latest outlook from FPA
We continue to believe that the U.S. economy is not on a sustainable growth path. The last twelve months
growth is primarily the result of inventory rebuilding, pent-up demand from the recession, and stimulus spending by
the Federal government. None of these factors can be upheld indefinitely. We continue to see headwinds for the
economy and the stock market, including declining credit generation from the banking system and the structured
finance system, a consumer that continues to reduce debt levels despite facing high unemployment and limited real wage
growth, and U.S. Treasury debt levels going north of 100% of GDP with higher deficit spending as far as the eye can
see. In addition, corporate profit margins are back to 50-year peak levels and are unlikely to expand from here. For these
reasons, we have, when the opportunities have presented themselves over the last several years, skewed the portfolio
to investments that are exposed to global-demand growth and/or global commodities. We have only done so, however,
when the investments have matched our criteria of industry leadership, strong balance sheets, quality management
teams, and prices far below their intrinsic values.
Job growth in this recovery falls far short of that in previous recoveries. As highlighted in a Wall Street Journal
article (WSJ September 4, 2010), the recession of 1981 lost close to 4% private jobs but then staged a recovery such
that private jobs were 8% greater than at the start of the recession. In the 1990 recession, we lost 2% private jobs, but
after recovery we were 4% ahead. In the 2001 recession we lost 3% private jobs, but were back where we started after
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recovery. During this recession, we lost close to 8% private jobs and we are still at 7% job losses 30 months after the
recession started. The underemployment rate, which includes part-time workers who want a full-time position and
people who would like to work but have given up looking, is now at 17.1%, one of the highest on record. Unless we
can create sustained growth in private sector jobs, the economy is likely to remain in a slow-growth mode.
Bank lending continues to be challenged. There was a tremendous increase in real-estate exposure at banks
during the last two decades, in effect a doubling from the mid-20s as a percentage of total bank assets to 55% at the
peak a few years ago. We anticipate that real estate as a percentage of the total mix will continue to decline for years
to come, bringing it closer to historic levels. Credit generation outside of banks has been on a steady decline since its
peak in 2007. According to Haver Analytics, the securitized loan market peaked at $3.7 trillion and has now dropped
steadily to $2.3 trillion. This substantial decline of over $1.4 trillion in securitized loans over the last three years equates
to 10% of U.S. GDP.
Besides having difficulty securing jobs and credit, the consumer faces other headwinds, including high debt
levels, no real wage growth, and a wealth hit from declining house prices the last several years. During the last decade,
consumer debt doubled from $7 trillion in 2000 to a peak of close to $14 trillion in 2007. This doubling of consumer
debt will likely have implications on consumer spending and deleveraging for years to come. An indication of the
deleveraging that is taking place is the U.S. household savings rate, which has steadily increased from 2.0% of personal
disposable income to over 6.2% currently. We anticipate this hunkering down and deleveraging to continue until real
wage growth takes hold. The last decade has been described as the lost decade for median household income (see WSJ
September 17, 2010 article). Using 2009 dollars, the median household income was $49,777 in 2009 versus $52,301
in 2000. This is a loss of $2,524 per household during the last decade, or 4.8%. This performance is worse than the
1970s, when real median income rose 1.9%, even with high unemployment and inflation. Without real wage growth,
we have difficulty seeing how this economy can return to prior growth rates.
Some economists, including David Rosenberg at Gluskin Sheff, believe conditions are now so bad that they can
be described as a depression. He points to the life insurance market as one example. In recessions, people don’t cancel
their life insurance policies. But in depressions, this is what happens. The number of people without life insurance has
increased by 50% the last five years, from 24 million not covered five years ago to 35 million today. We believe this is
another example of how this recession and recovery are not following historical precedence.
Corporations have done a tremendous job cutting costs. So good, in fact, that after-tax corporate profits are now
back to the peak levels of 2006 at 9.5% of national income. This should be compared to the long-term average margin
the last sixty years of a little north of 6%. Besides this decade, the after-tax corporate margins have only barely
surpassed the 8% level three times in the previous five decades. This was in the late 1940s, the mid 1960s and the late
1990s. Even though nothing is inconceivable, we think it is unlikely that margins will continue to expand from here.
In fact, every time in the past when margins have gone above the 8% level, they have dropped back below the 6% level.
This means that corporate profit growth should most likely track nominal GDP growth at best. Should margins move
back to the long-term average, corporate profits could undershoot current expectations by a wide margin.
