Three Stock Picking Themes

Posted on February 13, 2014 by tomdoerflinger

Investment themes—social and economic trends that provide “tail winds” for certain companies—can last for years and years.  Washington is abuzz about “income inequality,” which I highlighted as an investment theme in the late 1980s, advising clients to avoid the “mediocre middle” of retailing in favor of chains serving lower income folks or the affluent.  You need to get two things right: correctly identify the theme and find good companies that really will benefit from it.  Themes, including the ones discussed here, are often rather obvious, but they tend to get overlooked by professional investors focused on:

  • Short-term risks (“Will XYZ Corp. miss the quarter?”),
  • The always inscrutable business cycle (“Is it time to buy ‘defensives’ because the economy is weakening?”),
  • Financial characteristics (“Consumer staples should outperform because they have high dividend yields”).

Theme # 1: Purity Plays

Thanks to globalization and rising living standards around the world, there is more and more concern – on the part of consumers, regulators, and companies – about a broad range of contaminants that must be avoided:

  • Diseases that can cross oceans on airliners – avian flu, swine flu, HIV
  • Intestinal “bugs” that could ruin your whole Caribbean cruise
  • Impure or fake pharmaceuticals
  • Toxic substances in consumer goods (e.g., lead paint in toys)
  • Toxic factory emissions such as lead and mercury and even CO2
  • Bacteria such as salmonella and E. Coli in fish, meat, and vegetables
  • Mislabeled food (horse meat in the hamburger, Yellowtail passing for mahi-mahi)

It is “mission critical” for governments and companies to avoid these contaminants.  Bird flu in China cratered YUM’s stock price and caused a 20 percentage point swing in earnings.  Therefore, respected and reliable companies that can help customers detect and eliminate contaminants enjoy strong demand and have ample pricing power; they include Ecolab, Clorox, and instrument makers such as Thermo Fisher and Agilent.

Theme # 2:  A Cleaner, Greener, Safer Infrastructure

Much of the global energy and industrial infrastructure is being rebuilt to increase energy efficiency; reduce emissions of particulates, toxic substances, and CO2; and make the built environment (vehicles, houses, hospitals, airports) safer.  This phenomenon has many interlocking elements, including:

  • Around the world, tougher government regulation to reduce emissions by factories, power plants  etc.
  • Shift from coal to natural gas, especially in the U.S.  This requires new pipelines, processing plants, petrochemical plants, LNG export facilities, etc.
  • Renewable energy (solar and wind) and electric cars
  • China’s pollution crisis will force it to rebuild its industrial infrastructure
  • Cars and trucks will become smarter (stay in lane, avoid blind spots) and safer (more air bags, anti-lock brakes.)
  • Smart thermostats and sensors that save energy and enhance security.

Ways to play this broad theme include: engineering and construction stocks such as Fluor; diversified industrial stocks such as GE, Siemens, and 3M; semiconductor and electronics stocks with exposure to the automotive and industrial markets; vehicles with lower emissions such as Cummins Engine, Honeywell, and Borg Warner; makers of thermostats such as Honeywell (which will have to compete with Google following GOOG’s acquisition of Nest).

Theme #3:  Emerging Market Demand

Emerging markets may be slowing but they are still growing,  and as they develop they need a lot of what sophisticated companies in developed nations produce, in such areas as:

  • Agriculture—Monsanto, DuPont, Deere, Potash, etc.
  • Aerospace—Boeing, Airbus, GE, United Technologies
  • Commercial Real Estate—United Technologies, Honeywell, Siemens, etc.
  • Tourism—bullish for aerospace, hotels, luxury retail
  • Back-up power – Cummins Engine, CAT, GE
  • Cars, trucks, and trains—GE, Siemens, auto and truck makers and their suppliers

Many diversified industrials sell into these markets, including GE, UTX, MMM, ETN, PH, ITW, DHR, EMR and many others.  Short Wall Street research reports fail to convey how the three themes discussed above drive earnings.  In the slide deck accompanying its latest earnings report, 3M gave us a  flavor by highlighting three items:

  • 3M’s liquid filtration business in China rose 70% in 2013
  • 3M’s infection prevention business in India was named “Sterilization Services Company of the Year” by Frost & Sullivan.
  • A 3M product was recognized by Uptime Institute with the “Green Enterprise Award” for improving the energy efficiency of data centers.

Three Themes Propel Superior EPS Growth by Industrial Companies

Obviously these three themes overlap and intersect, but they are all positive for companies involved in creating a cleaner, safer environment in emerging and developed economies.  That is bullish for a broad range of industrial companies and their suppliers, including many tech firms.  But perhaps this thematic talk sounds too ethereal and abstract.  To measure its real world financial impact, I created two groups of stocks and compared their earnings growth, dividend yields, and valuations:

  • 16 major industrial stocks:  UTX, GE, ETN, BA, MMM, PH, ITW, PCP, FLR, UNP, BWA, CMI, CAT, DE, EMR, HON.
  • 16 major consumer staple stocks, many with significant emerging market exposure: WMT, PEP, KO, PG, CPB, GIS, K, KMB, CLX, CL, KR, SWY, COST, AVP, MCD, CAG.

The industrial stocks grew much faster than the staples stocks, had somewhat lower dividend yields, and about the same PE ratio.  Specifically:

  • The Industrials’ median 8-year (2005-13) EPS growth rate was 10.8% versus just 7.3% for the consumer staples stocks.
  • Industrials’ median PE was 18.2x versus 18.0x for the staples stocks.
  • Industrials median dividend yield was 2.1%, lower than the staples’ 2.9%.

Bottom line: the industrial stocks look more attractive.  Using the metric [PE / (EPS growth rate + dividend yield)], the industrials get a valuation score of 1.41 or [18.2/(10.8 + 2.1)], which is much cheaper than 1.76x for the staples stocks [18.0 / (7.3 + 2.9)].

Of course, these scores use historical growth rates and only have investment significance today if these growth rates continue.  That’s where thematic analysis comes in.  I think the three themes identified here will, in fact, continue to drive faster earnings growth for the industrial stocks than the staples stocks– particularly because such firms as PEP, KO, CPB and MCD will be hurt by a global push for healthier foods to fight obesity and diabetes.

Copyright Thomas Doerflinger 2014.  All Rights Reserved.

Full disclosure: I own quite a few of the stocks mentioned in this post but I am not specifying which ones to avoid appearance of an endorsement.

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Four Equity Errors

Posted on February 13, 2014 by tomdoerflinger

Secret NIH-funded research at the Wharton School of Finance in Philadelphia has demonstrated that prolonged exposure to the stock market permanently impairs the prosencephalon diecephaion subthalamus, the part of the human brain that governs good sense and logical thinking.  I’m just kidding.  But it would not surprise me.  Consider four egregious equity errors (and then take a look at my next post, Three Stock Picking Themes that can make you money).

Don’t be Shilled by CAPE

For some reason financial media treat bearish pundits far more gently than bulls.  Robert Shiller’s CAPE (Cyclically Adjusted Price Earnings Ratio) is regularly cited in the Financial Times and Wall Street Journal even though he has been wrong on the stock market for the past three years.  In January 2011 Shiller told CNBC, “I would say the market is overpriced on fundamentals.” It is up 36% since then.  And it’s not just the media that dons the CAPE. Asset allocation committees overseeing huge pension funds use CAPE to gauge whether stocks are “expensive.”  Shiller’s CAPE is simply

Current price of S&P 500 / (average inflation-adjusted GAAP EPS over the past 10 years).

