Friday, October 23, 2009

The Financial Crisis is Benefiting the Large at the Expense of the Small

By Vahan Janjigian - The financial crisis was brought upon us largely by big institutions that used too much debt. In particular, they used leverage to buy lots of mortgage-backed securities. Of course, thanks to exotic mortgages, some of which required no down payments, those mortgages themselves were already leveraged much more so than they had been historically.

Ironically, the crisis appears to be helping large institutions at the expense of small ones throughout all sectors of the economy. The credit crisis caused havoc for all companies and made it impossible for them to borrow. However, credit spreads have come down and large, investment grade corporations are having no trouble borrowing money at reasonable rates. Although the banks are still reluctant to lend, large corporations can go to the capital markets and issue debt.

Small businesses, however, don't have this option. They rely heavily on the banks for financing. But they can't get financing from the banks on reasonable terms. The inevitable result is that the big are getting bigger and the small are being driven out of business.

This should be extremely troublesome to politicians who are concerned about the rising rate of unemployment. According to the Census Bureau, there were just over 6 million firms in 2006 that employed people. Small companies (i.e., those with less than 500 employees) provided jobs for just over half the nation's workforce that year. More importantly, according to the Department of Labor and summarized by the Small Business Administration, small businesses account for most of the job growth. They were responsible for 64 percent of the 22.5 million net new jobs created from 1993 through the third quarter of 2008.

You don't find many small businesses that are publicly traded. Furthermore, most stock market indexes are market-capitalization weighted. As a result, the stock market provides a reasonable picture of how large businesses are doing, but it does not tell us much about small businesses. The strong rally from the March lows could be an indication that large businesses are successfully managing the economic crisis. The unemployment rate, however, is not likely to go down until small businesses get healthy again. That is not going to happen until the feds make sure that small businesses can also access capital at reasonable rates.

Tuesday, October 20, 2009

Forbes Article: Hold Cash, Sell Stocks

By Vahan Janjigian - I had an interesting lunch today with Kurt Schacht of the CFA Institute and Ravenel Curry of Eagle Capital Management. In February, the three of us traveled to Abu Dhabi and Dubai to lecture to the Abu Dhabi Investment Authority, Mubadala, and the CFA Institute's local chapter in Dubai. Today's lunch was an opportunity to catch up on that trip and learn about some new initiatives. Kurt is headed back to the U.A.E. in two weeks. This time he is taking Tom Keene of Bloomberg fame and Jason Trennert of Strategas Research Partners.

During lunch, we discussed the markets and economy. Both Ravenel and I remain skeptical of the recent rally. In my view, there is a good chance we will see a double-dip recession with the second phase coming in the first or second quarter of 2010. Government stimulus appears to have brought us out of the first recession, but I doubt the gains will last. I talk a little about this in my column in an upcoming issue of Forbes magazine. In the meantime, you can read my views on the market and the views of several others as recently published in Hold Cash, Sell Stocks.

Thursday, October 08, 2009

Not So Jolly Holiday Sales?

By Taesik Yoon - The National Retail Federation (NRF) recently released its forecast for sales for the upcoming holiday shopping season. The trade group projects sales covering the 55 days in November and December to decline one percent from the prior year to $437.6 billion.

Despite the expected decline, this would be a marked improvement over the 3.4% drop experienced in 2008—the first decline in holiday sales since the NRF began tracking industry sales in 1992. There are probably some that believe sales will be even better. They point to the recovering economy, the rise in equity values, and the reduction in overall consumer credit balances as reasons why Americans may be more optimistic about their financial security heading into the holiday season. This could induce greater spending than in 2008 where all of these metrics were trending in the opposite direction. Additionally, there is an extra shopping day between Thanksgiving and Christmas, which should also provide a boost.

But I don’t see it. In fact, I think it is quite possible that holiday sales will be worse. There are several reasons for my pessimism. The most significant of these is the pervasion of the value/bargain hunting mentality that has swept across the country. A recent article by the Associated Press titled Great Time for U.S. Consumers: America on Sale highlights this shift in mindset. Examples mentioned include everything from rare discounts on Tiffany engagement rings to lower spending on premium dog food.

Some may call this a trend. But I view it as more of a lifestyle change, which is typically longer lasting. This change has been fueled throughout the year by an absurd level of promotional activity. Value is everywhere. Airfare is cheaper, rents have come down… Heck even the Yankees just cut the price of certain seats at Yankee Stadium by about half. As such, I believe it will be difficult to get consumers to pay full price for anything during this holiday season.

