Saturday, March 03, 2007

Dell's Attempt To Regain Past Glory

Last Thursday's Wall Street Journal contained an article detailing the many recent senior level management changes at Dell Computer. I won't go into all the details. Suffice to say, the article presented the situation as one in which Michael Dell has returned to the computer maker which he founded, and is evidently leaving no organizational or personnel stone unturned, in his determination to revive the firm's fortune.
Instead, I'd like to focus on a more strategic view of the Dell situation. For starters, consider the Yahoo-sourced price chart above, comparing Dell, H-P and the S&P500 for the past five years (please click on the chart to see a larger version). While H-P has outperformed both Dell and the index, it was effectively flat from early 2003 until mid-2005, or two and a half years. Dell, too, was flat for most of 2005, until it began its recent decline. Neither has been particularly consistently superior to the index over much of the five year period.
Both H-P and Dell are, for the most part, engaged in the production and marketing of commodity electronic products- desktop and laptop computers, and printers. These types of firms haven't been on my equity strategy's selection lists since 1998. In the interim, the market for consumer computers has evolved to the point that most buyers can select and take home a perfectly adequate machine from a store at any one of as many as four chains (e.g., BestBuy, CircuitCity, Staples, Costco), with competitive pricing pressure providing similar values across the vendors and products.
In such a market, can we really expect either vendor, H-P or Dell, to somehow add sufficient extra value, and be paid for it, to drive its performance to a level of consistently superior total returns over several years? We're talking about producing some of the most common, nearly-disposable electronic devices you can imagine- personal computers and printers.
If price- and feature-based competition is so fierce, one would expect the performance differences among the firms to be in market segment growth or penetration. Here, Dell is notably scarce on dealer shelves, in a market in which buyers no longer seem content to wait for a 'custom' machine. So I don't really expect Dell to be returning to its past glory of nearly a decade ago. The competitive environment for its products, and the behavior of its target consumers, have changed to the extent that I don't think the product/market positioning of the firm will sustain consistently superior total return performance anymore.
Instead, the action seems to have moved on to online information and advertising purveyors- notable Google. This is not really a surprise. Over the years, consistent superiority of performance among technology firms has moved up the "food chain," from Intel and Microsoft, to the box makers, then the specialty applications software firms, to the online access and content providers. Now, it's moved beyond the last group, to simply providing tools to find information.
Although Michael Dell may return his firm to profitability and some revenue growth, relative to recent years, I don't think Dell has much potential to reward shareholders anymore.

Friday, March 02, 2007

Hillary Clinton's Call For Capital Flow Restrictions

The market, and America, got a good look at Hillary Clinton's misunderstanding of capital markets and economics, in an interview on CNBC this week, seen here.

The video clip is a discussion by members of CNBC's morning show, Squawkbox, of the interview, whose tape from the prior day is featured in the clip.

I would like to say that, having revealed herself to be a proponent of returning to an era of international capital flow controls, Clinton has severely damaged her presidential campaign and aspirations. Sadly, probably less than half of the American voting population will even understand what Hillary means by her statements, and how devastating her threats would be to the US and global economy.

Hillary expresses so many misunderstandings of economic reality that it is difficult to know where to begin critiquing her remarks.

First, of course, she is incorrect to suggest that we, the US, is at risk because we have debt outstanding held by foreigners. The debt is issued in our own currency. It is the debt of the world's leading economic growth engine, and only large, reliable and safe economy. The governments of China, and other nations, hold US debt because it affords them a competitive return on low-risk financial assets.

As Larry Kudlow pointed out, our allies hold approximately 80% of foreign-held debt. Further, Fed Chairman Ben Bernanke pointed out this week that our foreign-held debt is not a risk, in that they choose to hold these assets. Our debt is sought after for its relative return and low risk.

Next, Hillary indicated her lack of understanding of a growth economy. As one of the world's largest economies, the leading growth economy, and also a large, consuming nation, the US attracts capital from overseas to fund its growth. Foreigners buy US equities and debt, including that of our federal government, in order to participate in the growth in the American economy. We could not possibly fund all of our growth with domestic assets or savings anymore.

