Growth Offers the Best Value

In this week’s Barron’s Lawrence C. Strauss has an interesting article on the “growth versus value” debate. It is is a dumb concept invented by quantitative analysts and pension fund consultants that has little utility for real investors who actually understand the companies they own. A “growth stock” with an above average PE multiple can be a much better value than a slow-growing “value stock” with a low PE multiple, low price-to-book multiple, and high dividend yield. The keys are A) not to pay an excessive PE for growth and, B) make sure the company really will grow as fast as you expect. Item “B” is much harder than it looks. I recall writing thematic research reports where we asked each analyst for his or her best growth idea; looking at the names a few years later, many of them turned out to be duds. (If you don’t believe me, take a look at a 2-year chart of 3D Systems.)

The most useful insight to be found in Mr. Strauss’ column is a quotation from Oakmark’s Bill Nygren, who notes that today “investors are overpaying for high yields, which usually implies slower growth, rather than overpaying for high growth.” In other words, you are more likely to find good value among growth stocks that don’t offer particularly high dividend yields.

To test this hypothesis, I carried out a simplistic but nevertheless instructive analysis of the 30 stocks in Dow Jones Industrial Average. For each company I calculated:

  • Expected EPS growth in 2015
  • Dividend yield
  • PE on 2015e EPS.

Despite weak overseas economies, a strong dollar, and difficult comparisons after five years of S&P 500 earnings growth, a true “growth stock” should be able to grow at least 5% in 2015, given that the U.S. economy will grow about 3%. Here’s what I discovered:

  • Slow Growers: The 20 companies with less than 5% growth have a median yield of 2.9%; their median 2015 EPS growth is just 1.3%. This implies a “total return” (yield plus growth) of just 4.3%
  •  Fast Growers: The 10 companies with more than 5% growth have a median yield of just 1.4%, but their median growth is a lofty 9.3%. This implies total return of 10.7%–far better than the 20 slow-growers.
  • So, how much of a PE premium do you have to pay for the fast growers offering more than twice as high a total return in 2015? Very little. The median PE’s of the slow growers is 16.9x; that of the fast growers is just modestly higher at 17.7x.

Yield-starved investors are overpaying for stocks with juicy yields of 2.5% or more, even though many of these businesses face serious fundamental challenges that are stunting growth. I do not by any means claim to be an expert on all these companies, but here are some of the companies that may fit this description, followed by their 2015e EPS growth and 2015e PE:

  •  AT&T    1.2% EPS growth / 13.6 PE
  • Caterpillar   -25.1% / 17.8x
  • Coca-Cola    -1.5% / 20.9x
  • DuPont    2.5% / 18.5x
  • IBM    -3.1% / 10.0x
  • Intel    2.6% / 14.5x
  • J&J    4.0% / 16x
  • McDonalds    4.8% / 18.9x
  • Merck    -2.9% / 17.3x
  • Pfizer    -7.5% / 16.6x
  • P&G    3.2% / 20.6x
  • Wal-Mart    4.2% / 16.5x

I don’t hate all these stocks; in fact I own four of them. Some names may have temporarily weak earnings growth this year because of the strong dollar, the energy collapse, product cycles or special factors that won’t last forever. That said, it is fair to say that some of them—such as KO, IBM, MCD, MRK, PFE, PG & WMT – have fundamental problems that are likely to restrain earnings growth over the next few years, if not l longer. (Most obviously, Coke and McDonald’s are simply on the wrong side of the better and better-for-you healthy eating trend and show no signs of adjusting successfully.) Yet the average PE of the 12 names is a rather high 16.8x (median 17.0x). They are not great investments, in my opinion.

Now let’s look at the growth companies in the DJIA that are expected to grow faster than 5% this year. Of the 10, the 7 that appear to have the best fundamentals are:

  •  3M    9.2% EPS growth / 20.3X PE
  • Disney    10.3% / 20.8x
  • Home Depot    16.5% / 21.4x
  • Microsoft    7.7% / 16.4x
  • Nike    13.1% / 24.7x
  • UnitedHealth    8.8% / 17.7x
  • Visa    14.5% / 25.1x

Their average PE is 20.9x (median 20.8x); the average yield is 1.5% which is not great but not nothing either. Their dividends are likely to grow rapidly; earnings growth is strong and the average payout ratio is 30% versus 50% for the 12 slow growers discussed above. Interestingly, for these seven growth stocks the PE-to-total return ratios (i.e., PE divided by 2015 EPS growth plus dividend yield) are mostly in a remarkably tight range of 1.65 to 1.81; HD is the outlier at just 1.18.

To find good growth names to buy, you could do worse than to look at the top holdings of Bill Nygren’s Oakmark Funds, which is available on the website.

Copyright Thomas Doerflinger 2015. All Rights Reserved.

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Famous Random Events in American History

Item: President Obama opined that Americans were right to be concerned that in Paris there were “violent vicious zealots who behead people or randomly shoot a bunch of folks in a deli In Paris.” His spokesman Josh Earnest said the individuals in the Jewish “deli” were killed “not because of who they were but because of where they randomly happened to be. . . . these people were not targeted by name. This is the point. There were people other than Jews that were in that deli.” A State Department spokeswoman deflected a question concerning the motivation of the “deli” killer, saying that was a question “for the French government to decide.”

