I'm going to risk overstepping copyright quoting allocations and post comments that came out this morning from CSFB's Thomas Galvin:
Investment Summary
On the surface, it sounds awfully romantic. During the past two weeks, I visited with about 300 investors in ten cities during an around the world venture. It is just mind boggling what life must have been like before PowerPoint slides, Fed-Ex, Blackberry, cell phones and Diet Coke (the most important). For me, it always amounts to a feisty game of intellectual ping-pong. The clients win some volleys, I wedge in a few but at the end hands are always shaken no matter the disagreements. Selfishly, it allows me to learn what is really pressing for clients, which can never be gleaned behind a Manhattan desk watching a computer screen day-in, day-out. The irony of course is that I accumulate tremendous frequent flyer mileage but when it is time for vacation, I have no interest in traveling anywhere. At this stage, the same issues prevail across all zip codes. The consensus believes the best shot for the U.S. economy is a saucer not V-shaped recovery and L-shaped is a fast growing opinion. Earnings estimates remain too high despite record downward revisions. The Fed is pushing on a string and consumer demand for cars, homes and computers was satisfied long ago. The stars were aligned for capital spending during the last several years thanks to free equity capital, the invention of the internet and Y2K remediation. Consumer and corporate balance sheets are over-levered and without capacity for growth. Therefore, spending and consumption must revert to the mean leading to several upcoming years of destabilization. Productivity gains are over. Mortgage refinancings cannot overcome layoffs and utility bills. Investors finally learned in 2000 that buying on the dips does not always work and who cares anyway because anyone who could buy stocks already owns them. Three hundred billion dollars went into equity mutual funds last year and share prices still declined. Galvin, don’t you get it, we have seen this movie before: it is called The Japanese Bursting Bubble! It is said that the NASDAQ is the Nikkei Index with a ten year lag. All of this and my five year old daughter, Hanna, keeps asking me why I go on vacation all the time without her. The reason is because these trips just ain’t Disney!
If anyone out there feels they are the only ones arriving at these concerns, think again. Clearly there are times when the consensus is right and powder blue investment skies seem to have passed long ago. But frankly, when the list of ugly issues is this long, it suggests a world of minimal expectations has been created which is a good thing. To me, it is a binary event. Either the U.S. is about to enter a protracted slump like Japan or it is a classic credit crunch and inventory correction cycle. For months I have argued the latter, where the return of liquidity is fundamentally key in re-energizing the economy and aggressive production and price cuts will return inventories to balance by the second quarter. So here is my case why it is not Japan revisited.
First and foremost, the decade long stock bubble in Japan led to substantial over-investment in long-lived assets, particularly real estate. The U.S. dot com froth began and ended equally fast in less than two years. Although Silicon Valley real estate values will likely plunge, it is concentrated to a particular geographic region, but not the entire island called North America. More importantly, the dot com excess investments were almost entirely in short lived assets like software and servers. While new server list prices are sure to erode because of a weak used auction market, they will ultimately be absorbed at a pace light years faster than Tokyo office buildings or Texas oil rigs twenty years ago. The silver lining to the internet stock crash is that the over-investment process ended with the peak of the IPO underwriting calendar in the fourth quarter of 1999, i.e. fourteen months ago. Therefore, both the duration of the bubble and the long versus short lived asset intensity are the critical differences.
Second, the immediate and forceful response of U.S. policy makers to rescue the economy. The initial reaction of the Japanese back in 1990 and 1991 was to raise interest rates in order to fight inflation. Greenspan’s December 5th speech made it clear that Fed policy had taken a sharp right turn. The focus was no longer inflation but instead the economy. With that speech, credit spreads began to tighten in recognition that liquidity was on the way. The surprise initial 50 basis point cut showed that the Fed is not married to publicly known FOMC meeting dates in order to do the right thing. The total 100 basis point reduction in rates in one month had never before happened in Greenspan’s thirteen year tenure. The aggressive move was an admission of overdoing it in the first half of 2000 by raising rates with little pending signs of inflation as well as recognition that his gradualistic approach of 25 basis point incremental cuts seen between 1989 and 1991 dragged out the recovery process. We believe that the Fed realizes corporate and consumer balance sheets are primed to benefit from lower interest rates. The 500% recent year-on-year increase in mortgage refinancings makes it clear that consumers care about rates and unlike the Japanese, Americans are unlikely to reinvest in savings accounts yielding less than 1% when debt reduction and spending is encouraged.
Third, U.S. politicians know their time to earn voter support is limited, so immediate fiscal actions such as Bush’s tax cut gain bipartisan support. Would you like to be the Democratic senator telling a recently laid-off worker that he did not support the tax cut based on political, not economic, motives? Except for one brief interruption, Japan is the only major industrial democracy that for the last half century has been governed by the same political group, the Liberal Democratic Party (LDP). As a result, neither consumers nor businessmen have confidence that requisite change is forthcoming. In a recession, confidence is the key issue. The Japanese have a huge pool of savings, but consumers completely lack confidence in the monetary and governmental bodies to engineer a recovery.
Fourth, the U.S. encourages business investment, deregulation and competition. What struck me during my travels through Tokyo is how well developed their road system is and how nice their public buildings appear. Reason: The LDP’s fiscal stimulus amounted to excess spending in public works, which is always a low return on capital investment. We realized a long time ago that growing, not shrinking, the government is a badly failed economic experiment. The U.S. will continue to cut taxes to whatever level is necessary to encourage investment by entrepreneurs. The legacy of the LDP is an aversion to free market policies and competition. Our borders are open and intense import competition constantly keeps American industry on its toes. Japan’s focus is on competing with the U.S., while the U.S., being an island between two rough oceans, focuses on competing with the entire world. Japan has fought deregulation and import competition at every stage, which only extends the inefficiency.
