Geopolitics, Economics and Emotions
(Guest Commentary by Rick Konrad – May 26, 2011)
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 Mr. Rick Konrad to pen a guest commentary. Rick has been our regular guest commentator for several years and offers his unique insights to us twice a month. We highly appreciate your investment insights and general wisdom, Rick!
In this commentary, Rick takes stock of the changing dynamics of global financial markets—including the slowdown in the US economy, the European sovereign debt crisis, policies in China, and speculation in commodities. In such an environment, Rick argues that a selective focus on companies with well-capitalized, well-financed, and highly competitive companies is essential—and provides two ideas in the form of Microsoft (MSFT) and Cisco (CSCO). 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 “There'd Be Days Like This” for his last commentary). Prior to his founding Value Architects, Rick was a professional portfolio manager for institutional investors for over 25 years. A more complete profile of Rick is available on his blog. You can also email Rick at the following address if you have any questions or thoughts after reading his commentary. Rick is a very genuine teacher of the financial markets and treats it very seriously. Rick has also run 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 graded 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.
“Opinion is ultimately determined by the feelings, and not by the intellect”- Herbert Spencer
Though most of us incorrectly attribute the concept of "survival of the fittest" to Charles Darwin, this conceptualization was developed by Herbert Spencer, a 19th Century English philosopher after reading Darwin's "Origin of Species." Spencer also applied the theory of biological evolution to sociology. The above quote seems appropriate at a time when perception truly becomes reality.
The economy at the beginning of the year seemed to be in a full tilt boogey as GDP appeared to pick up versus the closing months of last year as a result of continued fiscal and monetary stimulus. Evidence is gathering that we are slowing. Historically, recoveries following financial crises tend to be drawn out and subdued, normally as a corollary of a lack of credit availability. Tight credit despite ridiculously low rates has certainly played an important role in constraining the current recovery. The cratering of housing and the consequences for the consumer balance sheet have placed limits on consumption growth as households focus on reducing debt and rebuilding savings. As we all know, almost a quarter of mortgage borrowers still owe more on their loans than the current value of their homes. Additionally, only half of all borrowers have the 20% of home equity needed to qualify to take advantage of refis at lower interest rates. Household debt has fallen from its peak of 135% of disposable income to a still lofty 120% at year end.
Looking at Europe and its sovereign debt woes, inaction or buying time is the only action. As the Financial Times described the seemingly hopeless Greek situation: "Two uncertainties remain: when to default, and how." The strategy of "Kicking the can down the road" or "Extend and pretend" does little to resolve the problem. Yet the ongoing contractions in these countries will be compounded by what could be a severe decline if their government spending or a cranking up (or in the case of Greece, actual collection) of taxes. In many ways, Europe seems to be in a state of suspended animation. The bold experiment of linking disparate governments, cultures, and resources through an irrevocable peg to a single currency without a unified fiscal authority is failing miserably.
A different set of policy challenges in China is also producing serious risks. While statistics demonstrate that China's policy tightening is delivering significant results—money supply is decelerating and new loan growth is half of what is was—the impact of this policy change is creating vastly divergent liquidity conditions across the country. Large enterprises can easily obtain credit at reasonable rates but small lenders, not unlike our own banks, are struggling to keep up with the reserve requirements. It appears to me that it's taking more and more credit to produce a unit of GDP in China. Questionable tracking of credit and the economy in general raises my suspicions. The single most widely held assumption by investors is that somehow economic recovery in the world will be driven by the Chinese juggernaut as well as other emerging markets. What if that does not occur? Speculative distortions exist in many of the companies geared to the growing Asian economy such as Caterpillar, and most raw materials companies and the commodities themselves.
Now that earnings season is over, as we assess the results, slowdown is evident. Fewer than 60% of companies beat according to Bespoke Investment Group, the worst performance since the last quarter of 2008. Even worse, fewer than 8% guided analyst consensus earnings higher. Looking at Commerce Department figures, US corporate profits expanded at an annualized rate of a little more than 5% for the first quarter, following an increase of almost 10% in the prior quarter. Margins seemed to be boosted by continued pressure in unit labor costs. It seems that the market is becoming increasingly vulnerable to disappointing earnings.