Despite the mindless carping of Fox News and the Israel Lobby, the White House is on solid ground. Frequently in American history, dispassionate historical research demonstrates, events that at first appeared to be carefully planned were, in fact, “random,” as the President perspicaciously observed with respect to the avowed Muslim terrorist who had already killed a police woman and just happened to seize hostages in a Kosher food store in the most prominent Jewish neighborhood in Paris. For example:

Forget the “grassy knoll” and all those conspiracy theories. In November 1963 Lee Harvey Oswald was leaning out of a Texas Book Depository Building, cleaning his high-power rifle, when it accidentally discharged, killing President John F. Kennedy and wounding Texas Governor John Connolly. Hey, accidents happen.

On September 11, 2001 rowdy passengers took control of two airliners and just happened to crash them into the twin towers of the World Trade Center. What a coincidence!

On September 15, 1963, a month after Martin Luther King Jr.’s historic “I Have a Dream” speech, someone bombed a church in Birmingham Alabama. It happened to be an African American church and four black children were viciously murdered. Using the logic of Presidential spokesman Josh Earnest, this must have been a “random” bombing because “no one was targeted by name.” Obviously, it was not random. It was the work of a white racist thug, just as the Paris Kosher “deli” killings were the work of an Islamic terrorist thug.

Now, President Obama is not stupid; the dumb comments made by him and his spokeskids about a “random” attack of a Muslim terrorist on a Kosher food store were a calculated attack on Jewish interests, as was Obama’s admonition to New Jersey Senator Robert Menendez—ranking Democrat on the Foreign Relations Committee and a respected expert on foreign policy—not to “listen to his donors” when deciding what to do about Iran’s nuclear ambitions.

Here’s the real question: How stupid are Jewish liberals? Will they continue to line up behind Obama and Hillary as the Democratic left targets Jews in Europe and Israel? Stay tuned.

Copyright Thomas Doerflinger 2015.  All Rights Reserved.

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Emerging Market Masochism: an Update

As I argued on  December 25, it is unwise for non-specialists to invest directly in emerging market stocks because:

  • You can get exposure to EM economies with far less risk by buying U.S. or European multinationals.
  • Emerging markets are very risky due to intrinsic financial weakness, corruption, high exposure to commodity prices, weak corporate governance, etc.

A couple of new data points underscore EM risks:

Dirty Oil

Petrobras, the giant Brazilian oil company that Wall Street loved after huge off-shore oil finds in 2007-2008, is, as The Financial Times put it, “awash in corruption.” According to the FT, “One lower tier executive has offered to repay $100 million.” As much as $20 billion may have been stolen. There is no valuation discount that would get me interested in such a stock. But I don’t mind owning Schlumberger, which I assume sells plenty of services to these guys.

China’s Purge Threatens Growth

The crackdown on corruption in China is starting to raise serious questions about the country’s growth prospects. Clearly, a great many projects were built by local governments over the past six years not because they made economic sense but, rather, because they would enrich corrupt officials and businessmen. This syndrome is hardly unique to China; nineteenth-century American railroad booms were great for bankers, builders and suppliers but not for European bondholders. Which is not exactly reassuring, because each of those railroad booms was followed by a multi-year depression. But, aside from the cyclical economic issues, Xi Jinping’s corruption crackdown is starting to look like a purge that will hurt long-term growth. According to the FT, “the crackdown has so far led to warnings or disciplinary action for about a quarter of a million cadres.” That’s a lot of warnings. Apparently the best way to protect your family from the crackdown is to commit suicide, which has become so common Beijing circulated a detailed questionnaire to families to get the measure of it.  Here is why this is so worrisome: Party members are key economic decision makers; now doing their jobs properly is less important than staying alive and out of jail. One way to do that is to avoid launching big new projects. That can’t be good for growth.

It gets worse. I learn from The New York Times that China’s government is also reducing Internet freedom by interfering with Virtual Private Networks. This makes life miserable for knowledge workers ranging from scientists to bankers to commercial artists. When we were in Shanghai our hotel could not access the United Airlines website. This is no way to promote China’s shift from a low-wage exporter to a modern service economy.

Copyright Thomas Doerflinger 2015.  All Rights Reserved.


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Equity Market Outlook: Still Mediocre but Not Terrible

January’s 3% decline in the S&P 500 is consistent with my observation on December 30 that “Stocks Are Expensive, Offer Mediocre Risk / Reward.” The main issues are:

  • Investors and strategists have become bullish and complacent; they were far more bearish two years ago, when stocks were cheaper.
  • Stocks are rather expensive versus history given that we are late in the cycle when profit growth is fairly weak. (See the Dec. 30 post for details.)
  • Tighter U.S. monetary policy is somewhat negative for stocks. QE has ended and the Fed will likely raise rates later this year.
  • Most foreign economies, which account for 35-40% of S&P earnings, are weak, including Europe, Japan, China and many other emerging markets (Russia, Brazil, Africa, the Middle East). The EU-Greece standoff and rise of extremist political parties elsewhere may hurt business confidence in Europe.
  • The oil price plunge hits S&P earnings hard. Energy companies’ earnings (11% of earnings in 2014) will collapse this year; suppliers such as CAT also take a hit. Contrary to what some observers believe, these effects are not fully offset by the benefit that certain companies get from lower energy prices, via lower costs (notably transports) and more discretionary spending. Said differently, a plunge in oil prices transfers income from the corporate sector to consumers; consumers save some of the money and spend much of it with non-S&P 500 companies.
  • The strong dollar is hurting earnings, and this may get worse. Looking at the average level of the monthly Fed Dollar Index, it was up 5.3% y/y in Q4 2014. If it stayed at January 2015’s level in February and March, it would be up 8% y/y in Q1 2015. If the dollar strengthens this year its average level could easily be 10-12% above 2014.