Further, when we spend money to import products, those dollars have to go somewhere. They return to the US via spending on exported US goods, and by investment in US enterprises or government debt. The mechanism of international investment requires US dollars to be used to pay for US investments. Thus, one way or another, US spending and growth leave claims on US assets in the hands of overseas individuals, companies, and other countries. This is simply a fact of global economics.

Hillary made a rather inane comment to the effect that the more we issue debt, the more the Asians buy it. Were that true! It's not that they buy because we issue. They buy our debt because it is offers a good return for the risk.

Finally, Hillary's hint at capital controls and somehow interfering with the issuance of debt or its purchase by foreigners runs the serious risk of triggering a global economic recession.

It was only with the dawn of the 1980s that better information and looser capital controls allowed private investors to discipline heretofore lax central bankers by punishing the currencies of profligate countries. International economics and finance have evolved to the point at which country finance ministers and central bankers must fear and respect the judgement of capital flows when managing their economies and currency issuance.

To retreat from this desired state, and return to the days of artificial controls on international capital movement, is to dismantle our relatively free and efficient global trading system, and harm global economic growth.

I'm very surprised Hillary's handlers even let her give this interview, let alone go afield with the absurd comments she made. It's on video, and will last through the entire election campaign.

Let's hope, first, that she doesn't get elected, and, second, that enough Americans understand what she meant to fear her appropriately.

Thursday, March 01, 2007

The Equities Markets Recent Turmoil

The business media is all a buzz with the biggest equity market news in years. A 3.5% drop in the S&P on Tuesday has everyone scrambling to discern whether this is a "corrective" phase in the equity markets, or the beginning of the dreaded "crash."

So, which is it? Well, I confess to being no seer of the future of the equity markets. But I can offer some observations on the past and current situations.

It's important to recall that, over the long term, equity market troubles inevitably reflect real economic issues.

For instance, in October, 1987, it was my alma mater, the Chase Manhattan Bank's refusal to back the United Airlines ESOP loan, that triggered Black Monday, on which the S&P fell 20.5% by that day's end. This called into question the overall credit expansion, and resulted in market turmoil for several months thereafter. But that single month was the one really bad one for equities.

The Asian debt crisis of 1997 had little effect on US equity markets, but crippled Asia for some time.

In 1998, Long Term Capital's demise resulted in a 14.4% loss for the S&P in August. However, with no actual real economy basis for this incident, the market recovered within only a few months.

With those incidents as background, we need to identify what would be current sources of weakness and shock to the current economic situation in the US, or around the world. From watching CNBC and reading the Wall Street Journal this week, I confess to not finding the smoking gun which would make the volatility of the past few days into the equity markets expression of a looming economic catastrophe.

Let's consider the most frequently named culprits: sub-prime mortgage lending, Asian equity markets, US and global economic growth, excess liquidity, hedge fund excesses.

As far as I can tell, the sub-prime lending troubles do not constitute the bulk of mortgage lending. True, lending standards are tightening again, which will lead to a continued pacing of any residential real estate sector recovery. But is sub-prime lending going to trigger a recession? From what I have read and heard, it's doubtful. Some companies will go bankrupt, and some homes will go empty for a while. But I don't think it will, on its own, tip the US economy into recession. If anything, it might lead to a quarter point rate cut by the Fed by the fall of this year.

The Asian equity market's 9% decline earlier this week was apparently more of a reaction to a similar runup in prices over the prior six trading days. There seems to be no visible, underlying economic weakness which triggered the decline. Chalk it up to short-term market froth in Asia.

While recent GDP adjustments have trimmed growth from 3.3% to 2.2%, the economy is still growing. Even given Samuelson's accelerator/multiplier effect, we should only see a slowing of overall economic activity, not an outright, longer-term decline or recession. There are some focused sectors of weakness- Detroit, for auto production, and selected real estate markets around the US- but overall economic activity remains strong, with low inflation. Even today's manufacturing report is positive.

Every spring for the past two calendar years, a legion of second- and third-tier economists have attempted to make their names by forecasting a "soft patch" or a recession, only to be proven wrong by fall of that year. It looks like 2007 is shaping up similarly.

