Rotten Fruit?

Has Apple’s shine come off?

Shares of Apple tumbled after their earnings release. While they met sales and earnings expectations, their margins narrowed, and they didn’t so much trim their guidance on future earnings so much as “shade” it—telling analysts that management’s expectations for future earnings were realistic rather than conservative: code for “We’ll beat this, but not by a lot.”

It was the profit margin that had investors worried, though. Their gross margin declined to 39% from 45% a year ago. The concern is that as Apple moves to lower-priced items in its product list, there just isn’t as much room for their fat margins. So in spite of 40% annual sales growth and 60% annual earnings growth over the past 5 years, the stock is now valued at 7.5 times earnings, adjusting for Apple’s massive cash hoard—35% below its high price last September.

Up until now, Apple could do no wrong. It was one of the four major asset classes: stocks, bonds, cash, and Apple. It grew to over 3% of the entire US market, and its soaring performance has been a big reason why so many portfolios have trailed their bogies—any decision other than to buy Apple has subtracted value.

The company and its shares have been a victim of their own success—growing to the point where the law of large numbers makes exponential growth increasingly hard. But even if the company moves to a more modest growth track, the stock is exceptionally cheap—valued more like a slow-growing utility than a world-changing technology innovator.

The recent swoon in the share price reminds everyone that trees don’t grow straight to heaven and don’t put all your eggs in one basket. Rational portfolio management demands diversification, no matter how hot one company’s prospects may be.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Supper Club

The Federal budget deficit isn’t hard to understand.

Imagine you and your spouse decide go out to dinner at a restaurant with another couple; for convenience sake agree to split the bill in half. If the other couple is having pasta and drinking tap-water, you’d be jerk to order the filet mignon and a bottle of expensive wine, knowing that the other couple is paying part of your bill. Do this more than once, and your financial arrangements would change.

Now imagine a neighborhood supper club. You and the folks on your street hold a pot-luck once a month. Every month people bring chili, or stew, or salad. But one family never seems to get around to fixing anything substantial—it’s just chips and a couple bottles of Coke. Eventually, someone will find out if there’s a problem of if that family is just freeloading. Either way, things have to change.

The problem with Federal spending is we’re having a giant potluck every day with 300 million other citizens. We don’t know each other, but we see this giant entity called “the government” providing dinner, lunch, health care, education, and all sorts of things. If you think your neighbor is having the filet mignon and you’re paying, you feel like a sap for not ordering the cannoli. So you order the cannoli, and the bill just gets bigger. Since this is the government, it’s hard to change the arrangement.

Government spending used to be constrained by custom, when we knew each other. Then it was limited by the Constitution–but that seems to be less effective today. So now we depend of “cliffs”: debt ceilings, government shutdowns, sequesters, and so on.

Where does it end? America cycles between activist and limited government. We’ve been trending towards more for almost 20 years. Turns come, but finding them is tough.

Douglas R. Tengdin, CFA

Chief Investment Officer

Trade On, Trade Off

Can trade be improved?

There are reports out of Davos—the generally worthless confab of glitterati and celebrity wannabees—that the US and Europe are close to a trade deal. UK Prime Minister Gordon Brown and Germany’s Chancellor Angela Merkel were among leaders pleading for lower tariffs and regulations. US Trade Representative Ron Kirk also got into the act, but noted that any deal would have to pass muster with US farmers and other interested parties.

Any deal would help. It’s estimated that existing trade barriers with Europe cost the US economy some $50 billion a year. That’s a lot of jobs. And the Europeans need to find some way to spur their anemic economies. Businesses on both sides of the Atlantic are generally in favor of reducing trade barriers. It opens the path to markets with millions of consumers.

But trade barriers can crop up in funny places. Many Europeans are skeptical of “frankenfoods”—genetically modified crops that help farmers fight plant diseases and pests. And pathogens like hoof-and-mouth or mad-cow disease pose difficult problems. It’s not just taxes, tariffs, and subsidies. Sometimes it’s a matter of culture as well. So while it’s well-and-good to talk about doing a deal in the next two years, one can’t help wondering, what about the last ten?