We continue to see the greatest risk in the resource groups. Although many companies are enjoying tremendous, even record cash flows, there is growing evidence of cost pressures that could threaten margins should some of the flaring expectations around commodity prices subside. While fundamentals remain supportive at present, political risk in the Middle East and North Africa, inflation fears and speculative demand are finding their way into prices for oil, precious metals and some industrial commodities. Given the downside risk this implies, I have been positioned very cautiously in resource cyclicals with a focus on low-cost producers and those with balance sheets required to sustain capital investments and weather earnings volatility. In terms of commodity exposure, areas such as natural gas agriculture and uranium are relatively attractive from a downside risk perspective.
As our initial paragraph suggests, this is a time for survival of the fittest. Well-capitalized, well-financed, and highly competitive businesses will maintain cash flows much higher than traditional analysis would suggest.
Here are a few favorites:
Microsoft (MSFT): Too much value to ignore. We have added MSFT for our accounts following the disastrous reaction to Skype. Skype is likely a waste of capital, perhaps serving a modest need, but ultimately, a minor diversion. More importantly, Microsoft's server and business application software products are well positioned to benefit from the rapidly growing onslaught of the cloud. The Windows operating system may well become a fading memory as PC based operating systems become superfluous. MSFT is not sitting idly by as the cloud evolves as well as MSFT's Azure cloud based platform. Though it is relatively easy to find places where MSFT flubbed or has wasted significant dollars, it seems that MSFT is intent on making the transition easy for .NET developers to migrate to Azure. Though it remains unclear whether MSFT can dominate this space as it has the PC realm, it seems reasonable to think that high switching costs and network effects will continue to benefit the company as it makes this transition. David Einhorn at last night's Sohn conference, touted the merits of Microsoft's financials but excoriated Steve Ballmer 's leadership having major opportunities in establishing tablet products to compete with Apple and wasting money on ill-conceived mergers and acquisitions. We think the stock has an intrinsic value of mid-$30's with or without SB.
Cisco (CSCO): Too much value to ignore.
There are many things which are going right:
- The balance sheet has $7.83 per share in cash and equivalents
- The company generated about $3 Billion in operating cash flow for the most recent quarter
- Positive revenue growth trends in the following:
||As % of Total Revenues
Within the new products area, collaboration revenue grew 39%, wireless grew 32%, and Data Center grew 31% YoY
Then we get to the problem areas. Switches which are down 10% YOY but up 5% QoQ are facing competitive challenges. They do represent about 30% of revenues down from about 35% a year ago. In the switching area, CSCO is addressing this through a technologically advanced product called Nexus which keeps it at a technology forefront. However,
- There are lower priced competitors;
- The improved functionality requires the company to sell three times as much product to garner the same revenue;
- The company is still early on the cost curve. Engineering needs to bring down the cost of production by some 800-1000 basis points in order to achieve comparable profitability. Chambers mentioned that cost reduction cycles need to be accomplished over 12-18 months as opposed to historically 2-3 years.
Company did guide much more conservatively than anyone would have conjectured with 1-2% growth in revenues for the next quarter. While somewhat disappointing, the company is being prudent in setting realistic expectations when it is in the midst of product transitions and restructuring.
I believe the company is taking the appropriate steps in rectifying its issues, especially taking out $1 billion in operating expenses. The strange decision-making structure has been addressed, the new COO seems to be having some influence, and the abandonment of expectations that nobody really believed clears the deck.
I anticipate further divestitures to be announced in the coming weeks and months. It will take another two or three quarters to gain credibility, but we see little downside from here. We think that the upside could be high $20's.
As Spencer indicated, opinion is more often than not a reflection of emotions and feelings rather than sound use of intellect. Equanimity in the face of market volatility is the hallmark of a value investor. The discipline of relying on individual company fundamentals and valuations rather than on capricious market headlines and macroeconomic trends should continue to serve us well over time as it generally has.
Disclaimer: I, my family, or clients own positions in Microsoft and Cisco.