Fifth, the Japanese bubble became highly institutionalized with the banks and insurance companies holding the dynamite. To this day, their balance sheets preclude them from encouraging growth or extending capital. The U.S. savings and loan crisis a decade ago painfully taught the financial infrastructure an expensive lesson. It does not eliminate problems, but it can identify them sooner and provide a process to solve them. The benefit of U.S. bankruptcy courts is that bad loans are taken out of governmental hands and into a definitive legal process so that the economic dam does not burst from political intransigence. Chapter 11 filings by California utilities could prove the most attractive solution because political self-interest is forced to take a back seat. Overall, net interest payments of U.S. corporations are extremely low as a percentage of cash flow suggesting significant flexibility to adapt to tough economic conditions without imploding the banking system.
Sixth, stock options and corporate governance is an American hallmark that usually forces immediate surgical action. Within three months, U.S. companies have announced record layoffs, while the Japanese still embrace lifetime employment. As well, dot com founders and software engineers probably have a better than average shot at being rehired. American CEOs are getting tossed out on a daily basis for lack of performance. It is not about pride, it is all about money. We encourage or demand wealth creation, while the Japanese prefer convenience, predictability and keeping the middle or lower class under wraps.
Last, but by no means least, is that the U.S. is much healthier economically from a demographic standpoint. A soothsayer once proclaimed that Japan is a corrupt nursing home. I would not disagree. In Japan’s population, nearly one in five are over 65 (that is 26 million people), and the number grows by about 1 million per year. A New York Times article recently detailed Japan’s declining fertility rate suggesting a population expected to fall from 127 million currently to 100 million by 2050 and only 67 million by the end of the century. To keep the system afloat, today’s teenagers will likely face more than double the taxes and 30% smaller pension benefits. The American Generation X and Y crowd represent another baby boom, which ultimately leads to consumption rather than savings, the inverse of Japan’s situation.
I have recently been chastised for faxing, emailing or snail mailing reports that are too long. For those already choked by bytes or paper, I apologize. But this comparison to Japan is the heart of the investing issue today. Either the above arguments are not compelling and treasury bonds are the only safe investment, or our present state is a classic credit crunch/inventory correction where stocks must be bought. Clearly, there is always the timing issue, but our case argues the worst is already over. For tech stocks, the collision of a credit crunch with an industry known for short product cycles and creative disruption suggests that only a subset of firms will survive and new leadership is always around the corner thanks to innovation. We do not believe that e-commerce as a revolution is over but recognize that the growth curve has changed. Can General Electric really be the only firm to figure out the benefits of the Internet to revenues, cost, productivity and return on capital? We think not, and so ongoing infrastructure investments must occur. If the internet is truly a viable vehicle of commerce for old and new economy firms, then the failing dot com ventures will eventually lead to consolidation with fewer players enjoying more traffic like AOL-Time Warner, eBay or Wal-Mart. While the old economy may not have a gun to their heads due to the short-lived proliferation of over-capitalized dot coms, the current economic state makes revenues, market share gains and cost reduction more critical today than one year ago. Therefore, productivity enhancing equipment and software will remain in demand. The next killer application is wireless internet, which arguably is two years away, but it is in front of us, not behind. If the pain to wait is too great, then healthcare stocks are the appropriate reallocation given excellent intermediate and long-term fundamentals. I expect healthcare to win out in February and double its share in the S&P 500 by 2010.
This report looks at money flows by sector and class of buyer. Fed data is suggesting that foreign buyers exceeded mutual funds as the largest U.S. equity purchasers during the third quarter of 2000. We are skeptical of the absolute data but fully expect foreigners to remain strong, active players in U.S. stocks for years to come. The front page table comparing currency moves to foreign buying activity shows an inconsistent correlation, and my client meetings confirm that the dollar is a secondary or tertiary consideration. Equity ownership by individuals outside the U.S. is small but growing rapidly. Our market has liquidity, transparency by both the Fed and corporate management and global industry leadership in tech, healthcare and financials. Europeans may not need to buy U.S. energy, steel or auto stocks because they have many in their backyard, but U.S. firms in service sectors often are best in breed. Valuation disparities between the U.S. and foreign markets are no longer extreme and in many areas, shown on pages 13-14, quite attractive.
Two new trends learned from recent client meetings are important allocation changes favoring the U.S. going forward. First, Brits, which make up 30% to 40% of foreign buying and whose economy and currency often track the U.S., are moving from a U.S. weighting driven off of their local pension competitors, which is low, toward a much greater MSCI Index weighting. Second, the Japanese having faced a decade of dormant returns at home are doubling their exposure to the U.S. I think the reasons cited above provide much of the rationale. All totaled, the appetite by foreign investors for U.S. stocks will remain particularly acute for years to come.
P.S. For all those California-phobics out there, I never on my trip experienced flickering lights, a trapped elevator, too little hot water or insufficient heat or air conditioning. Despite the power crisis, the new Disneyland addition, California Adventure, is opening on schedule and lights are plentiful and burning through the night. Conversations with taxi drivers, waiters, bell hops and fund managers suggest very little has changed in day-to-day living, though conservation must be accelerated and environmentalists must stand back and punt. Oregonians and Washingtonians are only more anti-California as their rising bills fund and warm the hot tubs down south. I think Salt Lake City, Denver or Texas will be the real winners as tech firms go out of state. Overall, East Coast investors waiting for economic armageddon will be sorely disappointed. Remember, Californians love earthquakes, so this stirs little fear. . . .
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