My impression from reading Street research is that Q4 earnings were subdued but about as expected, with Apple’s huge beat offsetting weakness elsewhere. Consult your local strategist for details. The Street is split on 2015 earnings, with some smart people still at $127 and others at only $120 (versus about $118 in 2014). Given the factors discussed above, I suspect the bears will win the argument.

There are, however, a couple of extenuating circumstances that may mean stocks can rise modestly this year despite flattish profits, much as they did in another year of commodity deflation, 1998. Energy stocks are valued on “normalized” earnings not current earnings. Investors will to some degree “look through” profit weakness caused by unfavorable currency translations, which affect reported profits but not underlying cash flows. Furthermore, dividends should grow at a double-digit pace in 2015; a 2% yield on stocks looks attractive versus bonds.

Bottom line: the S&P 500 should rise 5% this year, delivering a total return of 7%. Not bad when 10-year bonds yield 1.6%.

The Starbucks Effect

SBUX traded up 7% on in-line Q4 earnings because same store sales were stronger than feared. The bear case, which had been weighing on shares for the better part of a year, was disproved. Probably lower energy prices helped here, as consumers decided they could afford one more caramel macchiato low-foam extra hot latte. This will probably happen to other high-quality consumer companies. But avoid names, like Tiffany, that sell a lot to foreign tourists impacted by the strong dollar.

Copyright Thomas Doerflinger 2015.  All Rights Reserved.

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Keystone Kops Cuff the Middle Class; Will GOP Bail It Out?

Among Barack Obama’s many failures none is more stunning than his purported effort to reduce income inequality, which he calls “the defining issue of our time.” While the nefarious 1% prospers (and pays 35% of U.S. income taxes), the bottom 90% struggles. You know the bleak statistics – anemic GDP growth, stagnant real wages, the poverty rate at recessionary levels, record-high income inequality, median household income 8% lower than in 2007.

The Obama Mansion Boom

But to really appreciate how well the affluentials are doing, you need more than numbers. You need to visit my neighborhood and behold the building boom that is under way. It’s a Wall Street bedroom community where the housing stock consists largely of what John Kenneth Galbraith derisively but accurately called “Stock Broker Tudors” built during the 1920s bull market.

Back in 2009, when Barack Obama was inaugurated, the homes in my neighborhood were quite serviceable—no sagging rooflines, no cracked windows held together with masking tape, no broken-down porches, no 1979 Buicks sitting on cinder blocks in the front yard. According to Zillow, most of them are worth $1 million to $3.5 million. Nevertheless homeowners have decided they simply must upgrade to something bigger and better. Taking advantage of rising stock prices and super-low interest rates, they have improved and expanded and built and demolished and rebuilt. You’re not really cool in my neighborhood unless you have a dumpster in the driveway and a Porta-Potty for construction workers in the front yard. I count, within just a few blocks of my house, no less than 17 major construction projects started or completed in the last three years, specifically:

  • One giant new house, somewhat reminiscent of Versailles, is being built on a large lot with a splendid view of Manhattan.
  •  Nine houses have been substantially expanded and renovated, sometimes more than once.
  • Seven houses were either torn down and replaced or totally rebuilt inside and out—always with a big increase in square footage. A famous TV newscaster bought a sizeable older home for $2.2 million, tore it down, and built a palatial white colonial with 23 windows facing the street, as well as a separate three-car garage and an infinity pool in the back. A private equity partner bought a large, stately colonial for $3.75 million, rebuilt it from foundation to roof, increased square-footage 30%, and added a 3-car garage, elaborate new driveway, and multi-tiered terrace leading to the front door.

After you build or rebuild your mansion, you need to decorate it for Christmas with wreaths—lots of them. One for every window and door. The neighborhood record is 17 wreaths; two houses tied for second with 14.