While I'm tiring of his using it relentlessly, Larry Kudlow is right when he asserts, continuously, that this economic expansion is "the greatest story never told." As such, global economic growth seems to be keeping pace with the US.

The liquidity issue may affect equity markets if, in fact, as Doug Cass, of Seabreeze Partners, alleges, much of current hedge fund capital is, in fact, leveraged on the way in. If this is true, and recent performance weakness leads to large redemptions by European institutional investors of mostly-borrowed money, then US equity market prices might decline in the face of reduced supply of funds. That probably won't change relative values, though. And it might not even affect the market for much more than a few months. It's simply unknown what the size of such investments might actually be.

Consider that the US equity market. According to IMF data, it was roughly $11 trillion in 2004. If a hedge fund like SAC has even $40B under management, it accounts for less than .50% of the equity market. So the effect which Cass mentions may not be all that important.

Similarly, hedge fund losses would certainly affect prices. But it's somewhat of a chicken and egg issue. If the funds lose money because prices fall, do prices fall further because the hedge funds lost money? That's not clear, either. Certainly, the more risk averse retail investors may be running to the sidelines right now. But the cooler-headed professional investors are not.

Overall, I don't see the pundits I tend to trust- John Rutledge, Arthur Laffer, Larry Kudlow, Brian Wesbury- running for cover or sounding alarms. They all feel that, if anything, the current market represents a buying opportunity.

Wednesday, February 28, 2007

GE CEO Immelt's 2006 Compensation: The Comedy Continues

Today's Wall Street Journal details GE CEO Jeff Immelt's most recent compensation. In my last post on this topic, here, I noted that Immelt has already reaped at least $18MM in cash from GE since he took over from Welch.
As the Yahoo-sourced five-year price chart of GE vs. the S&P500 depicts nearby (please click on the chart to see a larger version), Immelt continues to lead GE to underperform the index for yet another year. This makes a total of six years during which he has received millions of dollars in cash, stock and performance units for doing less for his shareholders than a passive S&P Index Fund manager would have accomplished for them.
So, the news today is that Immelt received $8.3MM in "salary and bonus." So that makes a total of roughly $23MM in cash Immelt has now managed to loot from his employer since late 2001, when he began his reign as a failing CEO at GE. If the firm meets certain (fairly low-ball, as I recall from earlier articles) revenue, earnings and cash generation targets, and meets some stock price performance relative to the S&P, Immelt will receive as much as $18.6MM in 2007.
Immelt's base salary was $3.3MM in 2006, to which was added, unbelievably, a cash bonus of $5MM,"citing Mr. Immelt's 'offensive portfolio moves' and GE's 15% earnings-per-share growth in 2006."
Offensive indeed. It's another black day for corporate governance and responsible boards of directors.
Do you think any of these directors would dare to explain this compensation package to a live shareholders' meeting, and expect to make it out of the building in one piece?
I guess there is one consolation. The market is, in effect, voting on Immelt's lackluster performance and financial games, by leaving GE's stock price flat over such a long period. For the past five years, the stock price change is now actually negative.
Nice job, Jeff. And nicer that you have a board full of morons to pay you so handsomely for such mediocre performance.

The Vix Rises....Then Falls Again

So, equity volatilty surges on the day I write about its being dampened. Go figure.

Former Fed Chairman Greenspan's misunderstood comment about recession potential spooked investors in the Asian markets, triggering the 9% sell-off in China. The ripple effect drove the S&P500 down 3.5% yesterday. The Vix rose roughly 50% yesterday, to around 17, from 11.

Today, during and after current Fed Chairman Bernanke's Q&A with the House Budget Committee, the index is recovering, up .66% as of 12:30PM EST. And the Vix had fallen 2.7 points for the day so far.

To me, investing for the 'long term' does not mean leaving one's money in any one thing for very long, as I wrote in
yesterday's post. It means following a disciplined, reasoned strategy over a long period of time.

In fact, my partner expressed delight in the fact that, despite yesterday's market trauma, we didn't have to to anything. Nothing that occurred yesterday affected the strategy or its management. In a different context, it might have done so, but yesterday's events came nowhere near triggering any changes.