Shiller thinks stocks are “overpriced” if the current CAPE exceeds the historical average CAPE.  Here is all you need to know to see that this is a profoundly misleading metric.  The average CAPE since 1896 (which marks the inception of the DJIA and a modern stock market with numerous industrial issues) is 16.53x.  Now, if you look at the level of the CAPE each month since the start of 1990, there are only 16 months, or 5.6% of the time, when CAPE was below 16.53x and stocks looked “inexpensive”!  In other words, according to CAPE stocks were “overpriced” more than 94% of the time, even though the S&P 500 has quintupled since 1990. CAPE does not work for a few reasons:

  • Much of the time since 1871 the S&P 500 PE ratio was depressed by lengthy crises such as the post-1873 depression, World War I, World War II, the Great Depression, and 1970s inflation. None of those conditions exist now, though we do have Barack Obama to contend with.
  • GAAP EPS can be misleading—which is why no analysts use GAAP to value individual stocks.  For the last 15 years GAAP EPS has been depressed by new accounting rules (FAS 142) requiring companies to write-down goodwill from mergers if the goodwill seems impaired.  Often investors ignore these write-downs, but they reduce S&P 500 GAAP EPS and thus magnify CAPE.  The write-downs tend to be concentrated in a handful of failed companies (such as the tech companies that blew up in 2001-2002) that cautious investors can largely avoid.
  • It is wrong to compare the current PE with the average PE going back to 1871; the stock market has changed a lot since then.  Specifically, it has become much cheaper and safer to invest in stocks, thanks to lower commissions, tighter spreads, ETFs, lower mutual fund fees, and better regulation.  Don’t forget the fraud factor—average investors used to be regularly fleeced by corporate insiders and Wall Street operators.  The minor classic Frenzied Finance describes how in 1904 the “Standard Oil Crowd“ manipulated the flotation of a copper trust, Amalgamated Copper, in order to cheat the public. In the 1920s “pools” of big-shot speculators pumped up stocks (usually glamour issues such as RCA), drew in the public, and the sold at an elevated price.

Buy SBUX?  What About Bean Prices?

In the mid 1990s I travelled to the Midwest and met with the portfolio managers for a large state pension fund.  I mentioned that Starbucks looked attractive.  My clients demurred; they didn’t like the stock because profit margins might be squeezed by rising coffee bean prices. At the time, SBUX was trading at $2.00-3.00; now it is at $75. If these folks did not buy SBUX because of potential transitory margin pressure from bean prices, it was a very costly mistake.

Investors, especially Wall Street professionals worried about quarterly performance, can be more myopic than Mr. McGoo. They get cute about minor near-term risks while ignoring the Big Picture of a company’s long term growth prospects. “It’s a great company that could grow 20% per year for a decade, but it’s expensive.  Let’s wait for a pull-back.” Frequently, the pull-back never comes and they miss the stock. They end up trying to scalp nickels and dimes on mis-pricings of mediocre companies while leaving $1000 bills on the table.  Remember, if a company really can grow 20% per year for a decade, earnings rise by a factor of six.

The CNBC dEffect

Many (not all) of the people on CNBC and Bloomberg are intelligent and knowledgeable, and I do glean useful information.  But for the individual trying to learn how to invest, their programming is systematic disinformation—a catalogue of what not to do to make money in stocks, including.

  • Obsessive scrutiny of the economy and Fed policy (Will they taper? How much?  All T-bonds or some MBS?). Unless you run a bond desk on Wall Street, it doesn’t matter much. Famed investor Peter Lynch was not all wrong when he quipped, “If you spend 10 minutes a year worrying about macro issues, you wasted ten minutes.”
  • Analyzing every twist and turn of the stock market, which boils down to gauging investor “sentiment” rather than substantive matters.
  • A focus on “trading” not investing.
  • A fixation on problematic stocks that individuals should avoid.  Unless it is a super-expensive high flyer (TSLA, LNKD) or operates in an exotic and risky new industry (FB, TWTR, ZYNG, DDD, GRPN) or is the dumb idea of a famous hedge fund manager (JCP, HLF, SHLD) CNBC is not interested. The honorable exception is AAPL, but it gets way too much attention.

Harvard Hates America (or at least its Equities)

Jane Mendillo, the head of Harvard’s $38 billion endowment, was interviewed in the latest Barron’s.  For many years Harvard and other Ivy endowments have been underweight U.S. stocks even though they were, until recently, trading at or below the levels reached in 2000 (when they were overpriced) and 2007.  Today, Mendillo told Barron’s, Harvard has 49% of its assets in equities, broken down as follows: U.S. Stocks 11%, Foreign Developed Nation Stocks 11%, Emerging Market Stocks 11%, Private Equity 16%.

The allocation to U.S. equities looks way too low.  For one thing, Mendillo admits the Private Equity space has become too crowded, which will lower returns.  Harvard significantly underweights U.S. stocks even though A) they are more liquid than emerging market equities, B) they don’t carry the same underlying financial and political risk inherent in emerging markets, C) their corporate governance is better, D) U.S. firms have material exposure to emerging market GDP growth via exports and foreign subsidiaries, E) In many areas such as electronics, aerospace, biotechnology, consumer products, finance, etc. the world’s leading companies—those with the best technology, brands and global franchises—tend to be U.S. or European firms.  (On the last point, I will freely grant there are many important exceptions such as Samsung, TSMC, and Alibaba.)

Harvard is guilty of “anchoring”—of adhering to a prior view that has lost validity.  It became fashionable for college endowments to follow Yale’s lead and overweight private equity and hedge funds while deemphasizing domestic stocks.  This bias was smart for a while but not now. Back in 1995 Harvard’s exposure to U.S. public equities was 38%, more than three times what it is today.  Look for it to rise back toward (but probably not all the way to) 38% over the next decade.

 Coming Soon: Three Stock-Picking Themes

Having dissected with unbecoming elan these four equity errors, in my next post I will strike a more constructive tone by discussing three stock-picking themes, all of which tend to be positive for industrial stocks, broadly defined.

Copyright Thomas Doerflinger 2014.  All Rights Reserved.

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CBO Highlights ObamaCare’s Assault on Social Mobility

Posted on February 6, 2014 by tomdoerflinger

The new CBO Report further underscores a point we have been making for several years—Obamacare hurts employment growth in many ways:

  • CBO concludes that the equivalent of nearly 2.5 million jobs will not be filled because if you earn too much, you lose your healthcare subsidies.  This is a clear barrier to social mobility—if you are poor, it may not pay to succeed in the workplace.
  • At the other end of the income spectrum, higher marginal tax rates will cause some affluent people subject to new Obamacare taxes to work less and/or retire early.
  • Some small businesses will stay “under the limit” of 50 workers—a serious blow to business development and job formation.
  • Labor-intensive businesses are holding workers to less than 30 hours per week to avoid providing health insurance.  Virtually all of the victims are low-income workers–including the short order cook who complained to Obama in a recent Q&A that his hours had been cut.
  • Because it requires many firms to provide “better” coverage than they now offer, Obamacare raises labor costs and encourages firms to substitute cheap capital for increasingly costly labor.

Strangely, these points continue to elude many Wall Street economists as well as BSE’s (Big Shot Economists) such as Larry “Secular Stagnation” Summers.  Or maybe it is not so strange because economists working for big firms and universities have no firsthand experience with Obamacare.  Nor do they want firsthand experience; elite universities all have “grandfathered” healthcare plans that give faculty and staff more choice and higher quality care  than Obamacare affords.  Obamacare for thee but not for me.  How hypocritical.