Keystone XL: Out of Excuses

Democrats talk a good game about promoting “good paying middle class jobs” but invariably defer to enviromaniacs who oppose economic development having anything to do with dreaded carbon. Andrew Cuomo banned fracking despite its good environmental record in neighboring Pennsylvania. Obama promises to veto the Keystone XL Pipeline even though he has run out of excuses for doing so. It was painful to watch a hapless Senator Coons of Delaware debate the issue with Senator Hoeving of North Dakota on FoxNews Sunday. Coons spouted empty platitudes about ”An energy policy that includes growing good jobs, American innovation and infrastructure, energy independence, and that doesn’t hurt our environment.” Senator Hoeven, smarter and better-prepared, showed that building the Keystone XL Pipeline is a no-brainer from every point of view—economic, environmental, safety, and geo-political:

  •  It will create 42,000 well-paid jobs. No, they are not “permanent” jobs but then, as George Will pointed out, the only permanent jobs are in government.
  • After six years of study the State Department has concluded the Pipeline will not damage the environment.
  • Six state governments have approved it.
  • Pipelines are safer than moving oil by rail—which should concern Senator Coons because his state will see a surge of rail traffic once a new offloading complex is completed in Delaware City, Delaware. (Memo to the Senator: an oil train explosion in Quebec flattened a town and killed 47 people.)
  • The oil moved by the Pipeline is no dirtier than oil produced in California or oil we now import from Venezuela.
  • Oil imports from Canada reduce U.S. dependence on OPEC.
  • It makes diplomatic sense to treat our ally, Canada, at least as well as we treat Venezuela.
  • Having made a huge investment in their oil sands projects, Canadian companies will find one way or another to ship product to market, so banning the pipeline will have zero effect on carbon emissions.

An Opportunity for Republicans to Stick up for the Middle Class

Fortunately the average construction worker is not as dumb as Senator Coons or President Obama or Paul Krugman or Senator Elizabeth Warren. He or she knows that environmental elitists have total contempt for the average worker who needs to make a living in the real world, not the never-never land of the enviro-maniacs, where pipelines are “bad” but giant windmills that slice up birds and solar farms that destroy thousands of acres of natural habitat are “good.”

By supporting sensible development of fossil fuels, Republicans can demonstrate in 2016 that they care more about the prosperity of the middle class than Democrats beholden to rich enviro-maniacs. But only if they nominate an economically literate, politically adroit candidate who demonstrates real empathy for average workers. Republicans did not nominate such candidates in 2008 or 2012. (McCain’s economic platform did not extend beyond opposition to Congressional earmarks; Mitt 47% Romney, incredibly, never gave a coherent speech outlining his economic platform.) Let’s hope the GOP doesn’t make that mistake again in 2016.

Copyright Thomas Doerflinger 2015. All Rights Reserved.

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The Big Money Loves Tech & Healthcare, Not Industrials and Consumer

I like to check out the biggest holdings of the major mutual funds, for two reasons.   It shows which names are already loved by the Street and at risk of becoming less loved, and vice versa. Second, the guys and gals at the big fund complexes are smart and very well informed; managements of the companies they own or might own are in their offices regularly, and analysts and salesmen are constantly phoning with the latest company tidbits and industry insights. If a couple of funds have a major position in a name, it tells me the fundamentals are probably solid.

I looked at the top 10 holdings of 18 large-cap growth funds run by Vanguard, Fidelity, T. Rowe, and Gabelli—173 positions in all because the funds owned some bonds and foreign stocks. Here are the takeaways:

  • The most popular sectors by far are tech (49 positions, or 28% of the total of 173) and healthcare (44 or 25%). So over half of all the positions were in these two sectors.
  • The most popular stock was Apple, the top holding of 8 of the 18 funds; in all 9 funds own it. Other popular tech stocks are Google (9 funds own it), Microsoft (6 funds), and Facebook (7 funds). Qualcomm is a bit unloved with just one fund owning it. Intel is not a top 10 holding of any of the funds; neither is IBM.
  • Popular healthcare names include Biogen IDEC (6 funds), JNJ (5 funds) and Gilead (5 funds). “Big pharma,” broadly defined, is popular, with Roche, Lily, Merck, Pfizer, Novartis, AbbVie, Bristol Myers and Amgen collectively accounting for 21 of the 173 positions.
  • Financials are not popular; the favored bank is Wells Fargo (6 funds own it) followed by JP Morgan (3 funds).
  • The industrial sector is un-loved; together 3M, Honeywell, GE and Danaher account for just 7 positions of the 173.
  • Also unloved are staples stocks; P&G, PepsiCo, and Coca-Cola are each top holdings of one fund. (To me, this makes sense; the stocks are expensive and earnings are not growing much.)
  • Retailers are not particularly popular, but three funds do like the auto parts space (Advanced Auto, Genuine Parts, Autozone) and three funds count Home Depot among their top holdings. TJX and Starbucks are also represented.
  • Other names owned in size by the funds include Crown Castle (wireless infrastructure), Zoetis (animal health), Disney, McKesson, Marsh and McLennan, Thermo Fisher, Nike, CVS, and United Health.
  • A few funds own the credit card companies, Visa and MasterCard; however their popularity seems to be fading.

I own 16 of the stocks owned in size by these funds, so I can’t say I disagree with their views. That said, healthcare looks rather over-owned and in some cases quite expensive, though I agree it is the sector with the best earnings and revenue momentum. Don’t forget that blockbuster new drugs usually replace drugs already on the market, and healthcare does have exposure to the strong dollar and weak overseas economies. On the other hand, industrial stocks seem too unpopular. The XLI climbed just 6.2% over the last year versus 10.3% for the S&P 500, even though the U.S. economy is accelerating and many industrial companies are producing quite respectable EPS growth despite the strong dollar. (Admittedly the collapse in energy prices is a new headwind for some industrial stocks, albeit positive for others.) I think it is bullish for consumer durables such as restaurants, retailers and apparel that they are not popular holdings even though both revenue and margins should benefit from lower oil prices.