In the light of this afternoon, with Bernanke's testimony, and re-interpretations of Greenspan's remarks, the market has recovered, and yesterday's panic now looks excessive. Thus, the comfort of knowing we could sit tight, and confidently so, was very calming.

In the wake of a day like yesterday, it's important to note that relative longer-term values are difficult to assess amidst such rapidly falling prices. Probably the best, simplest decision is simply to either stay in one's long equity positions, go to cash, or go short. But not to try to trade amongst various equities.

Late last night, there were reports of unprocessed trades at the close of the market, and clearing running more than half an hour behind the market's close. In conditions like that, trading between equities is almost as risky, if not riskier, than simply doing nothing.

Tuesday, February 27, 2007

Equity Vix: Duration & Volatility

Yesterday's Wall Street Journal contained a piece on equity holding durations, trading frequencies and volatility.

Among the interesting factoids cited by the article were these:

-in 1999, the average holding period for equities was more than a year.
-in 2006, the average holding period for equities was less than seven months.
-The CBOE's volatility index is at its lowest level in 10 years.

According to Justin Lahart, the Journal article's author, computing and communications technology are mostly responsible for the changes. Lower trading costs, decimalization, and increased computing power has allowed for some previously theoretically-only strategies to become reality. Such developments would tend to exploit inefficiencies in prices, moving them closer together.

Hedge funds are also believed to be a cause of the shorter holding periods for equities, due to their own need to meet quarterly performance expectations.

Funny how that works, isn't it? Even privately-held financial firms offer vehicles whose performance is judged over short time periods, just like the non-financial, publicly-held firms whose equities the hedge funds trade.

Reading the piece, however, brought me to wonder about the artificiality of the terms "trading" and "investing."

What is the difference? Perhaps trading is what you do to implement investment strategies.

However, my biggest surprise was that as recently as 1999, investors typically held equities for over a year. Even I haven't done that since I began actively using my proprietary equity strategy. For a brief time, the holding period was a year, but for nearly a decade, it has been six months.

Furthermore, I don't think there is any meaning to the equity duration timeframe. With trading costs so low, why should anyone overstay the performance of an equity they hold, relative to expectations about its performance, and the performance of other equities?

I cannot understand how, with rapid dissemination of information, low trading costs, and quarterly publication of company fundamental results, investors can justify planning to hold equities for as long as a year. There have been some equities which my selection process has chosen for as many as three sequential six-month holding periods. But I never planned, a priori, to hold the stock that long.

Rather, it is difficult for me to believe that most equities can offer an expectation of relatively consistently superior returns for over a year. Thus, I would not expect to buy an equity and expect to hold it for that long.

With all the reasons investors have for trading any given equity on any given day- price appreciation, breaking news, a better opportunity in another equity, cash needs- why is it so important for investors to hold equities for as long as a year? Furthermore, doesn't frequent trading contribute to more price information and, thus, an expectation of fewer large-scale price changes, i.e., decreased volatility? Isn't lower volatility preferable for any equity holder?

Based upon Lahart's article, I don't see any particular cause for concern in emerging trading patterns which support equity investments

Monday, February 26, 2007

Fox To Start Business Channel in Late 2007

Finally, it looks like there will be some competitive pressure for CNBC. Fox has announced that it will commence operating a business news channel in late 2007.

As I wrote recently, expect to see Fox poach some of CNBC's better, more attractive female anchor personnel. My prediction is that Rebecca Jarvis and Erin Burnett will be lured to the new network. They are the brightest, most articulate, attractive female anchors who also have limited exposure.

While Becky Quick and Michelle Cabruso-Cabrera are probably better, more knowledgeable and skilled anchors than Burnett and Jarvis, they enjoy maximal exposure already.

Then again, who knows how many women, and men, may wish to bolt to Fox just to get away from "money honey" (is that trademarked yet?) Maria Bartiromo.

Additionally, I understand that, perhaps because of the 'glamor' of network exposure, compensation for anchors at CNBC is not all that lavish.

Should be interesting to see who jumps, and what the eventual anchor lineups are come fourth quarter of this year.