A New Barrier to Social Mobility

The bigger question is: How should the Republican Party position itself with respect to ObamaCare?  I think it needs to characterize ObamaCare as a huge barrier to social mobility for poor and middle class workers.  This scheme damages both sides of the labor market, simultaneously reducing incentives for Americans to work and for employers to hire.  (No wonder the employment population ratio has not improved at all since 2009.)  As such, Obamacare increases economic and social inequality in a way that really matters – people in the lower and lower middle classes are having a harder and harder time getting a well paid job that moves them into the middle class and perhaps eventually much higher.  (This is far far more important than a rise in the Gini Coefficient of Inequality caused by Bill Gates, Eric Schmidt or other super-rich folks getting even richer, which has no negative impact on the middle class.)  One little-known aspect of this story is that Obamacare does not directly affect large corporations that self-insure; it only directly impacts smaller firms that do not self-insure.  So Obamacare is the quintessence of elitist crony capitalism.

Republicans need candidates who can go beyond weak one-liners (“Where are the jobs?”) to a lucid and compelling explanation of how Obamacare destroys economic opportunity and social mobility.  The CBO expose of 2.5 million lost jobs provides a great proof-point for that argument.  But it does need to be fleshed out in a complete and compelling explanation, not just a bullet point.  To be sure, Republicans are starting to do that.  Senator Roy Blunt’s response to Obama’s dreary State of the Union Address was very effective, as was a recent speech by Senator Ted Cruz, discussed in my November 1, 2013 post.

Copyright Thomas Doerflinger 2014.  All Rights Reserved.

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CEO’s Say the Global Economy Is Strengthening

Posted on February 1, 2014 by tomdoerflinger

Sometimes I am clueless about what is driving stock prices.  In September 2008 I did not sell a share even though my commute took me past the Lehman Brothers building on 7th Avenue, which was being both swarmed by rabid reporters and vacated by shell-shocked employees clutching cardboard boxes.

But lately I have had a better grip on the markets.  In an upbeat post last January I said there could be a “valuation levitation” that would drive stock prices well above most year-end 2013 S&P 500 price targets on the Street, because strategists’ PE assumptions were way too conservative. (Why buy a 2% treasury bond, I asked, when you could buy a blue-chip equity with 2-3% current yield and 5-12% dividend growth?)  A year-end 2013 price of 1864 was not crazy, I suggested.  More recently I detected a “cacophony of complacency” and excessive bullishness, setting the stage for increased stock market volatility.  Voila.

Where are stocks headed next?

Higher over the next 3-6 months, but with ample volatility as emerging markets cope with Fed tapering that exposes the economic and financial fragility of certain countries some of which are in political turmoil (i.e., Turkey, Ukraine, Thailand, Egypt, Argentina).  Chinese growth is fine for now, but so was U.S. growth in 2006; the country needs substantial financial reforms to avoid a major credit crisis, and there is little evidence those reforms are under way. Meanwhile, back in the U.S., Obama continues to be a weak and divisive leader who fails to tackle big issues such as tax reform.

Q4 Profits Suggest Global Growth Is Improving Modestly

As stocks vaulted higher at the end of last year, commentators searching for an explanation opined that U.S. growth was strengthening and we would have “synchronized global growth” in 2014.  But recent EM turbulence and some weak U.S. data call that into question.

To get a fresh perspective we examined the comments, on Q4 earnings calls, of twelve important, globally diversified companies with aggregate annual revenue of $504 billion.  I don’t pay too much attention to the forecasts of CEOs and CFOs, but they do have a granular knowledge of current business conditions.  Right now they say the global economy is indeed improving.  They see decent growth in the U.S. and emerging markets (principally China) and palpable improvement in Europe.  Southern Europe is stabilizing.  Global growth is definitely stronger than it was in the first half of last year and seems consistent with the sell-side strategists’ estimate of $120 for S&P 500 EPS.  With PE ratios elevated, this earnings growth is important to continued stock price appreciation.

My source is earnings call transcripts available on www.seekingalpha.com, which, by the way, is a very convenient way to access Street presentations.  (Why does every company have to arrange its Investor Relations website differently, even though they all do exactly the same thing?).

GE—solid growth

“Orders grew by 8%….Growth market orders grew by 13% and the U.S. expanded by 8%, and Europe grew by 3%.”  (Note to Jeff Immelt: Please come up with a better term than “growth market” to refer to emerging markets.  After all, the U.S. and Europe are also growing.)

United Technologies – revenues accelerating

“Organic sales were up 4% in the fourth quarter after being flat through the first three quarters.”  This is significant as UTX is widely diversified across aerospace, construction, and other markets.

Honeywell – strong growth

Sales “grew an impressive 8% on a reported basis, 5% on an organic basis.  The strength we saw at year-end was broad-based.”  Organic sales growth was 5% in the U.S., 4% in Europe and 13% in China.

3M—acceptable global growth, with gradual improvement in Europe

Local currency sales growth was 4.5% in the U.S.  Organic sales growth in EMEA was 3.4%, including 3% in Europe, which continued “the positive trends we have seen in recent quarters.”  Asia Pacific had 3.3% organic growth in the fourth quarter.

Thermo Fisher Scientific  — solid growth globally

The company reported “ongoing strength in Asia Pacific and improving conditions in Western Europe.”  The U.S. is improving somewhat.  “North America revenue grew in the low-single digits. Europe grew just above the company average and Asia Pacific grew in the low teens, with China growing in the mid-teens. Rest of world grew in the mid-teens,”

Caterpillar – Asia Improving

Mining equipment is still very weak.  But demand for construction equipment in China is improving.  “Our sales in China were up more than 20% this year.”  CAT expects 7.5% GDP growth in China in 2014.

DuPont—Decent Global Growth

Sales rose 6% globally—4% in North America, 8% in “developed Europe, Middle East and Africa and 9% in Developing Markets.”   Unusual seasonal patterns in the ag business boosted revenues; on the other hand, currency was a modest negative (as at most multinationals).

Illinois Tool Works—modest improvement

“Q4 revenues were up 4.8% [y/y] in a modestly improving macro environment.  Our Q4 organic growth of 3% was up from flat in Q3, driven largely by North America and China, with overall organic growth of 2% in Europe.”  (Even modest growth in Europe is an improvement compared to the past year.)

Parker Hannifin – acceptable growth

The company generated 3.1% organic sales growth (which excludes acquisitions, currency and new joint ventures).

TE Connectivity –decent growth, led by vehicles

“The majority of the markets we serve continue to improve…..Orders increased 8% in the quarter.”  The company raised guidance for the fiscal year.  “Global auto demand continues to be strong running a little ahead of historical long-term vehicle growth rates…..Europe was up about 11% due to strong exports and slight improvements in local demand.”

Praxair—decent global demand for industrial gasses

The company, which has a big Brazilian operation, said “Organic sales increased 7% from higher volumes and higher overall pricing, with growth across all geographic segments.”  Organic sales growth in Europe, excluding the effect of currency translation, was 7%.  Southern Europe “appears to be stabilizing.” In Asia, sales grew 5% on volume growth of 8%.

SBUX – Good Global Performance, including Europe & Asia

Global same store sales growth was 5%.  “Our important EMEA (Europe, Middle East, Africa) region with over 2,000 stores had the strongest growth in more than three years.”  Starbucks America had 8% revenue growth and comp sales up 5%.  Revenue in Asia rose 25%, with comp growth of 8%.

P&G—decent growth

The company, which has had a spotty growth record over the past few years, registered 8% growth in emerging markets.  This largely reflects a “same country, same category, apples to apples growth rate.”