Copyright Thomas Doerflinger 2015. All Rights Reserved.


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Cotton, Capitalism and Poverty Reduction

“Dyed in Blood: A Harvard historian shows how every stage of the industrialization of cotton rested on violence.”

So reads the headline in last Sunday’s New York Times Book Review, regarding Sven Beckert’s volume, Empire of Cotton. The book is part of a new and important historiographical school—the history of capitalism—and also exemplifies a popular genre, the global history of a commodity. With Madeira wine, tobacco, sugar, coffee and mahogany already claimed (consumed?) by other historians, Professor Beckert wrote an informative if biased account of the global history of cotton. He reminds us early and often about the nefarious drawbacks of global capitalism — “the realities of slavery, expropriation, and colonialism” (p. xviii), “slavery, colonial domination, militarized trade, and land expropriations” (p. 60), “the many spoils of imperial expansion” (p. 81), “the newly global, dynamic, and violent form of capitalism” (p. 84), “the onslaught of European merchant capital” (p. 131) and—just in case you didn’t get the message—“a vast and impenetrable machine, a painfully efficient mechanism for profit and power” (p. 135). Like George W. Bush, professor Beckert doesn’t do nuance.

From War Capitalism to Industrial Capitalism

Beckert calls the first phase of his narrative “war capitalism” —a term I like because Britain did indeed fight a seemingly un-ending series of wars with the Dutch and French in the 17th, 18th and early 19th centuries. The line between warfare and commerce was thin. In this period most of the world’s cotton was grown and spun into thread in India’s countryside, then woven into cloth that was beautifully hand printed with colorful designs—paisley, chintz, madras, etc.. Not only was cotton lighter and less scratchy than woolens or linens; it held dyes better. The British East India Company muscled its way into India and set up “factories” (trading posts) that exported the cloth to England. From there some of the cloth was sold domestically, some was reexported to North America and Europe, and some was shipped to West Africa and bartered for slaves in the despicable “Guinea trade.” About half of the cargoes sent to Africa from London and Liverpool consisted of cotton cloth; the other half was metal, guns, alcoholic beverages, and cowry shells (used as currency in West Africa).

In the later eighteenth century “war capitalism” gave way to “industrial capitalism” thanks to two historic developments. A brilliant series of British inventors and industrialists figured out how to mechanize the spinning and weaving of cotton, dramatically increasing labor productivity. Meanwhile, across the Atlantic, Eli Whitney invented the cotton gin, igniting a boom in the planting of cotton in the American South. This was a moral and social disaster because planters in Virginia and Maryland—who owned more slaves than they could employ profitably in the declining tobacco sector—were able to sell their slaves in the cotton frontier (Georgia, Alabama, Mississippi, Louisiana, etc.) rather than set them free, as was gradually occurring in the North. Many black families were broken up as slave traders marched “coffles” of enslaved African Americans hundreds of miles southward to slave markets in New Orleans and other cities.

Once “industrial capitalism” took hold in the 19th century, a powerful trans-Atlantic dynamic developed. Slaves on southern plantations produced cotton that was exported from New Orleans and Mobile either directly to Liverpool or to New York merchants who in turn sent it on to Liverpool (reserving some cotton for factories in the northeastern U.S.). Merchants and bankers in New York, Liverpool and London financed the production and shipment of cotton, thus effectively financing the westward expansion of slavery. By the 1850s over half of total U.S. exports were cotton. England’s notorious “dark satanic” mills, which used waterpower and the newfangled machinery to turn bails of cotton into bolts of cloth, came to symbolize the Industrial Revolution. In Beckert’s telling workers in England and America were violently coerced into working in these cacophonous brick factories.

Ignoring Poverty Reduction

Beckert’s book has many virtues. I love its global vista; you can’t understand cotton from the perspective of a single region, be it India, Britain, Africa or North America. And he tells some parts of the tale – such as the gradual mechanization of the English cotton production in the 18th century– exceedingly well.

Unfortunately the book is marred by its leftist bias and disregard of straightforward economic relationships. For example, we hear a great deal about the production of cotton fabric but almost nothing about its consumption. Millions of consumers, roughly half of them women, benefited from the availability of affordable cotton cloth. The tactic employed by historians to dismiss the rise in living standards generated by capitalist productivity gains is condescending invocation of “consumerism,” as though an impoverished woman who could finally afford to own a comfortable cotton dress was comparable to a suburban housewife buying her 10th pair of shoes at the mall. But Beckert pretty much ignores the rise in living standards, and associated alleviation of poverty, stemming from the expansion of the cotton industry.

Another problem is the Euro-centric treatment of manufacturing in India. We learn on page 34 that European demand for cotton cloth—which was promoted and satisfied by the British East India Company—“clearly benefited” Indian weavers. We learn further that “This ‘factory’ system, with its continuing dependence on local traders and local capital, persisted for roughly two centuries.” Obviously an industrial system that benefited thousands of Indian weavers and traders over two centuries merits more than a couple of pages. Precisely how many workers were involved and how much did they benefit from the creation of a global market for their product? Very relevant and important questions, but answering them would confound Beckert’s anti-capitalist narrative.

