Sunday, March 15, 2009


My text today focuses on “RE.” One might think of this prefix as returning to past times of glory or relearning past lessons. With all due respect to various writers of imaginary kingdoms and a number of sermons, my thoughts are on the return of capital (employed) and the return on investment.

Starting with the most controversial application of “RE,” the biggest long-term risk is reflation. (Some may use the term re-inflation.) Many governments around the world are incurring debts at current levels of interest to cover their deficit spending, as well as the new manipulation entitled “stimulus spending.” In either case by inflating the value of the currency they will be paying back the debt with devalued currency. Further, higher prices for goods and services will increase the level of taxes paid. With some exceptions (e.g. social security payments and the value of some deductions), income taxes will rise. Prices for property, whether real estate or other forms of equity, will rise to offset the decline in the value of the currency. Part of the danger coming from inflation is that the increase is built into the cost structure of tradable goods and services as well as various forms of property. Eventually after prices rise above their real value based on their utility function, prices will decline, often rapidly, which can lead to various stresses including bankruptcies. For these and other reasons, I believe governments, including our own, will reflate by putting too much credit and money into the system.

Out of the fear of such future occurrences of inflation, in many accounts I use Treasury Inflation Protected Securities (TIPS). I recommend at least some TIPS in every balanced account of stocks and bonds. If interest income provides most of the living expenses and charitable gifts, the portion invested long-term in TIPS should approach the level of interest income generated from high quality bonds. Even in the case of a large commitment to stocks, some holdings in TIPS may act as the “canary in the mine,” a very sensitive indicator of future perceived inflation. There is one major drawback to the use of TIPS in a tax-paying account: the calculated incremental rise in the value of the debt (which is how inflation is accounted for at maturity) will be taxed each year even though the investor did not receive the income in the year charged. While the risk of rising inflation is very real over time, the tax-related issues are such that investors should consult with their investment manager and their tax accountant.

The second “RE” is “releveraging” or the opposite of the more popularly-used term deleveraging. On an overall global basis, incomes can not grow faster than the sales of products and services unless the commodity is in permanent short supply, (which doesn’t often last long), or when leverage is applied. There are two types of leverage, operating and financial. These are detailed in my book MONEY WISE. Operating leverage occurs when sales grow at a faster rate than costs. Often operating leverage occurs when there is a high break-even point due to capital employed. This desired attribute is called a rising operating margin. Often “growth” stock investors look for increasing operating margins with the hope that this growth will be sustained. Until sales and distribution costs, as well as prices, turn unfavorable, growth is a winner. Very few companies can actually maintain rising operating margins for long periods of time in a competitive world.

The second form of leveraging is financial leveraging; buying additional productive capacity through the use of debt. For this to work the interest rate paid on the debt needs to be below the operating margin. Debt also needs to be repaid or refinanced, so the ability to generate sufficient cash to repay the debt is very important. “Value” investors often focus on stocks and bonds of a company that can pay off their debt quickly and substitute operating earnings in place of interest payments. Often this focus leads to only looking at companies that the markets perceive as being distressed. “Value” investors see productive use of financial leverage as looking at free cash flow, net of the interest and principal of debt service. In other words, they are saying, “To get us out of the hole, we will add back in debt service spending that they believe will be declining.”

The next “RE” is reviewing the facts beneath the surface. Let me suggest two very different examples of facts, that when reviewed will suggest a difference from the popular view. The first is the report that a number of large commercial banks are both profitable in the first two months of the year and that they are increasing their loans. Many potential borrowers from banks, such as corporations, tax-free institutions, and some individuals, have obtained lines of credit for future borrowings. In a period where cash is becoming king, some are now tapping into these lines because they are fearful that the money will not be available when they have a real need for capital. These loans are being taken down by the borrower while the lender records an increase in lending. In some cases the borrowers have no immediate need for the money and turn around and invest it in short-term, high-quality paper (e.g. US Agency or commercial paper). From a macro viewpoint, this is not a stimulus-oriented use of capital. I do not know what proportion of the increase in lending and bank profits are due to this type of activity, but this is an example of looking underneath the headlines in press releases.

The second area to review is more difficult to identify. I am beginning to sense that the long- term trend of substituting machinery for human labor may be decelerating. With new capital equipment costs high, and the abundance of highly motivated, intelligent people who will work at much lower wages and fringes than in the past, we can see changes. One is already seeing former business people driving cars, trucks and buses which in the past sat idle for the lack of drivers. A number of unemployed people have entered the market for services, either as part-time employees of established businesses or franchises, or are becoming entrepreneurs. I am told that there are many commission-only jobs available, some will be filled by enthusiastic people who never in the past were directly involved with sales. I am not privy to whether these people are listed as unemployed or underemployed. Government statistics are always behind in measuring changes in the structure of the economy and that may be why I don’t have statistics to back up my view.

The final “Re” for this session is relearning. As children, many of us were required to save a portion of our meager allowance each week. Some of us tried to install this concept with our own children. Many families from other parts of the world, particularly Asia, are prodigious savers. From an overall economic standpoint, our government is trying very hard to get people to spend now and even incur more debt. This “logic” holds that with consumption in the neighborhood of 70% of GDP, this spending will jump-start the economy. As often the case with politicians facing elections, this is very short-sighted. Consumption spending without saving is like treading water: surviving for now, but not leading to a rescue. In pure economic terms savings leads to a much higher multiplier effect than consuming. As savings grow, it will build up in the financial system, though whether that will be in the formal banking system is another question. Eventually the small savings will filter into the investment stream, which over time, will direct it to a high return on investment (with risk of loss very much in mind). If we can get the savings rate in this country up to 10%, which produces (after the current “delay”) annual returns anywhere from 6-12%, we will be giving our next generation the financial means, and more important the discipline, to deal with the huge debt needed to cover the excessive spending done while we were, theoretically, in the driver’s seat.

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