Collapsing EM currencies will Hit Q1 earnings of some companies

When a currency such as the Turkish lira makes a quick, steep decline, the value of a U.S. multinational’s revenue and profits in that country decline pretty sharply.  So the recent collapse of EM currencies will hit the profits of some multinationals in Q1 and beyond.  However, this is not too big a problem so long as China is reasonably healthy.

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Mon Dieu! Meme Francois! – Europe Rediscovers Capitalism

Posted on January 20, 2014 by tomdoerflinger

When Francois Hollande won the French election back in May 2012, Paul Krugman mocked the media “hysteria” about the victory of a left-wing politician who promised to revive the French economy by raising taxes even higher on wealthy Frenchmen.  I, as usual, took a more moderate, nuanced and balanced view, writing a squib titled “Seven New Reasons Not to Create Jobs in France.”  They were: a new wealth tax, a 75% top marginal income tax rate, a hike in the estate tax, a hike in business taxes, a “dividend tax” on companies (to encourage reinvestment), higher taxes on bonuses and stock options, and a rise in the tax on equity trades.

In addition to chasing Gerard Depardieu to Russia, these tax hikes killed lots of jobs. In May 2012 the unemployment rate was 10%; now it is 10.8% and headed higher in a moribund, uncompetitive economy with a rising trade deficit despite weak domestic demand.  It turns out that, contra Dr. Krugman, job growth is not all about aggregate demand.  The supply side matters too.  If you attack employers with a raft of taxes you get less employment, less economic growth, and weak tax revenue.  Hollande almost sounded like Larry Kudlow when he exclaimed at his press conference, “How can we run a country if entrepreneurs don’t hire?”  (But then he returned to form, asking “And how can we redistribute if there’s no wealth?”  Please take note, Mayor DeBlasio.)

How do you say U-turn in French?

To save his presidency, Hollande has reversed some of his anti-business policies. Only a few. It will be a long time before he is as popular in the corporate boardroom as he is in the Parisian boudoir.  Hollande’s U-turn exemplifies a trend toward healthy international competition within Europe.  While Hollande was busy proving Dr. Krugman wrong, so were British Prime Minister David Cameron and Chancellor of the Exchequer George Osborne.  These benighted conservatives adopted a dreaded “austerity” program of cutting spending in order to rein in budget deficits and shore up Britain’s credit rating.  After a slow start, this policy has worked, with economic growth picking up nicely and the unemployment rate declining from 8.2% in May 2012 to 7.4% recently.  Meanwhile, the German economy has been expanding and Spain, through a brutal process of “internal devaluation” (slashing real wages because the country could not devalue its currency), has also become much more competitive.  Will Italy follow?  (Another positive sign: Europe is starting to notice that its renewables-first energy policy will be an economic disaster because it impoverishes consumers and makes heavy industry uncompetitive versus the all-fracked-up United States.  Germany’s giant chemical industry, for example, could relocate to Texas and Louisiana.)

With France falling behind long-standing rivals Britain, Germany and Spain, Hollande decided he had to change course.  It is far from clear his reforms are deep enough.  In his press conference he was vague about how he would cut spending to pay for tax cuts, and many politicians in his coalition hate capitalism and capitalists.  When the government spends 57% of GDP, you have a long long way to go before you have a vibrant capitalist economy.

In truth, I have been somewhat too bearish on Europe.  The Euro still seems to me to be fundamentally dysfunctional, and Germany’s prescription that all nations in the EU should run trade surpluses is absurd.  With banks still in deleveraging mode, lending may be too weak to fund healthy growth.  Nevertheless a few years of pain and agony have indeed driven salutary reforms that are improving economic performance.  Maybe even in France, eventually.  This is positive for U.S. profits; something like 15% of S&P profits are in Europe, and while growth will not be strong it is far better for it to be  growing than shrinking.

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Larry’s “Secular Stagnation” Excuse

Posted on January 14, 2014 by tomdoerflinger

Larry Summers disclosed his latest macro insights at an IMF Meeting last November, which he elaborated upon in a Financial Times article:  “We may . . . be in a period of ‘secular stagnation’ in which sluggish growth and output, and employment levels well below potential, might coincide for some time to come with problematically low interest rates.”  In other words, we will continue to have weak GDP growth and high unemployment despite a zero Fed funds rate and low bond yields.  This stagnation, he now claims, has been evident since 2000, which is why even the 2003-2007 housing bubble was not enough to spark rapid economic growth. (No word on why he failed to notice the secular stagnation of 2003-2007 until 2014.)  Summers identifies three possible ways to escape “secular stagnation.”

  • Supply side reforms such as improving labor force skills, increasing companies’ capacity for innovation, structural tax reform, etc.  But this he dismisses on the grounds it will take too long.
  • Super low interest rates.  He rightly says we are already doing this but it isn’t working, and besides we can’t continue it forever without causing bubbles in asset prices.
  • Aggressive Government Spending.  “The third approach—and the one that holds most promise—is a commitment to raising the level of demand at any given level of interest rates, through policies that restore a situation where reasonable growth and reasonable interest rates can coincide.  This means ending the disastrous trend towards ever less government spending and employment each year – and taking advantage of the current period of economic slack to renew and build up our infrastructure.” (Emphasis mine)

Secular Excuse

No offence, Larry, but it looks to me like you are concocting a phony, after-the-fact secular excuse for the spectacular failure of President Obama’s economic policies.  Come to think of it, those were your economic policies, because you were Obama’s Senior Economic Advisor.  The failure of your policies is not a surprise.  Back in 2009 I wrote that we would have yet another “jobless recovery” that would be even worse than the prior two because of Obama’s anti-capitalist policies.  And so it has come to pass; the employment population ratio is far below the level of the Bush administration and has not improved at all since the depths of the 2009 recession.

Larry’s simplistic model has just three variables – “supply side reforms,” monetary policy, and fiscal policy.  What’s weird is that most Wall Street economists, who are paid to be right and twist in the wind when they are wrong, accept this model and ignore the structural impact of Obamanomics—which is why most of them have been too bullish on growth for the past few years.  On “Bloomberg Surveillance with Tom Keene,” you can hear well-paid, erudite PhD’s go on for hours about the U.S. economy without ever mentioning structural issues such as Obamacare.  Tom should remind them it was “structural reforms” in Germany’s labor market, 2003-05 ,that revived the putative “sick man of Europe.”  Structural reforms, including deregulation and supply-side tax cuts, likewise rescued the U.S. from 1970s “stagflation.”  It’s not all about fiscal and monetary policy, Larry.

“Stagnation” Solution: Un-do Obamanomics

Forget secular stagnation. The path to growth is obvious:  Reverse Obama’s many anti-capitalist sins of commission and omission, which have collectively killed “animal spirits” and hiring in the private sector. To name a few:

  • Obama’s rhetorical attacks and tax hikes on “millionaires and billionaires” have convinced job creators (including the CEOs of MMM, INTC, ETN, WYNN, L, JPM & EMR) that the U.S. is a bad place to invest.
  • As political comedian Mark Steyn noted, the $823 billion “stimulus” package managed to do the seemingly impossible—spend immense sums on “infrastructure” without building a single major improvement that anyone can point to.  Money was wasted on weaning America off fossil fuels just as the fracking revolution was cutting energy costs and CO2 emissions.
  • The EPA attacked the energy and utility industries, among many others.
  • Dodd Frank enveloped the banking system in miles of red tape that discourage banks, especially community banks, from lending to small businesses.
  • Attacking JPM with huge fines, including—most ludicrously—fines for failure to detect the Madoff fraud when the SEC failed to do so despite explicit, detailed warnings from Harry Markopolos, which were the subject of a Barron’s article. 
  • Obamacare raises labor costs for small and medium-sized businesses and creates strong incentives to stay small (under 50 workers) and use part-time workers (under 30 hours per week.)  Companies have spent millions of hours coping with unnecessary disruption of their healthcare benefits.  No wonder they’re not hiring.
  • Failure to OK the Keystone XL Pipeline.
  • Failure to reform the U.S. tax code, not even the ludicrously uncompetitive corporate tax regime.  This keeps $1-2 trillion of corporate cash stranded off-shore.
  • Failure to reform immigration, which would increase entry of much-needed high skilled and low skilled workers.