New England Textile Workers—Attracted, not “Coerced”

Still more problematic is Professor Beckert’s conflation of New England’s early cotton factories with the “dark satanic mills” in the British midlands, which in many cases employed indigent refugees from England’s orphanages and poor houses. Things were radically different in New England, which unlike Britain had a labor shortage, not a surplus of desperately poor people. (Nearly every British visitor to ante-bellum America remarked on the absence of poor white people.) There is abundant historical evidence about how entrepreneurs staffed New England’s textile mills—both factory records and the writings of the workers themselves. As historian Thomas Dublin has written in a standard work on New England’s mill workers:

“According to the conventional view, women in the early Lowell mills were young, single women attracted from the surrounding New England countryside. They entered and left the mills frequently, working for repeated short stretches in the years before marriage. While in Lowell they resided in company boardinghouses, erected by the textile corporations and managed by boardinghouse keepers. . . . This description is basically correct and uncontroversial.…”

For our purposes, the operative word here is “attracted,” which is the precise opposite of the “coercion” Beckert alleges. Impecunious but respectable unmarried women living on hardscrabble New England farms were “attracted” to factory work by decent living conditions, acceptable working conditions and fairly good wages. For example, Thomas Dublin dissects the finances of one Mary Hall, whose earnings, net of charges for room and board, “must have enabled Hall to support herself quite well.” Factory girls could afford more fashionable clothes than the drab homespun worn on the farm. With the support of factory managements, some workers created a newspaper, The Lowell Offering, which helped to create a spirit of sisterhood among the workers. The factories offered flexible employment opportunities and a measure of independence—not oppression—to unmarried women. Later in the ante bellum period they were supplanted by Irish immigrants, whose living standards were much higher in America than they would have been, had they remained in Ireland.

The Seductive Charms of Rural Poverty

An obvious question—relevant to 18th century England, 19th century America or 20th century China—that capitalism’s critics fail to ask, let alone answer, is: “If factory work was so awful, why did so many people migrate from farms to factories?” To the impressionable outsider the simple rural village seems far more salubrious and appealing than a crowded, dirty factory town. But the rural poor knew better. They lived dreary lives of hard work, long hours, low pay and social isolation. Historian Joyce Appleby provides insight in her excellent book on early 19th century America, which is based in part on over two hundred autobiographies:

“Contemporaries looked on factory work as benign when compared to the farming life. Chauncy Jerome, one of the trail blazers of the clock industry, painted a particularly grim picture of what life held for him after his blacksmith father died in 1804: ‘There being no manufacturing of any account in the country, the poor boys were obliged to let themselves to the farmers, and it was extremely difficult to find a place to live where they would treat a poor boy like a human being.’ John Thompson echoes Jerome’s lament when he explained that he ‘did not want to work for the farmers thereabout, for they worked late and early and their work was too hard for me.’ James Riley recalled that the farmers he worked for were loath to release him for schooling despite his apprenticeship agreement.”

Factories Provide an Escape from Poverty

The reality that Professor Beckert and many other historians do not care to confront is that the alternative to rising manufacturing productivity orchestrated by greedy capitalists was—in a context of rising population and finite land—acute and intensifying rural poverty, malnutrition, starvation, and disease. For example, the percentage of people in China with an income of less than $1.25 per day is 6.3% versus 24.7% in India. Why so much higher in India, even though it boasts so many brilliant engineers and entrepreneurs and had a head start over China in creating a modern economy after World War II? A key reason is that China developed a vibrant labor-intensive manufacturing sector producing everything from toys to clothing to smart phones to computers. India has failed to do so, in large part because of burdensome over-regulation of manufacturing firms by corrupt and capricious government bureaucrats. (See my January 14, 2014 post for details.)

Copyright Thomas Doerflinger 2015. All Rights Reserved.

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Stocks Are Expensive, Offer Mediocre Risk / Reward

Using $124 S&P 500 EPS for 2015, the forward PE of the market is 16.8x, which seems reasonable compared to the 17.1x average PE since 1989. Unfortunately this comparison is misleading for two reasons:

  •  The average since 1989 is inflated by the tech bubble of the late 1990s.
  • It is also inflated by recessionary periods when earnings were depressed and investors looked forward to strong earnings growth as the economy recovered. That is not the case today, six years into an expansion. Profit margins are high; revenue growth is tepid. Profits rose 7% in 2014 and will rise around 5% in 2015, impeded by weak energy earnings.

How expensive are stocks, taking those two factors into account? Based on history, “very expensive.” Consider:

Since Q1 1989, using quarter-end price and our proprietary data on “pro forma EPS” (which exclude unusual gains and losses) we have the forward PE ratio for 104 quarters. As noted, the average is 17.1x. But let’s exclude the tech bubble (1997-2000) and six recessionary years (1991-92, 2001-02, and 2008-09). That leaves us with PE’s for 64 non-bubble/non -recession quarters, comparable to where we are today in the economic cycle. Of those 64 quarters, only four had higher PE ratios than the current 16.8x. The mean and median for the 64 quarters are only 14.8x.

