful out there but keep swinging the bat!

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