Killing Factory Jobs and Hurting the Poor in India

Much as Larry’s lousy policies have hurt America’s poor, over-regulation has stunted growth in India.  I know little about India but have always wondered why its economy is so weak even though the country produces thousands of immensely talented emigrants who have made huge contributions to the U.S. economy.  So, with few preconceptions, I read two books with contrasting perspectives on the topic that were featured in The New York Review of Books.

Sen’s Sins

An Uncertain Glory: India and Its Contradictions, by Jean Dreze and Nobel Prize winner Amartya Sen, discusses Indian economic growth and “argues that the country’s main problems lie in the lack of attention paid to the essential needs of the people.”  In prose that I found to be weirdly windy, gauzy, elliptical, garbled, turgid, convoluted, complicated, tortuous, abstract, and repetitively convoluted and complicated Dreze and Sen claim the state needs to intervene in markets if economic growth is going to help the common man and woman.  A couple of excerpts:

Those who dream about India becoming an economic superpower, even with its huge proportion of undernourished children, lack of systematic health care, extremely deficient school education, and half the homes without toilets . . . . have to reconsider not only the reach of their understanding of the mutual relationship between growth and development, but also their appreciation of the demands of social justice, which is integrally linked with the expansion of human freedoms.

The case for going beyond private profit calculations in making economic decisions is strong, particularly in a country like India.  The existence of what economists call externalities – like the pollution of air or water, or denuding of natural resources—tends everywhere to drive a wedge between private gains and social benefits….A further reason for avoiding complete reliance on private-sector allocations is poverty and inequality.  Since profitability is conditional on the ability of the purchaser, or the consumer, to pay, private profits can often be a very inadequate guide to the priorities of public need.  Some of these problems can be dealt with by instituting appropriate taxes and subsidies….

Left unsaid by Dreze and Sen is that India has long followed a socialistic approach to economic development, with politicians and intellectuals wringing their hands about inequality while a corrupt, inefficient bureaucracy does much to keep the poor poor by mismanaging large parts of the economy.  The electricity grid, for example.  Blackouts are very common; one in 2012 plunged half of India into the dark.  Yet even though they admit “lack of responsibility seems to run through all the layers of hierarchy,” Sen and Dreze oppose privatizing electricity for reasons that remain obscure.  They opine, “The bankruptcy of the power sector in India is part of a general political problem that has to be addressed at an overall level and involves the need to resist (or counter) the political influence of privileged pressure groups.”  Whatever that means.

How Regulation Kills Factory Jobs in India

In Why Growth Matters, Jagdish Bhagwati and Arvind Panagariya offer a point-by-point rebuttal to India’s socialistic approach to development. It turns out that excessive regulation, very reminiscent of Obamacare, creates strong incentives for small firms to stay small—which is a major reason why India has failed to develop labor-intensive manufacturing industries such as apparel and footwear, which require large firms that can achieve economies of scale to compete with giant factories in China, Vietnam, Cambodia, Thailand, etc.  Bhagwati and Panagariya tick off the many penalties and burdens that India’s oh-so-moral social planners heaped on firms that made the mistake of hiring too many poor people:

  • For manufacturing units with 10 workers using power and with 20 workers not using power, the 1948 Factories Act:
    • Limits worker hours to 48 per week;
    • Limits work without a day of rest to 10;
    • Requires a paid holiday for each 20 days of work;
    • Prohibits employing children under 15 years of age;
    • Bans employing women for more than 9 hours per day;
    • Factory premises must be kept clean, with whitewashing every 14 months and repainting every 5 years;
    • Separate washrooms for men and women;
    • Uninterrupted supply of drinking water;
    • Factories with 150 workers must provide lunchrooms.
    • At 250 workers factories must provide a canteen.
    • If the firm employs 30 women or more, a day-care center must be provided.
    • The 1952 Employees Provident Fund and Miscellaneous Provisions Act requires three types of benefits:
      • a contributory provident fund,
      • pension benefits to the employees and their family members,
      • insurance for sickness, maternity benefits, etc.
      • The list of burdens on employers goes on and on.

These requirements are costly and require extensive paperwork, and they create plenty of opportunity for official corruption. So the good news is that Indian laws require factories that, on paper, are great places to work.  The bad news is, there aren’t many factories, and Amataya Sen has to dream up excuses for why India lags far behind China in reducing poverty and improving the lives of ordinary workers—even though India had a thirty year head start in building a modern capitalist economy.  And back here in the U.S., Larry Summers is confecting the excuse of “secular stagnation” in a pathetic attempt to explain away the failure of Obamanomics, which he helped to design.

Copyright 2014 Thomas Doerflinger.  All Rights Reserved.

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Emerging Markets for Cowards

Posted on January 7, 2014 by tomdoerflinger

In the 1830s British investors spotted an attractive emerging market offering high returns with low risk. The United States was booming, thanks to industrialization in the Northeast, rapid settlement of the Midwest, and expansion of cotton production into new areas such as Arkansas and Texas. Merchants in New York and New Orleans controlled the lucrative shipment of cotton to London and Liverpool as well as return cargoes of European manufactures. The banking system was well-regulated by the Second Bank of the U.S., and the national balance sheet was pristine. In the 1830s the national debt (not just the budget deficit) was eliminated.

Despite these strong fundamentals U.S. bond yields were a lofty 5.3%, 60% higher than in England.  So British capital poured into the U.S..  Net foreign inflows soared from $7 billion in 1832 to $59 billion in 1836, most of it invested in bonds issued by state governments to finance canal construction.

Bad timing.  Andrew Jackson “killed” the Bank of the United States in 1836 and issued a “specie circular” stipulating that government land could only be purchased with gold and silver.  A brief speculative bubble in 1837 was followed by a collapse in land prices, financial panic, and a depression stretching into the next decade. “During the early 1840s nine states defaulted, and several more came close,” writes NYU professor Richard Sylla.  British capitalists abandoned the U.S. for more than a decade.  As a smart Boston hedge fund manager once told me, “scared capital comes home.”

Crumbling BRICs

British investors’ misadventures in Jacksonian America are typical.  It is hard enough to figure out what is going on in your own country (Federal Reserve economists missed the last three recessions), let alone someone else’s. Back in the late 1980s Americans believed that Japan would soon overtake the U.S. economy. Oops.  Wall Street completely failed to anticipate the “Asian financial crisis” of 1997-98.  In 2003 Jim O’Neil of Goldman Sachs dreamed up the brilliant acronym BRICs; he argued Brazil, Russia, India and China had embraced capitalism and would become globally dominant countries by 2050.  We’ll have to wait another 37 years to learn if he was right, but recent developments are not encouraging and BRICs have dramatically underperformed the S&P 500 over the past five years (up 10% on average versus 98%).  Here’s why:

  • Brazil is beset by 6% inflation and anemic GDP growth of 1-3%.
  • Russia has yet to embrace the rule of law and so is not a capitalist country.  GDP growth slipped to around 1.7% in 2013 and remains highly vulnerable to any drop in oil prices.
  • India’s economy is strangled by a corrupt and dysfunctional bureaucracy.
  • How long can China grow 7%+ when the main driver is local government investment in dubious infrastructure projects?  In the two and half years to June 2013, there was a 70% surge in local debt, much of which cannot readily be repaid.