The Fed Is “Behind the Curve”

The counter-argument is that interest rates have never been this low. What’s not to like about stocks offering a 2% yield and mid-single digit earnings growth when the 10-year treasury yields 2.2%? I have championed that argument in many reports on “dividend fountains” since the dark days of 2009, and it still has merit. Maybe PE’s will indeed remain lofty in a low-yield world.

But maybe not. Risks are rising. It makes no sense for Fed funds to be at zero as we enter the seventh year of an economic expansion that is clearly accelerating—see GDP, employment, unemployment, industrial production, ISM’s, etc. We are rapidly moving toward “full employment” – particularly given that Obamacare, the EPA’s war on fossil fuels and other policies have damaged the supply side of the economy. As we saw with the “taper tantrum,” Fed tightening may well cause indigestion in the domestic and international bond markets, producing unexpected defaults and global turbulence. After all, the ultra-low Fed funds rate of the early 1990s (down to 3%) and 2003-04 (down to 1%) caused destructive asset bubbles, so why shouldn’t a protracted zero rate regime have similar effects?

Adding to the risk are slow global growth and general economic mismanagement in Europe (excluding the UK), Japan, and many emerging markets. How long will Europeans accept 10% unemployment before they vote for extreme parties on the Left and Right? A bearish near-term scenario I laid out on December 16 has so far failed to materialize, as the Fed spread easy-money-talk foam on the global economic runway. But the Fed cannot do that forever.

I will freely admit that stocks still look like the best game in town. But it is important to avoid complacency, anticipate greater volatility, recognize that equity returns may be modest over the next few years, and accumulate cash now if you need liquidity. Don’t extrapolate the past two years.  We are no longer in early 2013 when the economic expansion was two years younger and the forward PE was 14.0x, not 16.8x.

Copyright Thomas Doerflinger 2014. All Rights Reserved.

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Enviro-colonialism in New York

Liberals have unlimited capacity to compartmentalize issues and ignore their obvious interconnections. It would not be surprising to see The New York Times decry wage stagnation on Monday and income inequality on Tuesday; bemoan the low incomes of African Americans on Wednesday; attack carbon spewing coal-fired utility plants on Thursday; and then congratulate Andrew Cuomo for banning fracking on Friday. Never mind that fracking in New York would create high-paying blue-collar jobs in a depressed region, thereby raising median wages, reducing inequality and creating more jobs for African Americans—not to mention expanding output of natural gas which is “cleaner” than coal and raises real incomes by reducing utility bills.

Andrew Cuomo pretends he knows nothing about fracking and so left the decision to his health commissioner. Only Andrew believes that. His report banning fracking is a model of biased, illogical “analysis.” It cites “environmental impacts and health outcomes” potentially associated with fracking, such as:

  • Air impacts that could affect respiratory health
  • Climate change impacts due to methane emissions
  • Drinking water impacts
  • Potential surface spills that could contaminate soil and water
  • Surface-water contamination resulting from inadequate wastewater treatment
  • Earthquakes
  • (This is the weirdest) Community impacts from “boom-town economic effects” such as increased traffic, road damage, noise, and stress.

These are issues worth considering. It would be great if we had many years of experience drilling thousands of hydro-fracking wells, to evaluate the health risks associated with fracking and determine how we can reduce them. But of course we do have such experience—in Texas, Oklahoma, Colorado, North Dakota, Ohio and nearby Pennsylvania. The report presents no hard evidence that fracking created significant health risks in these states. Even the EPA, sworn enemy of fossil fuels, has signed off on fracking.

And then one must ask, “compared to what?” We know that windmills slice up birds and create a racket that gives the neighbors headaches. Solar farms destroy thousands of acres of habitat and require lots of water to keep clean. Both wind and solar are expensive and require unpopular, disruptive power lines to transfer electricity from the source to the city. No energy source is perfect, including fracking and including all the alternatives.

Third, the report cites potential methane emissions (which can be minimized with careful management) but ignores the climate virtues of producing more natural gas to supplant coal.

Fourth, the report ignores the beneficial effects on health and overall well-being bestowed by stronger economic growth, more job creation, higher personal incomes and reduced poverty. This is a favorite tactic of environmentalists—measure health effects of pollution or pollution reduction while ignoring the beneficial economic effects of cheap energy, which in turn have positive implications for the health of average citizens. Poverty and high unemployment are not conducive to better health.

The notion that an economic boom would trouble western New York is particularly absurd. The population of Broome County (home of Binghamton) declined from 221,815 in 1970 to 200,600 in 2010. I seriously doubt a fracking boom that boosted the population 10% back up to the 1970 level would upset the citizens of this economically depressed county. As for the impact on tourism, the Southern Tier already has many natural gas wells, most of them tucked away in the expansive fields and forests of a beautiful and thinly populated agricultural region. Let each individual town decide whether it wants to put up with the disruption and prosperity of a fracking boom.

Enviro-colonialism . . .