It’s not like the Bush administration was hostile to trade, or the US has lots of barriers now. Europe currently exports $20 billion in food to our 300 million consumers, while we only export $11 billion to theirs. Indeed, one of the best ways for Europe to spur growth would be for them to unilaterally reduce tariffs—enriching their consumers and eliminating deadweight loss to the economy. But that’s politically hard to do.

Still, every little bit helps. And if the pols and pundits at Davos can build a bridge and have it actually go somewhere, that will be an unexpected pleasure.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Case For Japan?

Is the Japanese market coming back?

For over 20 years the Japanese stock market has been in a funk. After topping out the last day of 1989 the market value of the Nikkei average fell over 80%. A thousand hearts have been broken—and billions of dollars lost—betting on a comeback for the world’s third largest economy. But the new Prime Minister Shinzo Abe recently announced a 10 trillion yen stimulus package—the equivalent of a $300 billion program over here. Their stock market has rallied 25%, and a lot of folks are wondering if now is the time.

Certainly, a generous fiscal package and an expansive monetary policy is a start. The fiscal package could stimulate spending in key areas, and a monetary policy that reverses the Yen’s appreciation of the past few years could seriously help exporters like Toyota, Canon, and Sharp Corporation. But is Japan’s economy too indebted, too old, and too corrupt to begin to grow again?

Not necessarily. Unlike the periphery of Europe or even the United States, Japan’s debt is primarily internal. Its elderly population is the primary holder of government debt. That means that with the right combination of estate taxes and investment incentives, much of that debt could be retired without crippling the economy with high marginal tax rates.

Some people claim that Japan’s stock market is cheap, because the ratio of market price to book price is historically low. But book prices are a poor proxy for value, especially for an entire market. It goes to the question of what something is worth: for a financial asset, its value should be based on the ability to generate positive cash earnings. Book value is simply an historical record of what someone was willing to pay in the past. For long-lived assets, circumstances change, and book value becomes increasingly irrelevant. Does anyone think a Kodak Instamatic factory is worth anything like what the owners paid, unless it is re-purposed?

Japan has been a classic value-trap—always looking cheap, until it gets cheaper. Based on current earnings, the market is still expensive relative to other markets around the world. But with a new government seemingly willing to take its economy in a new direction, the market bears watching.

Douglas R. Tengdin, CFA

Chief Investment Officer

The End of Affluence?

Is growth over?

Recently Robert J. Gordon, a professor at Northwestern University, created a stir by asking whether the remarkable growth in living standards that the world has enjoyed from 1750 until the present is slowing to a crawl. He argues that the world—and the US in particular—is facing long-term economic headwinds: demographics, education, inequality, globalization, energy/environment, and an overhang of consumer and government debt.

To some extent these headwinds have always been with us. We’ve been an aging society ever since public health initiatives started extending our lifespans. Globalization has also been an issue since 1492, as has environmental degradation and energy prices. 150 years ago New England was 90% deforested due to the appetite for firewood. Coal and heating oil have allowed our forests to grow back.

Over against these headwinds Gordon admits there have been three waves of productivity growth that have allowed the economy to expand dramatically: the industrial revolution that began in England in the 18th century; electrification and the internal combustion engine that took hold in the US around the start of the 20th century; and the information technology boom that started in the ‘60s and ‘70s and is ongoing. He makes the point that the inventions from these periods were not all created equal, and that the gains from electricity and the engine were far more important than anything that came before or since.

In essence, he’s saying that the easy, most productive discoveries have already been made. This is a point that economic pessimists have been making ever since Thomas Malthus drew his graph lines in 1798 and predicted mass starvation. It’s why economics is called the “dismal science.” And it ignores the innovation that England bequeathed on the world that made the industrial revolution possible: private property.

In the late 1600s John Locke discussed how life, liberty, and property were the unalienable rights of mankind. He did this in a political document that justified the loyal opposition to a tyrannical king. A few decades later Adam Smith noted how private property and personal interest could enhance the wealth of nations. And an American author re-worked Locke’s thoughts into a different kind of political manifesto—one that established a new nation, conceived in liberty—personal and economic.