High Risk in Emerging Markets . . .

As we have seen over the past seven years, the U.S. economy is frequently mismanaged, but it has the political, institutional, and intellectual infrastructure needed to get back on track.  (The Tea Party attack on Obamanomics, resulting in the budget sequester that cut Federal discretionary spending, is a case in point.) The U.S. also enjoys the “inordinate privilege” of having a reserve currency, and its huge internal market makes it insensitive to exchange rate fluctuations. The U.S. economy is widely diversified across technology, aerospace, consumer products, tourism, energy, chemicals, healthcare, agriculture, financial services, etc.  Emerging markets are far less diversified, have less robust capitalist institutions and face greater financial risk because many of them must borrow abroad.  Mere mention by Bernanke that he would “taper” bond purchases sent a shudder through EM financial markets.  Plus, you have to worry about the quality of corporate governance of individual firms.

. . . and How to Avoid Them While Still Participating in EM Growth

For all these reasons, emerging markets offer poor risk / reward.  Yet Wall Street has a weird affinity for the EM game, partly from a desire for greater diversification. Look at the asset allocation advocated by a prominent Midwestern wealth manager — 45% in fixed income and 36% in Equity, including 6% in emerging markets.  This allocation is conservative, with far more bonds than stocks, yet a sixth of the equity portion is in EM stocks.

That’s too risky for my taste. You don’t need to own EM stocks to get exposure to EM economies; U.S. multinationals are a safer method.  As they modernize, emerging markets need and want what U.S. firms produce, be it Abbot medical supplies, Boeing aircraft, Monsanto seeds, YUM’s Kentucky Fried Chicken, PM’s Marlboros, or Schlumberger energy services.  You can get plenty of EM exposure without worrying about India’s balance of payments, Brazil’s inflation rate, or Putin’s latest outrage.

The Fayez Formula

What EM exposure gives U.S. multinationals is not necessarily much faster growth in the near term, but long-term sustainability of fairly fast (7-12%) earnings growth.  If you buy a stock for $20 per share with DPS of $0.60, the dividend yield is 3%.  If the dividend grows 10% annually for 15 years it will become $3.34—a yield of 16.7% on your cost.  In another five years that yield is 26.9%.

A rich and famous practitioner of this investment style is Houston money manager Fayez Sarofim, who was profiled in a recent Barron’s article.  He owns top-quality multinationals for years and years.  The Dreyfus Appreciation Fund, which Sarofim manages, has lagged the S&P 500 by about 1% percent per year over the past decade. That’s unimpressive but not a disaster considering the fund has a low-risk, tax efficient strategy.  The top 10 holdings, accounting for 38% of market cap, are, in order, AAPL, PM, XOM, KO, CVX, JNJ, PG, Nestle, MCD, and OXY.  Two other names mentioned by Barron’s are IBM and WMT.  The median EPS CAGR of these 12 stocks, 2010-13, was only 7%, well behind 8.8% growth rate of S&P 500 EPS.  To my mind, portfolio problems include:

  • Too many big, lumbering staples stocks whose products are going out of style in developed markets (KO, MCD, WMT) or have poor execution (PG and, until recently, JNJ).
  • Too many giant energy firms.  Their production is growing slowly, they mostly missed the fracking revolution, and they need to cut deals with greedy foreign governments to secure new places to drill.
  • Too few industrial companies, which are great plays on emerging markets where people are travelling more (BA planes, GE and UTX aircraft engines), living in modern apartment buildings (UTX), buying cars and trucks (CMI), eating better (DE, DD, MON) and need back-up electric power (CMI, CAT).  Broadly diversified industrials such as ETN, PH, ITW, DHR and MMM are also well-positioned.
  • Although AAPL was a great purchase, not enough new tech such as GOOG and QCOM.

To be fair to Fayez, when you run $30 billion and have fairly concentrated portfolios, it is hard to sell major holdings and easy to get stuck in slowing companies such as KO, PG, MCD and WMT.  Which reminds us “average investors” that even a patient, buy-and-hold approach requires constant vigilance and a willingness to sell companies that slow down.  Which is difficult to do correctly.  For example, after years of mismanagement JNJ has revived thanks to a new CEO and a string of new drugs.

Copyright Thomas Doerflinger 2014.  All Rights Reserved

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Don’t Overhype Buy-backs

Posted on January 6, 2014 by tomdoerflinger

In Barron’s Up & Down Wall Street column, titled “Buyback Bonbons,” Kopin Tan marvels that “Companies have already repurchased a staggering $445 billion worth of shares in the 12 months ended on September 30.”  According to Josh Brown of the Reformed Broker blog, this is enough to buy more than half the real estate in Manhattan.  Tan writes the buy-back bonanza “merely reflects the abundant cash sloshing through our markets, and the dearth of convincing, good ideas for just exactly what else to do with it.” Josh Brown opines that in a low-growth environment buy-backs “are less risky career-wise for a CEO or a board of directors than expansion or acquisitions.”  Recently Pimco’s Bill Gross noted “Stocks have their own QE: ‘corp buybacks’ at $500 billion a year.  They are a main reason stocks go up.  When do THEY taper?”  The overall impression we get is that buy-backs are an artificial and unsustainable boost to stock prices resulting from misallocation of corporate capital.

Buy-backs’ Two Functions

This buy-back hype is misleading because it does not take into account a second reason, in addition to returning capital to shareholders, why companies repurchase shares: to prevent “share count creep” from employee stock options.  If companies did not buy back shares and the share count increased, earnings per share would decline.  My former colleague David Bianco, Chief U.S. Equity Strategist at Deutsche Bank, wrote a great report on this topic back in November.  According to him, S&P 500 companies spent 5% of market cap on net buy-backs over the past two years but shares declined only 2.3%.  In effect, about half of the “$500 billion” ballyhooed by Barron’s, Brown & Gross is not a return of capital to shareholders, but employee compensation.

The mechanics, as explained by David Bianco, are as follows.  In the cash flow statement the “funds spent on buy-backs” figure is a net number:  expenditures on buy-backs minus money received by companies when they issued shares to employees who exercised stock options. Shares are repurchased at the market price, which is higher than the strike price at which stocks are sold to employees exercising their options.  Therefore the percentage decline in shares outstanding is significantly less than (net buybacks as a percentage of market cap).  Here’s a simple example.  Assume XYZ Corp. has 100 shares outstanding, with a market price of $10, implying a market cap of $1000.  If XYZ buys back 20 shares at the market price of $10 each ($200 total) and sells 10 shares to employees for $5 each ($50 total), then:

  • Its net expenditure on buy-backs is ($200 minus $50) or $150, which is 15% of market cap.
  • Its shares outstanding decline by (20 repurchased minus 10 issued) or 10, which is only 10% of shares outstanding.

