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Only the Strong Survive

(Guest Commentary by Rick Konrad – May 27, 2010)

Dear Subscribers and Readers,

For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in our regular guest commentator, Mr. Rick Konrad for a guest commentary.  Rick has been a regular guest commentator for several years and offers his unique insights to us in his twice-a-month mid-week commentaries.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick will discuss his views on the current volatility and long-term economic problems of the developed economies.  Rick then offers several stock picks that he believes are suitable for this environment – reminding us that stocks with high returns on capital are imperative in the rapidly changing regulatory and macro environment.  Without further ado, following is Rick's biography:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on MarketThoughts.com (please see "The Greek Oil Slick” 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 involved with grading CFA examinations.

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.


The last few weeks have caused the pendulum swing of investor emotion to sway into deep seated fear mostly relating to the potential disintegration of the Euro and the contagion of the Greek fiscal problems. For previous discussion please check our recent post. As I have visited many brokerage offices in this time period as well, and have spoken to my investors, it seems to me that so many investors were obsessing about the negative repercussion of this without really spending much time on other issues. Sentiment was dreadful and risk aversion became the only game in town.

Risk aversion can be as dangerous to your financial health as risk taking. At least, it is at times of maximum risk aversion that the greatest opportunities exist to create wealth. Obviously, many investors are shirking from their riskier investments and selling in order to purchase what they deem to be safer. Hence, riskier assets demand higher risk premiums in order to be accorded attention. Ergo, higher returns for those willing to bear risk.

Two of my clients terminated their accounts earlier today…as they indicated to me, “We're sorry, you've done a great job but we just can't stand the volatility.” Great job may be overstating it, but we have added over 1600 basis points over the benchmark in three years. Even better on a risk-adjusted basis. Yet, fear prevails. As Howard Marks of Oaktree once put it so succinctly, “”Skepticism calls for optimism when pessimism is prevalent.”

Many hedge fund investors and friends are gathered today at the Ira Sohn Conference, a wonderful charitable event that provides humor and insight from many of the most highly regarded investors in America. Though I was unable to attend this year, some interesting comments are getting tweated my way. It seems that many are not that worried about Euro-contagion or China…its Washington and a new regulatory framework in banking. Tax targeting the wealthy is never a message that goes over well with hedgies and as history has demonstrated, taxing is nowhere near as effective as fiscal discipline in dealing with government spending issues. Apparently, at today's conference, Sam Zell brought an animation of a dodo bird with references to Charles Darwin and an admonition: “I guess the message is, he who adapts, succeeds. He who doesn't may not be here next year. ”

So how do we adapt? What will the “new” environment look like? In my view, fiscal restraint combined with higher taxes or at least enforced tax policy in some of the more egregious economies will translate into slower growth. Think of the people of Latvia, the first Euro economy that faced austerity measures as a result of its fiscal problems in 2008. The civil service was slashed by some 20%. Salary cuts amounted to some 25+% for the 80% lucky enough to retain their jobs. GDP in Latvia fell by 17.5% last year in response.

As The Economist observed in its Feb 25, 2010 edition: “Even if a catastrophe has been averted for the moment, Latvia's economy remains troubled. Unemployment, at 22.8%, is the highest in the EU. Growth is unlikely to resume until late 2011. After a decade of prosperity based on a construction boom, cheap manufacturing and transit from Russia, Latvia needs new sources of income. The biggest task is to harness local brainpower. Emigration has been a safety valve for jobless Latvians, but the country loses if fraying public services, high taxes and low pay drive its more productive workers abroad. And nobody seems to be trying to stop them.”

Bottom line, the penance that we face for profligate spending is slower growth. Policy wise, we should expect:

  1. Government activism- After a few decades where government got out of the way, encouraged by the likes of Reagan and Thatcher, government will be the new activists. Activism may embrace trade, employment, and finance. Perhaps some governments will take on greater ownership of some private enterprises…not surprising after witnessing GM, Citi, and AIG.

  2. Deleveraging- It's payback time for all of us, consumers and governments. Unlike many prior slowdowns, the corporate sector is in fabulous shape across most sectors. As Barron's outlined in its May 17th edition,

    “Corporate America is prepared to return cash to investors and to accelerate the spending, hiring, investing and acquiring that most companies curtailed amid the credit stress and deep uncertainty of the financial crisis and the 2007-2009 economic contraction. Mergers and acquisitions, capital spending, share buybacks and dividend increases have been running at historically low levels and are just beginning to rise. While this anticipated corporate cash deployment won't in itself carry the economy or propel the stock market to towering new heights, it should contribute to growth and help enrich investors in companies with solid balance sheets.”

  3. Increased industry restructuring is likely- Tough times expose flawed business models and structural weaknesses. Companies will get better or get out. Competitive intensity will increase.

Like the song lyrics go:

Your time has come - you can stand or you can run
But don't keep it all inside
Cause you gotta understand that there ain't no second chance
No-one gets outa here alive - only the strong survive

Growth for the sake of growth will likely be replaced by fairly intense scrutiny of capital usage i.e. return on capital. I think the focus for investors will be on business model volatility or cash flow volatility rather than beta.

A few names that we own that we think fit these sorts of parameters.

Compass Minerals (CMP)- http://www.compassminerals.com/

This minerals producer has generated decent returns on invested capital in the 20's while growing top line at about 7% for the last 5 years and growing operating income at 17% over that time frame.

Raytheon (RTN)- http://www.raytheon.com/

Defense contractor with some 30% of its backlog from international sources continues to impress me with its working capital management and attention to detail. Return on capital has exceeded the cost of capital for years. Current ROIC is around 12% and has been inching up from levels of 9 and 10% some five years ago. Balance sheet is in the best shape ever actually holding cash in excess of debt. A decade of deleveraging has transitioned balance sheet from worst to first.Five year revenue growth of about 4% looks boring until we look at operating income growth of 17% CAGR over the period. Part of my defense stocks are the new defensive stocks thesis.

Telefonica (TEF)- http://www.telefonica.com/en/home/jsp/home.jsp

I know it's Spain but TEF has operations in 25 other countries. Free cash flow generator as a result of fat operating margins in Spain. Top line growth is squat, not unlike its competitors:

But operating cash flow margins are a different story:

Even though the Spanish economy is weak with 20% unemployment, some important elements of TEF are showing rapid growth, for example, data revenues grew 52% in 2009.

Over 60% of its customers are in Latin America but they represent about 40% of revenues and EBITDA.

With a 7% yield while you wait, the business is earning at a 13% rate on its capital, well above its cost of capital.

Disclaimer: I, my family or clients own positions in all of the securities mentioned in this post.

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