We are pleased to provide you with our report for the Third Quarter of 2007.
Capital markets have had a widely disparate performance this year. The widely followed Dow Jones
Index is up about 11% year-to-date compared to the S&P 500 +7.6% and the Russell +3.16%. For the
quarter, the Dow was +4.19%, the S&P 500 +2.05, and the Russell was -3.09%.
There is an overwhelming consensus viewpoint that the economy is slowing down if not teetering on
the brink of recession. In fact, former Treasury Secretary Robert Rubin has been recently quoted as
saying that there were only two near-term paths for the US economy – either a soft landing or
recession. With all respect, we have a significant problem with this viewpoint…empirical evidence
seems to be pointing the other way. While most observers are mesmerized by the weak housing
sector, the rest of the economy seems to be doing fine if not improving.
Admittedly, housing looks awful and the numbers continue to deteriorate. Meanwhile, incomes kept
rising, consumption spiked upward, and manufacturing indicators are improving – with one hitting a
record high.
For example, in the Richmond Federal Reserve Manufacturing Survey, participants were more bullish
about their business prospects for the coming six months with significant improvements in just about
every category, including expected shipments, new orders, capacity utilization, and planned capital
expenditures. Similar results have been reported in the Milwaukee Purchasing Managers’ Survey as
well, in fact a record high for this survey since 1998. The labor situation shows little evidence of
deterioration with jobless claims data hovering through this year in a range between 300,000 to
340,000 claims just as they have since the middle of 2006.
Despite the consternation that the news media and breathless CNBC commentators may express,
third quarter real GDP grew a very strong 3.9% annual rate in the initial third quarter report. At 3.5%,
final sales were stronger than expected thanks to heady government spending and a solid result for
equipment investment. Growth was more broad-based than in the second quarter, with large
contributions from trade (+0.9 percentage points), consumer spending (+3.0%), and structures
(+12.3%) and more moderate support from inventories (+0.4 %) and equipment and software
investment (+5.9%). Residential investment fell 20.1%, matching its pace of decline in the third
quarter of 2006. From an income standpoint, the numbers still look quite strong…employee
compensation rose 5.1% annualized after 5.8% in the second quarter and 4.5% in the first three
months of the year.
Why is there so much fear around? A central tenet beneath the widespread forecast of a slowing
economy (if not a recession) is that consumer spending will slow. The combination of falling home
prices, re-sets on complicated mortgage products, and tougher credit standards will undermine
consumption. We are not so sure. Most of you have already heard us describe the importance of free
cash flow to a business. One of our economist friends (the best friends in this business are the
independent thinkers!) calculates a similar figure on an aggregate basis for the American consumer.
To calculate consumer free cash-flow he takes after-tax personal income adjusted for inflation, and
subtracts property taxes, mortgage payments, homeowners insurance, rent, car lease payments, and
debt service payments, including auto loans and credit cards. It sounds reasonable, what you have
left for all of life’s necessities after you cover your cost of housing and your cost of getting to your job.
Through the second quarter, this measure of real free cash-flow was up 3.4% versus last year, or
$230 billion. Remember, that is an increase of $230 billion based on a free cash flow calculation for
the American consumer that totals about $6.7 trillion. Many economists are concerned about the
sub-prime resets that will peak over the next couple of years. Most estimates are for $20-$30 billion in
additional payments that these affected homeowners must make to lenders. It’s certainly a big
number, and for the individual borrower it may be overwhelming. But as a percentage of the total
consumer free cash flow, it is almost meaningless…absorbing about 0.5% to 0.6% of aggregate
consumer free cash flow.
Another belief of the bears is that the falling price of housing will crater consumption. We are not so
sure about that one either. Household net worth is up more than $20 trillion in the past five years, and
it takes years for consumers to fully react to changes in wealth. A 10% decline in home prices would
chop only $2 trillion off that number. To put it into a historical perspective, let’s look at the strong
creation of wealth that occurred in the nineties as a result of both housing and stock markets. From
late 1994 through early 2000, consumer net worth increased $18.2 trillion. In the next 2.5 years, it
dropped $5.4 trillion. But note, consumption grew at a 2.7% annual rate over the period of declining
net worth.