Our economy will always face headwinds—it’s why growth is called progress. But asserting that growth will slow because we don’t know how productive future inventions will be isn’t just pessimistic, it foolishly ignores the greatest resource: the human mind.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Clash

Should they stay or should they go?

That’s the question Great Britain’s Prime Minister David Cameron wants UK voters to decide. In a speech originally slated to be given in Amsterdam last week, Cameron proposed an in-or-out referendum to be held after the next general election in the UK and after he negotiates the return of some powers from Brussels to London, such as determining holidays or setting limits on the work week.

He spoke at Bloomberg LP’s London office—a remarkable place from which to announce a policy initiative. He said that public disillusionment with the EU is at an all-time high. And while the public may not consider Europe to be a hot button issue, there’s still a lot of Euro-skepticism: in a recent UK poll, 40% of those questioned said they would vote to remain in the EU, while 34% said they would rather leave.

Because while the 17 nations that have the Euro as a common currency are becoming more deeply integrated, the demands of global competition raise significant questions for the 10 non-Euro EU members. For example, eleven Euro nations are moving forward in adopting a financial transaction tax, something that Cameron’s government adamantly opposes. But capital is highly mobile—don’t they need uniform rules?

It’s a little strange to see Great Britain questioning its EU membership—something they only achieved in 1973 after 15 years of petition. They are now Europe’s third largest economy and the sixth largest in the world. De-coupling from the many trade and financial ties they have with the Continent would be an economic disaster.

And yet: there’s clearly something distasteful about having distant bureaucrats decide the details of your personal life. We see it here when people complain about Washington. And it’s particularly galling to see Cameron labeled a “scaredy-cat” because he wants to offer Britons a referendum regarding what could be the most important policy decision of their lifetimes.

But one thing Cameron has achieved: Germany and France are now united. They despise him.

Douglas R. Tengdin, CFA

Chief Investment Officer

Rooting for the Home Team

It looks like the Kings are headed to Seattle.

Hedge-fund billionaire Steve Hansen and Microsoft CEO Steve Ballmer have teamed up to purchase a majority stake in the Sacramento Kings, the NBA franchise that moved to Sacramento from Kansas City in the ‘80s. The deal values the franchise at $525 million; it’s widely expected that the new owners will apply for permission to move the team to Seattle. Seattle has been without an NBA franchise since the SuperSonics moved to Oklahoma City in 2008.

It’s inevitable that hedge-fund managers should become involved in professional sports team ownership. The Detroit Pistons, the Philadelphia ‘76ers, and the Boston Celtics in basketball; the New York Mets, the Milwaukee Brewers, the Tampa Bay Rays in baseball–all have hedge-fund related owners. Sports teams are a conspicuous display of wealth, and most of these managers haven’t been too shy about showing the world how successful they’ve been. Team ownership is the closest thing we have to royalty in America.

But I suspect the main reason hedgies have been buying up sports teams is that they’re good investments. The combination of a dedicated local market, media-rights, and merchandising creates steady, positive free cash-flow. Apart from some high-profile bankruptcies–almost always brought about by owner shenanigans—professional sports teams almost always make lots of money. And if the team can get a fancy stadium paid for by their customers’ taxes, that’s a bonus.

But moving a team from a city of 470 thousand to one of 620 thousand—with a growing high-tech economy and which already supports valuable baseball and football franchises–should be a layup.

Douglas R. Tengdin, CFA

Chief Investment Officer

Lies, Liars, and Lance

Why do people lie?

Most people like to think of themselves as basically honest. When they look at themselves in the mirror, they want the respect the man or woman looking back at them. So we all tend to think of ourselves as nicer than average, better-looking than average, and more truthful than average.

Only it’s not that way.

Several recent studies show that if people can cheat and get away with it—just a little bit—they tend to do so. Also, if it looks like most people in the group are cheating, we’re more likely to cheat ourselves. Some college students were given a set of math problems to solve by hand in a short amount of time and were paid a dollar per problem solved. When the time was up, they shredded their papers and then self-reported how many they did. After examining the papers—the “shredder” was a ploy—the researcher found most students exaggerated a little. Out of 30 test subjects, about 18 thousand lied a little, while a handful lied big-time.