A Modest Boost to EPS Growth

The reduction in the S&P 500 aggregate share count from buy-backs boosts S&P 500 EPS by shrinking the index divisor, which is declining 1-2% annually.  This is not trivial, but with index EPS rising 6-9% in 2013 and 2014 share buy-backs definitely are not the main driver of earnings growth.  The reality is that firms’ allocation of cash is currently quite rational and shareholder friendly.  Firms are not afraid to invest for growth where opportunities exist, but capex is disciplined—unlike the behavior of tech and telecom firms in the late 1990s or of big banks during the housing bubble.  Judicious investment preserves profit margins by preventing over-capacity.  Meanwhile, firms are raising dividends rapidly and buying enough shares to boost overall EPS modestly—which is a lot better than the share count creep which usually occurred in the past.  M&A activity has also been disciplined.

Why Timing Is “Terrible”

One other point. It is often said that companies have “terrible timing” when they buy back stock, because they buy more at the top of the market than during recessions.  My first response is: Join the club! – most people are terrible market timers, so why should companies be any different?  Aside from that, companies need to repurchase more shares when the stock market is strong, the price of their own stock price is rising, and more employee stock options are “in the money.” Also, it is better to buy back stock near the top of the market than to make dumb acquisitions.  By the way, during the next recession all the strategists who now criticize corporations’ market timing will be churning out lists of “safe” companies with strong balance sheets, giant cash hoards, and minimal debt—not the ones that are buying back lots of stock.

True Yield

In measuring how much capital a company is returning to shareholders, one should not look at money spent on buy-backs, but rather at the actual shrinkage in share count.  “True Yield” – a measure of the total amount of capital returned to share holders – equals (dividend yield + annual percentage decline in shares outstanding).

A profitable, well-managed, mature growth stock should be able to grow EPS 6-12% (through a combination of organic growth, acquisitions, and share buy-backs that reduce the share count 1-3% annually) and also offer a dividend yield of 2-3%.  That implies a total return of around 8-12%, which is not bad when 10-year Treasuries yield 3%.  A few companies shrink their share counts far more aggressively; Eddie Lampert’s Autozone comes to mind.

Copyright Thomas Doerflinger 2014.  All Rights Reserved.

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Big Bucks in the War on Poverty

Posted on December 24, 2013 by tomdoerflinger

With the poverty rate stuck at 15% for an unprecedented three straight years, everyone is worried about the rise in poverty under Barack Obama.  The New York Times just published a book-length expose of the travails of Dasani, a bright and brave little girl with seven siblings who are all homeless and forced to live in one room in a Brooklyn shelter.

Relax.  The war on poverty is working great, if you just know where to look.  The ostensible beneficiaries (the poor) may not be doing too well, but poverty warriors—the valiant and selfless bureaucrats, social workers, foundationistas and academics struggling to create a more just and equitable society—are doing just fine.

Consider the research grants received by one prominent academic, who shall go nameless.  Based on the list of grants detailed in his CV, he and his co-researchers have received $7,914,083 in grants from governments and foundations, nearly all within the last 15 years. Most of the payout has come from the National Institute of Child Health and Development, the National Institute of Mental Health, and foundations we hear about all the time on NPR—Ford, Russell Sage, Annie E. Casey, William T. Grant, MacArthur, etc..  Here is a run-down, with slight changes of amounts and other details to hide the recipient’s identity.

  • Government grant of  $750,000 to study families
  • Government grant of  $736,000 to study families in Latin America
  • Foundation grant of  $27,400 to study school achievement
  • Foundation grant of  $65,000 to study ways to better measure poverty
  • Government grant of  $1,455,305 to study children and families
  • Foundation grant of  $71,360 to study family resources and education
  • Foundation grant of  $24,900 to study school readiness
  • Government grant of $139,000 to study child development
  • Foundation grant of  $79,600 to study childhood programs
  • Foundation grant of  $43,048 to study test scores by race
  • Foundation grant of  $17,506 to study test scores
  • University grant of $50,000 to study Head Start
  • Government grant of  $24,487 to study families and work
  • Government grant of  $2,545,000 to study child neglect
  • Foundation grant of  $410,000 to study inequality
  • Foundation grant of  $172,000 to study early childhood education
  • Government grant of  $600,000 to study family leave policies
  • Foundation Grant of  $252,000 to study parental leave policies
  • Foundation Grant of $180,000 to study humans (more or less)
  • Foundation Grant of $60,000 to study labor markets

Not to mention large sums received by this professor for numerous fellowships, conferences, etc.  And keep in mind these are the winnings of just one academic and his co-workers, albeit one who appears to be particularly proficient at grantsmanship.  There are many more where he came from.

I know what you’re thinking.  Instead of spending money on research that has yielded no observable benefit to the poor over the past fifty years, why not spend the money directly on the poor?  Dasani and dozens of other poor children could get a good education in a first-class private school, such as Washington DC’s Sidwell Friends, where Sasha and Malia Obama go.  Annual tuition at Sidwell Friends’ lower school runs $34,288, so the research funds spent by just this one professor could pay for 231 years of schooling at Sidwell Friends.

The flaw in such thinking is obvious.  We know, from the brilliant research of the brilliant Paul Krugman and other brilliant Keynesians, that the best way to expand GDP is through government spending.  If we actually reduced poverty by giving Dasani and her siblings a good education, government spending would go down and the economy would suffer!  The anti-poverty grants must flow freely to keep our wobbly economy afloat.

Copyright 2013 Thomas Doerflinger.  All Rights Reserved.

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Shame of the (Democratic) Cities

Posted on December 23, 2013 by tomdoerflinger

On the Sunday shows Newt Gingrich made a telling point that Republicans should take to heart.  After Robert Reich lamely defended the “War on Poverty” as “successful for a time,” Gingrich observed that “Every major city which is a center of poverty is run by Democrats.  Every major city.  The policies have failed and the fact is the poor have suffered.”

Republicans must stress this point relentlessly. They can’t let Democrats seize the moral high ground on the issue of poverty, as Mitt Romney did.  Not only has Obamanomics failed spectacularly at the national level—with the poverty rate stuck at 15% for an unprecedented three straight years.  It has failed in Democratic strongholds like Detroit, Baltimore, Chicago, Philadelphia, Newark, New Orleans and Cleveland.  In New York, by contrast, Giuliani and Bloomberg turned around Harlem and Brooklyn, creating economic opportunity for thousands of poor people.  Republicans must eschew trite generalities like “free enterprise” and emphasize that where Democrats have full sway their policies fail.  And not because of sweeping macro forces such as jobs moving south from the “rust belt.”  Many cities in the prosperous Northeast have conspicuously failed the poor.

The Poverty Algorithm: Government of the Public Employees, by the Public Employees and for the Public Employees

Mike Bloomberg calls it the “labor electoral complex.”  By squeezing the private sector to benefit public sector unions, big city Democratic machines eventually kill the golden goose.  They are left with a bloated city government burdened by huge financial obligations (largely pensions and healthcare costs), a shrunken tax base, decrepit infrastructure, decimated job market, ineffective schools, high crime and an impoverished, poorly educated citizenry. But their biggest problems are not financial but intellectual. Virtually no one is left in town who understands how the free market operates to reduce poverty.

The Philadelphia Story

The city’s reputation has been sliding for a while. W.C. Fields, who was born in Philly in 1880, had much to say about his home town, none of it good.  “I once spent a year in Philadelphia, I think it was on a Sunday.”   “First prize is a week in Philadelphia. Second prize is two weeks in Philadelphia.”  But the city was not always a punch line.  In the 18th century it was a boomtown attracting savvy entrepreneurs from around the Atlantic world.  From Liverpool, by way of Maryland, came Robert Morris who got rich as a shipping merchant and became America’s “financial czar” during the Revolution. His good friend George Washington lived in Morris’ opulent townhouse during the eventful summer of 1787.  From Bordeaux came the one-eyed ship captain Stephen Girard who managed, year after year, to compound his capital at 30% by trading with the West Indies and Europe. Eventually becoming one of the richest men in America, Girard was not one to waste time or money.  When his wife went insane and had to be institutionalized, Girard formed “the acquaintance of a young Quakeress, a tailoress by trade, by whom I amuse myself at very little expense and when I have time.”  But the Quaker City was not all business.  Benjamin Franklin, Dr. Benjamin Rush, and clock maker David Rittenhouse were among those who made it the center of the enlightenment in America.