The consumer debt explosion is now being followed by a Treasury debt explosion. Debt issuance by the
government is set to escalate rapidly. Gross U.S. Treasury debt is currently $13.6 trillion, or 93% of GDP. According
to the IMF, U.S. debt to GDP will reach 109.7% by 2015. Thus, the critical issue is current and future large fiscal deficits.
The Congressional Budget Office estimates that we will run deficits adding up to $9.3 trillion the next ten years. The
Heritage Foundation, for example, estimates that the deficits will add up to $13-14 trillion over the next ten years.
Whether the number is $9.3 trillion or $14 trillion is not the point, it is the path we are on that is alarming.
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A recent study by Arnuad Mares of Morgan Stanley points out that the gross debt to GDP figure is misleading
for four reasons: (1) it overstates the liabilities, it is the net debt figure that is more important, (2) missing liabilities
understates the problem, such as entitlements, (3) it is not GDP but government revenues that matter, since they are
servicing and paying off the debt, and (4) debt to GDP is backward-looking; it is future debt accumulation or repayment
that matters. Looking at points two, three and four, we can see why our current direction is disturbing. Arnuad estimates
that when adding structural deficit spending and the cost of aging (unfunded Medicare and Social Security liabilities)
to the initial debt level, U.S. government net worth is a shocking negative 800% of GDP.
The U.S. is not the worst offender when it comes to negative government net worth. The poster children of
Europe for bad finances, Greece and Ireland, both have negative net worth of greater than 1400% of GDP. However,
looking at our ability to service government debt, we are in worse shape than even Greece and Ireland. Our federal
government debt to revenue ratio is 358%, versus 312% for Greece and 248% for Ireland. There is a silver lining though,
and that is how heavy the government is taxing its citizens. This is where the U.S. looks the best, with only 14.8% of
federal government revenues to GDP. Most Western European countries have tax structures in the mid-30s to mid-40s
as a percentage of GDP. This means there is room for the U.S. government to raise taxes to cover its unfunded promises
of the past. However, should we decide to pursue the way of increasing government taxation, the odds of continued
sluggish growth could increase.
Ludwig von Mises, one of the founders of the Austrian School of Economics, said it best: to create real economic
growth one has to attract capital and increase capital per capita, and this is best done by lowering taxation, having a stable
monetary unit with little to no inflation, removing excessive regulation, and providing a lawful environment that
protects capital. Thus, based on his theories, any policy that increases taxes, hurts the stability of the dollar, puts
unnecessary regulation on businesses, or decreases the rule of law and the protection of capital, will likely reduce capital
accumulation and capital per capita. Accordingly, the increased taxes proposed for 2011, the quantitative easing that’s
been done and is being considered anew, and the increased regulation on businesses, will likely constrain real wage
growth and impact real economic growth negatively.
As we noted earlier, there have been a limited number of opportunities that meet our criteria for purchase so far
this year. For example, our core screen that selects companies below certain levels of price to earnings, price to cash
flow, price to sales, price to book value and debt to capital, has generally produced 200-250 names to conduct further
research on. When times are plentiful, this screen produces north of 300 names. Currently, the number is 143, which
is toward the lower end of qualifiers.
This is not surprising since investors have moved out of cash and into stocks. The average equity mutual fund
cash level is now close to an all-time low at 3.5%, which is below the cash level reached before the financial crisis of
2008. As always, we will patiently wait until we find something that meets our challenging criteria for purchase. The
stars don’t align that often on all these criteria, but when they do, the upside profit potential can make the wait well worth
it.
We continue to focus our investments in companies that are exposed to global growth. Our oil service, oil and
gas exploration, and technology companies comprise more than 75% of our equity investments. These investments have
a heavy exposure to global-demand growth, as opposed to U.S.-demand growth. For the reasons outlined, we believe
domestic growth will lag global growth. Thus, our global exposure is likely to drive more rapid growth of the intrinsic
value in our investments. Oil also has a sharp decline curve, estimated to be 9% by the International Energy Agency,
which makes it more difficult to grow supply. In addition, oil in the ground and real assets that are used to produce it,
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should provide a store of value against potential future monetary inflation. For these reasons, we continue to like our
investments in the oil service, oil and gas exploration and technology areas.
Finally, we are happy to be able to report to you that the FPA Capital Fund retained its number-one spot as the
best-performing diversified mutual fund in the U.S. over the last 20 years, according to Morningstar. We thank you for
your continued support during these challenging times, and will strive to retain the confidence you have expressed in
us through your investment in FPA Capital Fund.
Respectfully submitted, |