Furthermore, it is possible that promotional activity may not be as heavy as consumers are expecting. A portion of the deals that consumers have come across over the past year have been due to aggressive inventory management. Retailers have been clearing out excess or past-season merchandise at sharp discounts as a way of improving cash balances and the overall health of their balance sheets. But many of these retailers are now very lean on inventory. This reduces the likelihood of excess supply as well as the associated markdown activity.

For example, it may be valid to question whether a consumer that paid $20 for a pair of jeans regularly priced at $69.50 during a denim sale (a promotion the Gap ran the first week of July) would be willing to pony up more during the holiday season. But perhaps an equally valid question may be whether the Gap will even run such a generous promotion during the holiday season now that inventories have come much more inline with the expected level of sales.

The change in tender mix is also very telling. Credit card usage (as a percentage of payment methods during the holiday season) rose in 2006 and 2007 while cash fell in both those years. The opposite occurred last year with cash usage rising and credit card usage declining. I believe the same trend will occur this year due to the aversion to credit many consumers have adopted over the course of the year. Credit card companies have also been extremely aggressive at reducing credit limits and become more stringent in approving new credit cards applications. These actions reduce the total pool of resources available to consumers to pay for purchases.

Then there are also the additional job losses since the 2008 holiday season. Indeed, according to the Bureau of Labor Statistics, the U.S. has lost 5.55 million jobs in the 12 month period ending in September. The number of workers that are underemployed also continue to climb, hitting 17% last month. No doubt this will also negatively impacting holiday spending.

The combination of all of these factors—value mindset, potential for less promotional activity, a shrinking pool of consumer credit/credit aversion, and the continual rise in unemployment—could prove costly for holiday retail sales. But more importantly, it could also prove costly for owners of retail stocks, many of which have fared extremely well so far this year. Indeed, the S&P Retail Index is up 36% year-to-date and a whopping 66% since its March 9th low. Some profit taking may be prudent. And while I would normally advocate booking profits in January in order to defer taxes on capital gains, in this case, that will probably be too late.

Wednesday, October 07, 2009

How to Get Investors Focused on the Long Term

The following commentary is from the October issue of the Forbes Growth Investor, released to subscribers on October 1.

By Vahan Janjigian - As stocks bucked the trend by rallying in September, President Obama was out in force trying to sell healthcare reform. Unlike previous presidents who liked to keep a low profile, this one keeps popping up everywhere. He even appeared on just about every possible television program. However, the talk among financial regulators focused on the short term versus the long term. They want less of the first and more of the second. Corporate directors apparently feel the same way. According to Agenda, a newsletter for corporate directors published by Financial Times, independent directors claim that pressure to focus on short-term results is the biggest corporate governance issue they face.

Clearly, running a corporation with a long-term perspective in mind is better than trying to maximize earnings or the stock price during any particular quarter. For example, management could easily boost earnings this quarter by delaying capital expenditures or investments in research and development. Doing so, however, could prove costly over the long term. While we all want to see more long-term thinking, how best to achieve that goal is subject to debate.

One proposal that comes up repeatedly is to ban quarterly earnings guidance. Many observers blame guidance for fostering a myopic investment and management style. However, as I explain in chapter 10 of my book Even Buffett Isn't Perfect, eliminating guidance is a bad idea. Research studies show that ending guidance not only reduces the amount of information disseminated to shareholders, it also increases uncertainty and the disparity between actual earnings and the consensus estimate. In addition, it results in a statistically significant loss in shareholder wealth; and it does nothing to reduce the focus on short-term results or increase the emphasis on the long term.

Other proposals to encourage long-term thinking make more sense. For example, in the U.S. we currently tax long-term capital gains at lower rates than short-term gains. If we want investors to pay more attention to long-term results,we should reduce the tax rate on long-term gains even further. If we want to be serious about this, let’s eliminate taxes altogether on any gains that are accrued over periods of 10 years or longer.

Let’s also look at voting rights. As things stand today, any investor with deep pockets can buy a bunch of shares and have as much say as the investor who has owned the stock for years. Why not consider a weighted-average voting scheme; one where the number of votes you get is tied not just to the amount of shares you own, but also to how long you have owned them?

Proper executive compensation can also make a difference. Let’s tie bonuses to long-term metrics and reward executives with stock they cannot sell for several years; and let’s take back bonuses based on financial results that are later determined to have been bogus.

A stronger focus on long-term results makes sense. While there are many effective ways to achieve this goal, eliminating guidance will not do the trick.