Starbucks' Schultz Sees Senescence

Saturday's Wall Street Journal carried a lengthy article concerning an internal email from Howard Schultz, the firm's chairman, regarding his concerns for the firm.

Back in April of 2006, in this post, I wrote,

"So Howard Schultz is opening more than 10 company stores per week, which would account for the employee growth. That is, 2 company stores per day, plus 5 licensee stores per day, plus turnover. With 'more than 100,000' employees currently, they are adding roughly 1% to their employee base per week. Allow for some Kentucky windage, and they are growing like topsy.

At these rates, I would guess Schultz lies awake nights wondering how his company's culture can withstand this sort of dilution and explosion among its ranks. When the US military saw these levels of growth during WWII, they employed the "cadre" system- seeding new units with experienced combat veterans. Is Starbucks doing this? Can they afford to, if they are moving into new locales?"

Interestingly, Schultz isn't planning to limit growth- he plans to more than triple the current number of stores to 40,000. Rather, he frets over the changes that have been wrought in Starbucks stores in order to maintain revenue and volume growth.

Changes such as automatic espresso machines which are tall and obscure the sight of the "barista" at work. A switch to pre-ground and packaged coffee, so that one no longer smells roasted coffee upon entering a Starbucks store. The aroma of burnt cheese on occasion, as the chain's new breakfast sandwiches cause some mess that is not immediately cleaned out of the ovens.

On one hand, I have to admire Schultz for his ethic in understanding that "success is not an entitlement." I really do admire that realistic attitude in a CEO or company leader. However, when Schultz wrote in his email,

"We desperately need to look into the mirror and realize it's time to get back to the core," just what does he mean? Hire more people and backtrack to more labor-intensive, poorer-quality service levels of the past? Trim the product offerings, and drop skim milk?

Perhaps Schultz is simply confusing limits to growth and consistently superior returns, with his company's own recent history. My proprietary research has found that there is a natural senescence that all successful firms experience. Just as athletes age, firms eventually outgrow their initial markets, attract competition, and simply become harder to lead, manage and grow in a manner that sustains consistently superior total returns than they once were.

This Yahoo-sourced chart (click on the chart to see a larger version) illustrates that, versus the S&P500, Starbucks has actually been stuck in neutral for about two years. While the company's stock price has outpaced the S&P for the last five years in total, it's been flat for the last two. The S&P is higher over that period, while Starbucks has plateaued. In fact, Starbucks is among the better performing shorts in my equity strategy, were we to be using the short strategy right now. It's been superior over several years in terms of total return, but inconsistently.

My guess is that Starbucks is simply reaching a Wal-Mart-like limit to profitable growth that can sustain a consistently superior total return performance.

From the Journal article, it appears that Schultz is not exactly a well-educated, deeply knowledgeable businessman. Rather, it notes that he was a salesman who moved to Seattle in 1982 to join the coffee roasting firm. It's just possible that he does not realize what happens when a firm outgrows its initial niche. In Starbuck's case, it must now add food, music, etc., to maintain growth levels. And it has engendered renewed competition in coffee from the likes of Dunkin' Donuts and McDonalds.

I should probably note here that I hold McDonalds in my equity portfolio. And that, truth be told, when offered a choice, I'm a Dunkin' Donuts guy, not a Starbucks aficionado, for takeout coffee. I do, however, religiously buy one-pound bags of espresso beans at Starbucks, because Dunkin' Donuts refuses to sell me bags of the espresso beans they have in the store to brew their own espresso.

However, back to the Schultz email. It surprised me to read that Schultz puts so much emphasis on the "romance and theatre" of a Starbucks store. I guess I really am not their target market customer, because I've never had a romantic or theatrical experience in one of their units. I've had bad service. But I could personally care less if I see the guy/gal - excuse me, the barista- actually make my cup of coffee.

If Schultz and his crew plan to hit their target of 40,000 stores, I think they will find themselves making lots more changes than they have yet anticipated. If anything, a Starbucks will probably become even more distant than Schultz' dreamy original-style store than it already is.

So, kudos to Schultz for being uncomfortable and suspicious of what success his firm has enjoyed. But I'm not sure there's that much he can actually do to avoid the inevitable effects of senescence upon Starbucks.