What we have here is a rich urban and suburban enviro-gentry imposing its prejudices and misconceptions on poorer, less powerful rural folks. Consider the figures on median household income and poverty rates (2009-13) for the two regions:

  • Three counties in the “southern tier” (Broome, Chemung, Chenango): median household income averages $39,193 and the share of people below the poverty level is 16.2%, on average for the three counties.
  •  Three counties in the New York City suburbs (Westchester, Nassau, Bergen): median household income averages $87,810 and the poverty rate averages 7.6%

So—even leaving aside the super-rich precincts of New York City—the affluent anti-fracking counties are more than twice as rich and have less than half the poverty of the poor counties denied jobs and prosperity by King Andrew’s edict. No wonder inequality is rising and wages are stagnating. If you want to prosper, go west to Texas and Oklahoma—which is precisely what workers are doing. Between 2000 and 2010 New York State’s population rose 2.1% and New Jersey’s 4.5%, while population growth was 20.6% in Texas and 8.7% in Oklahoma.

. . . could Split the Democratic Coalition

 It’s not just King Andrew. Elizabeth Warren attacks fossil fuels while opining “if we commit ourselves to clean energy and energy efficiency now, in the long run we can reduce price swings and lower our overall costs.” As Keynes said, in the long run we are all dead. Right now the cost of heating houses in New England is about to soar because inadequate pipelines prevent cheap natural gas from reaching Senator Warren’s constituents. This is no big deal for wealthy professionals like Senator Warren; it matters a lot to average workers. Will she oppose the Keystone XL Pipeline?

And it’s not just energy. Democrats seem to be lining up behind the Reverend Al Sharpton against “racist cops.” They are attacking CIA patriots who (with the oversight of Congressional Democrats including Nancy Pelosi and Dianne Feinstein) water-boarded Islamic terrorists in order to protect Americans and eventually kill Osama Bin Laden.

 Hopefully Republicans can find a candidate who—unlike Mitt Romney in 2012—will adroitly expose and exploit the rift between Democrats’ enviro-gentry and average workers of all ethnicities, genders, races, income levels, sexual preferences etc. The anti-capitalist environmental extremism of the Obama era has been a disaster for average workers—while the affluent have prospered.

Copyright Thomas Doerflinger 2014. All Rights Reserved.


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Emerging Market Masochism

I had lunch in midtown with my friend Fred, a veteran Street salesman, who handed me a glossy brochure from an emerging market fund manager who had visited his office. The pitch was (Surprise!) emerging markets have underperformed, investors are “underweight” EM relative to the MSCI global index, the markets look cheap, and it’s time to buy.

It’s not just dedicated fund managers who like EM. One of the biggest and best wealth managers is telling clients to have a total equity allocation of 34.5%, of which 6% should be in EM. They also want you to have 4% in commodities, which are highly correlated with EM. Therefore more than a quarter of your “risk assets” are in EM or EM-correlated commodities. [(6+4)/(34.5+4)=0.26]

I have a big problem with EM, which I described a year ago (see “Emerging Market for Cowards,” Jan 5, 2014). U.S. equities are risky enough and periodically drop more than 20%. When you buy EM stocks, you are embracing several new layers of risk, which are auto-correlated, and which you don’t need to accept to get exposure to the economic growth in emerging markets.

Four Big Risks

Because emerging economies are financially risky, their currencies periodically plunge. Most of them run current account deficits; i.e., they borrow from abroad. This is fine so long as the money is spent on productive assets such as factories, but often it goes for consumer goods, presidential palaces, boondoggle infrastructure, weapons, or (in the case of Russia) apartments in London and Manhattan. Much of the borrowing is in dollars, so if the EM currency declines the effective debt burden increases dramatically. To defend its currency, the country raises interest rates and slashes government spending; a severe recession ensues. (See Russia, 2015.)

It gets worse. Many (not all) emerging markets rely on commodity exports and so are hurt by weak commodity prices, which are inversely correlated with the dollar – strong dollar, weak commodity prices. So U.S. investors in EM get hit with the double whammy of weak EM currencies and weak EM economies.

Third, corporate governance, which sometimes sucks in the U.S., is even more problematic and opaque in emerging markets, for three reasons: weaker standards of corporate governance, more government corruption, and the difficulty U.S. investors have in monitoring far-away companies operating in an alien business culture.

Then there is economic policy, which is bad enough in the U.S. (see Obama, Barack). EM economic policies are often hostile to capitalists because they are socialistic (India, Brazil), exceptionally incompetent (India, Argentina), corrupt (Russia, India, China, Turkey), or distorted by political instability (Thailand, Middle East).

Bad Timing

Because they are so risky, you need a huge “risk premium” (i.e., very low valuation) to justify investing in emerging markets. That means buying after a crash. Unfortunately that is not when Wall Street will tout EM; brokers will wait until the markets have recovered and they can tell clients “If you had owned EM over the past year, you would have done better than owning boring U.S. stocks. But there’s still time to diversify into EM, which will cut the volatility of your portfolio.”

Rather than trying to play this complicated, risky game, normal investors who are not closely monitoring the elections and economic performance of India, Brazil, Russia, Argentina and Turkey should simply purchase U.S. or European multinationals, along with an occasional high-quality EM stock such as Samsung. These companies produce what developing nations need, whether it is iPhones, Nike running shoes, Diageo whiskey, Philip Morris cigarettes, Monsanto seeds, Boeing aircraft, or Schlumberger oil services. Leave the currency risk to the Treasury Departments of these companies.

Copyright Thomas Doerflinger 2014. All Rights Reserved



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