When the researcher “salted” the exam room with someone obviously cheating—who announced, “I’m done!” about two minutes into the test (which was designed so that no one could finish on time)—and who received the same payment as everyone else—the incidence of cheating went up. When others lie and get away with it, you can feel like a sap for sticking to the rules.

Which brings us to Lance Armstrong. By his own confession, every one of his seven Tour de France victories was accomplished with a little help from performance enhancing drugs: steroids, painkillers, blood boosters, and so on. Because he denied using drugs—and aggressively attacked anyone who contradicted his denial—he has been banned from professional sports for life.

But cycling has been especially fraught with doping scandals. Every pro sport—baseball, football, boxing—has had its share. In the last Tour de France, you had to go down to number 17 to find someone who was admittedly substance-free. The incentives seem too significant and the penalties too diffuse and distant for most athletes to resist. In spite of the health and reputational risks, the potential gain is too much to pass up.

But Lance has now been skewered. That’s the risk of egregious cheating and serial denial. Lance Armstrong used to be an example of a generous, courageous cancer-survivor. Unfortunately, his name will become a byword for blood-doping shame.

Douglas R. Tengdin, CFA

Chief Investment Officer

After Chavez?

What happens after Hugo Chavez?

Hugo Chavez had an operation for cancer in December and hasn’t been seen in public since. Now, the country is in political limbo. The 58-year old has been President of Venezuela for the past 15 years, where he has been both highly popular and highly divisive. Constitutional reform, land reform, nationalization of key industries—all were part of Chavez’s policies. At times Chavez has been autocratic and vicious.

But the source of his popularity is simple: of the roughly $800 billion in oil revenues earned by Venezuela since he took power, approximately $200 billion have been used to alleviate poverty. It’s easy to be popular when you can hand out billions. But that oil-wealth is going to be a cause of trouble going forward.

When Chavez dies it will pitch rivals against one another. In fact, his senior lieutenants have already begun to jockey for position. His older brother Adan; a crowd of politically-connected tycoons; a group of ideologues known as “Chavistas”; and of course the army—all would like to control $40 billion a year in oil-export revenues in a country of 30 million people.

Who else is watching the coming succession battle? Cuba, of course. They’ve received billions in subsidized oil. And Nicaragua—which had a $30 million loan from Venezuela forgiven, along with a “gift” of another $10 million. Indeed, much of the Latin American “pink tide” of the last decade has been supported by Venezuelan oil money. When Chavez is gone, that money—and perhaps the movement—may go with it.

Latin America has been unusually quiet for the past decade. When Hugo Chavez passes out of the picture, that’s likely to change.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Circle Game

What can Joni Mitchell teach about investing?

40 years ago Joni Mitchell wrote “The Circle Game,” a lyrical song about a young man’s gradual coming of age. The most memorable part is the refrain, which goes: “We can’t return, we can only look behind from where we came / and go round and round and round in a circle game.”

Circles and cycles are part of investing. The economy cycles through growth and recession every 4 to 8 years; businesses magnify any economic decline into a significant profit downturn; and investors take those business losses and run with them, bolting for the exits en masse and causing market panics in the process.

The economy doesn’t decline that much because we all need to eat, sleep, and heat our homes no matter what our mood. Corporate leaders can’t be too moody, either. They need measure their firms’ progress and manage by the numbers, not their feelings. But there are no checks on the swings of investor psychology. Investors are the classic manic-depressives—alternately crazily bullish and depressingly despondent—driving prices along with them. So most investment risk doesn’t come from the economy or the business cycle, but from investor psychology. And that’s where Joni Mitchell comes in.

For four years we’ve heard the gloom-crew tell us to get off the train, batten down the hatches, and look out below. But four years of successively higher highs and higher lows have the bears in retreat. The painted ponies are moving around the carousel from depressive to manic. Because the returns on “safe” investments are so low, people are moving out the risk curve to preserve their income. And so it’s time for a little caution.

Because what the wise do in the beginning, fools do in the end. Four years ago it was wise to go against the flow and bet on a recovery. It wasn’t easy. But those bets have paid out in spades. Taking a little money off the table now will be equally difficult. But the alternative—another circle game—could be worse.

Douglas R. Tengdin, CFA

Chief Investment Officer