Philadelphia’s commercial leadership slipped early in the 19th century as Baltimore and New York seized inland markets, but it remained the financial capital until Andrew Jackson “killed” the Second Bank of the United States in 1836.  Though overshadowed by New York, Philly remained a major center of finance, transportation, manufacturing and culture throughout the 19th century.  Its principal manufacturing firms were family-owned, producing high quality specialty products such as Stetson hats and Baldwin locomotives.  They relied on skilled labor rather than unskilled assembly line workers.  Few of these firms, whose red brick carcasses can be seen from Amtrak trains shuttling between New York and Washington, could long survive the shift to cheaper, lower-quality products demanded by mass marketers like Sears and J.C. Penney.

Although it is commonly believed that blacks in northern cities were hurt by the demise of manufacturing, this is not strictly true because they were rarely employed by industrial firms. (Detroit was an exception.) University of Pennsylvania professor Walter Licht writes,

. . . African-Americans were almost completely absent from Philadelphia industry.  Major firms in the city, for example, made a practice of not employing black workers and certainly not black youngsters through the 1930s.  The Budd Company, Bendix, Cramps Shipyard, and Baldwin Locomotive, with combined work forces of over 35,000 employees, hired not a single black (not even in the most menial positions) until the late 1930s.

Where, then, did black Philadelphians work?  In a fascinating 1896 study, The Philadelphia Negro, W.E.B. DuBois reported that 45% of black men were laborers, 34% were servants, and the rest were in skilled professions (2%), conducting business on their own account (6.5%), and clerks (7%).  About 75% of black female workers were in domestic service.

A Nice Place to Live, but I Can’t Find a Job There

Philadelphia’s fortunes have been sliding since World War II, at an accelerating pace.  Since 1970 employment in Boston, New York and Washington DC has increased 5-20% while Philadelphia’s declined more than 20%.  Everyone knows why.  Taxes are too high.  The combined state and local tax burden on Philadelphians is 13.7%, just about the highest in the nation and far above Houston (6%), Phoenix (7%) and Indianapolis (8.7%).  The chief culprit is the Philadelphia wage tax, a notorious levy on all compensation paid to employees in the city or received by residents who works outside the city.

For business, the solution is to avoid Philadelphia.  If you drive down bustling City Line Avenue, which separates city from suburb, it is obvious which side is beyond the reach of the Philadelphia tax man.  When I worked on Wall Street one of my top Philly clients was located well outside the city’s borders. Not surprisingly, of the top 15 employers in Philadelphia 12 are non-profits (universities and hospitals); the three corporate holdouts are Comcast, U.S. Air, and Allied Barton Security Services.

Despite this fiscal idiocy, Philadelphia is not shriveling up as Detroit did.  It is an inexpensive and interesting place to live, and the population has been growing modestly.  But to attract residents the city has had to provide juicy 10-year tax abatements to building developers and owners; they are exempt from property taxes on new construction.

Let’s Soak the Poets

Sometimes an anecdote is worth a thousand pictures.  In 2007 Pulitzer Prize winner Stephen Dunn gave a poetry reading in Philadelphia, for which he received $2,000.  Then in 2011 he received a tax bill from the City of Philadelphia for $10,073.  It seems that Mr. Dunn had A) failed to pay the city’s “Business Privilege Tax,” B) failed to obtain a “Business Privilege License,” which you need before you pay the tax, C) failed to file a “change form” needed if the aforementioned license was only for one day, D) was liable for sundry fines for failure to file, E) owed interest on the unpaid taxes, fees, and fines. Unlike the wage tax, the Business Privilege Tax generates very little revenue.  But it does scare off lots of entrepreneurs, who may develop an idea at such universities as Penn and Drexel but elect to build their business beyond the reach of Philly’ fiscal felons.

Scrounging for School Money

Philadelphia has a long-standing structural problem.  Its government is too big for its economy, so it is in chronic fiscal crisis, which prevents rational reform of its tax code.  Comcast executive David L. Cohen dryly observes, “If you have to raise taxes five years in a row in order to afford the government, then you better start looking at the government because it is clearly not a government you can afford.” Mayor Nutter is constantly battling the municipal unions to control costs.

The biggest cost is teachers, who earn $46,000 – $83,000, which is equivalent to $68,000-$124,000 given that they work 67% of the hours of a private worker.  Remarkably, they pay nothing toward their health coverage.  At the start of the 2013 school year, the city found itself in a cash crunch and needed $50 million to open the schools.  Like a home owner scrambling to make the mortgage payment, the city considered all options:

  • Dun landlords who were in arrears on property taxes.
  • Start taxing non-profit “eds and meds” – the one part of the local economy that is still healthy
  • Renege on the aforementioned property tax abatement.
  • Get aid from the State of Pennsylvania.

Any business watching this chronic fiscal chaos knows that, whatever tax deal they cut with Philadelphia’s government this year, it may be abrogated next year when the city confronts a new crisis.

Fruits of Failed Liberalism: an Issue for Republicans in 2016

Philadelphia and its suburbs are full of earnest liberals who lament the evils perpetrated by hard-hearted Republicans.  But what have these oh-so-virtuous liberals wrought in their own neighborhood?  A “state of the city” report from the Pew Foundation reveals that Philly:

  • Has “one of the highest poverty rates, 28.4 percent, and one of the lowest household median incomes, $34,027, among all major cities.”
  • In 2012 the unemployment rate was 10.7%, 2.6 percentage points above the national level and above all comparable cities except Detroit.
  • Philadelphia’s median household income is only half that of the suburban counties.
  •  In 2012, Philadelphia had the highest homicide rate among the nation’s 10 largest cities at 21.6 per 100,000 residents, although it was lower than Detroit (54.6), Baltimore (35.0) and Cleveland (24.6).  80% of homicide victims were African American, 2007-2011. Fortunately homicides declined in 2013.
  • The Philly metro area’s share of U.S. venture capital was only 1.5%, versus 8.8% for New York metro and 2.7% for D.C. metro.
  • Educational results are below par.  According to Pew, results of the test designed by the National Association of Educational Progress show Philly’s public school students “scoring well below both the national average and the average for large cities in math and reading.”  Only 18% of eighth graders were “proficient or advanced” in math versus a big-city average of 26%; in reading 16% were “proficient or advanced” versus a big-city average of 23%.

The media ignores urban poverty perpetuated by Democrats by focusing on the supposed problem of “inequality” at a national level, which is a separate issue having little to do with the plight of the urban poor.  Republicans must shift the spotlight to where it belongs—the failure of liberal policies that place the interests of government employees ahead of ordinary citizens who remain mired in poverty due to lack of jobs, failing schools, and overall mismanagement.

Copyright 2013 Thomas Doerflinger.  All Rights Reserved

References:

Thomas Doerflinger, A Vigorous Spirit of Enterprise: Merchants and Economic Development in Revolutionary Philadelphia

W.E.B. DuBois, The Philadelphia Negro

Walter Licht, Getting Work: Philadelphia, 1840-1950

Pew Charitable Trusts, Philadelphia 2013: The State of the City

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