We are not attempting to gild the lily…there are risks that we perceive in this economy, but in our
view, the knee jerk association of falling house prices with falling consumption is erroneous. The
concerns about a broadly based drop in consumption based on sub-prime resets are misplaced. We
are much more concerned about other things. Recessions are caused by tight Fed policy, tax hikes,
or protectionism, not a “tapped out” consumer.
Corporate taxation is one of the most rapidly changing areas of global tax policy. As capital and labor
have become more mobile in recent decades, the dominant trend around the globe has been toward
lower corporate tax rates as countries compete for jobs and investment, and hence, accelerating
growth.
This trend has been especially sharp throughout Europe, where the close proximity and economic
similarity of countries like Ireland, Germany, Greece and many Eastern European nations has led to
intense corporate tax competition. This movement transcends political philosophy, with center-right
( Australia), centrist ( Germany) and center-left ( New Zealand, Spain) governments all considering
corporate income tax rate cuts.
As OECD countries continue to lower their corporate income taxes, they can expect to reap more
foreign direct investment from the U.S. A recent academic study found that a 10 percent corporate
rate reduction by an EU member-state can reap a 60 percent short-run increase in investment by U.S.
multinational corporations. While foreign governments (even Canadian) entice U.S. investors by
lowering their corporate tax rates, the federal government in the U.S. stands pat with the same rate
structure it has had since 1994.
Protectionism sentiment is rising in Congress. In our view, import duties or restrictions designed to
'protect' unproductive and uncompetitive industries would make them even less competitive, since
duties will now diminish the competitive pressures. For the US economy, rising protectionism would
also mean far higher inflation rates, as well as a huge competitive disadvantage on the global markets
for US corporations.
Our equity investment focus is decidedly global, looking for beneficiaries of these growth trends at
reasonable valuations. For example, we have added 3M with 61% of its revenues overseas has a
return on its invested capital of more than 30% (over two times as profitable as the average American
company) yet sells at a below average multiple of its earnings and cash flow. The company has
announced its plan to bring its tax rate down 1% a year for the next five years. We have added
Unilever, which for years was perhaps one of the most under-managed consumer companies in the
world. The company, under new leadership, has simplified itself and is now managed globally rather
than locally, allowing global insight and synergies to permeate the entire organization. The
restructuring has enhanced profitability with its return on invested capital reaching 18% most recently
after years of barely attaining mid-single digit profitability. Despite these achievements, the stock in
our view is priced at a significant discount to its intrinsic value.
The bloodbath continues in the financial services sector with little discernment of individual bank
fundamentals. This has allowed us to purchase US Bancorp, a Minneapolis based commercial bank
that gets 25% of its revenues from a global payments business and another 15% of its revenues from
wealth management and securities where it boasts a large and growing corporate trust operation with
$4 trillion in assets under administration. This is a bank that derives most of its revenues from
something other than lending. On the lending side, sub-prime loans represent less than 3% of the
total. As a wise man once told this writer, no bank makes money from lending…they make it from
collecting the actual payments. Net charge-offs are only about one half of 1% of loans. Finally, we
have bought a position in Citigroup, the red-haired step-child of American banking. Tier I capital (a
classification of international banking) is 7.4%, well above the 6.0% regulators require for banks to be
considered well-capitalized. In our view, Citi can be accused of under-managing its balance sheet,
which is very bloated on reported basis with close to $1 trillion in trading assets and reverse repos,
and about $240 billion in investment securities. Citi has slowly been selling lower yielding investment
securities in recent quarters without taking losses. Most people would be surprised to learn just how
little mortgage exposure (not just sub-prime, but mortgage exposure) there is at Citi. Mortgage loans
represent only 12% of assets. It is our belief that Citigroup earnings are less exposed than most major
banks to the problem that most investors are worried about, rising real estate loan losses. Though
reserve building and write-offs will continue and restructuring is needed, Citigroup, in our opinion has
become too cheap to resist.
The fact that investors will exhibit emotions of greed, fear or folly is predictable. The sequence in
which they will appear is not predictable. Over the short term, the vagaries of the market can make
sensible investing look like folly. But over the long run, it pays to be “inversely emotional.” When we
sense pain and fear in the market, we recognize the value these emotions create. These opportunities
create long term performance.
We appreciate your confidence and trust and as always welcome your questions and comments.
Richard H Konrad, CFA, CFP®
