The World We Live In

For me, the final month of the year has always been a time to reflect upon the past as well as plan for the future. Analyzing the year soon to pass provides a valuable perspective with which to evaluate the important issues that will impact our country and economy going forward. In this context, 2013 sure has been a memorable year highlighted by horrific natural disasters, the deaths of Margaret Thatcher and Nelson Mandela, and on the lighter side, the unforgettable ending to perhaps the greatest Iron Bowl ever played.

From a market perspective, 2013 was no less historic with the Dow Jones Industrial Average as well as the S&P 500 hitting all-time highs. The tech-heavy NASDAQ was the only major index not to achieve an all-time high during the year. Despite these exciting headlines, there is reason to be a bit cautious going into the New Year. Over the past four years the stock market has appreciated 60%, while the Price/Earnings ratio has increased 45%. Essentially, the vast majority of the gain in stock prices has come from PE multiple expansion instead of earnings growth. This revaluation upward has been driven by zero interest rate policy (ZIRP) by the Fed. After years of money flowing into bonds, the tide seems to be turning in the favor of stocks over bonds. Although this could continue next year, it is a warning signal that the rally in stocks may be approaching its later stages.

How long will the Fed continue its quantitative easing in order to keep interest rates extraordinarily low? And beyond that, should they taper their bond purchases, what would happen to stock prices? If economic momentum continues the Fed will have room to gradually pull back on its quantitative easing, but if done too soon, and the economy falters, stocks would likely decline. While difficult to time, the odds favor rising rates at some point in 2014. Whether stocks can tolerate higher rates depends on the relative strength of the economy.

An economy on the upswing?… The most recent employment report offered hope that the economy is improving, with strong job gains and unemployment falling to 7.0%. If this trend continues, the odds will increase that the Fed will taper its bond purchases sooner rather than later. Yet it is far from clear that the overall economy will accelerate enough to support continued improvement in employment. The economy has not fully absorbed the recent tax increases or the complete implementation of Obamacare. Both of these forces, along with excessive litigation, regulation, and compliance, from the ever-expanding federal government, will continue to suppress economic growth. In essence, accommodative monetary policy by the Fed is offsetting the negative impacts of fiscal policy as it relates to economic growth. Again, this delicate balance worked in 2013, but there is no guarantee it will next year. Leadership change at the Fed and interim election partisanship add to already heightened political uncertainty. It may not be fun to contemplate, but it is the world we live in.

From a stock perspective, 2014 will be further impacted by three trends: Narrow stock market leadership, valuation-driven rotations between industries and sectors, and volatile overall moves driven by exogenous and unpredictable global events.

First, a persistent slow growth environment will force companies to slug it out with competitors in a battle for above average earnings growth. Those that do will be handsomely rewarded with soaring P/E ratios, a scarcity premium not unlike the valuation of rare, precious gems. Ownership of these companies will greatly enhance performance, but vigilance will be required in terms of monitoring the fundamentals because any stumble will likely cause a mad dash for the exits.

Second, in an overall market that is likely to be somewhat challenged, there will be rotations between industries and sectors as portfolio managers search for relative value. Employing disciplined valuation parameters will be essential to maintaining an optimal relative weighting in each key sector as these rotations occur throughout the year. In addition, relative weighting limits are important to utilize, which we in fact do to monitor the overall risk to equity portfolios. Specifically, in our core equity portfolio we maintain exposure to the seven major sectors between 50% and 150% of their respective weight in the S&P. The current S&P sector weights include: Technology 18%, Financials 16%, Health Care 13%, Consumer Discretionary 12%, Industrials 11%, Energy 10% and Consumer Staples 10%.

Third, as the U.S. retreats from the world stage, global tensions are escalating in the Middle East and in Asia. Russia appears to be stepping into our role and this transition makes the world potentially more volatile, in my view. Confrontations or unanticipated political events in either region could roil markets around the world. Like it or not, it is the world we live in.

Closer to home, 2013 was a year for which we at Willingdon have much to be thankful for. Three outstanding professionals joined our team, pushing our first string to a grand total of eleven. In a couple months we will be moving into a new office in the Huntersville Business Park. Most of all we are thankful for our wonderful and loyal clients, spread out across twenty-six states.

Merry Christmas and God bless everyone. After all, it is His world we live in.

Equality of Opportunity

Countless statistics show that the gap between the rich and poor has widened considerably and continues to widen. To an extreme, an economics professor at George Mason recently published a book in which he predicts the population will be divided into two groups: those who are good at working with intelligent machines, and those who can be replaced by them. This is obviously a scary outcome, but are we focusing on the wrong thing?

At the risk of offending Thomas Jefferson, individuals are not created equal. We all have unique skills and talents, and it is this diversity that helps make the world a great place. Some level of inequality is inherently good for society. Motivation to better oneself and one’s family through hard work and innovation leads to economic growth and job creation. Without financial motivation, economic systems and societies crumble. But what degree of inequality should societies tolerate or even strive for? This is an intriguing question, but one that may be impossible to answer.

Most politicians, economists, and journalists are focusing on equality of outcome, which I believe is the wrong area of focus. The inherent dynamic nature of the human race makes this an impossibility. Rather, we should be focusing on equality of opportunity.

The key variable to increasing equality of opportunity is education, and there are two very concerning trends in our education system – the lack of competitiveness when comparing our students with the rest of the world and the growing gap in test scores between rich and poor children in the United States. Paul Peterson, a Harvard professor, and Eric Hanushek, a senior fellow at the Hoover Institute performed an interesting study that showed a country’s economic growth is directly tied to the cognitive skills of its citizens. Countries at the top of the achievement distribution such as Korea, Taiwan, Singapore and Hong Kong had growth almost 2% per year higher than countries with average achievement statistics. In contrast, South Africa, Argentina, the Philippines, and Peru were at the bottom of the achievement distribution and had growth almost 2% lower per year than countries with average achievement statistics. Differences in education also explain disparity within our country. The current unemployment rate is 7.2%, but that jumps to 11.3% for individuals with less than a high school degree and drops to 3.5% for those who have a college degree or greater.

Improving our education system will enhance our economic growth and expand opportunities for individuals to climb the economic ladder. But how do we best do this? Throwing money at the problem will not solve it. According to Peterson and Hanushek, the U.S. spends on average $12,000 per pupil in grades K-12, one of the highest amounts in the world. Furthermore, states that spent more per pupil did not see higher student performance. How we spend money is much more important than how much we spend. Where to get the most bang for the buck, in my opinion, is by spending money on those that directly impact our students: our teachers. Deciding how to distribute increased funds to teachers should be based on rewarding the most effective teachers, however assessing teacher effectiveness is no easy task. National student test scores contain biases, and results can be skewed by influences outside of the classroom. According to an article in The Economist, a recent study attempted to strip out the biases in test scores and quantify the importance of good teachers. This study found, “exposure to better teachers is associated with an increased probability of attending university, and among pupils who go on to university, with attendance at better ones, as well as with higher earnings.” The study also found that, “good teachers also seem to reduce odds of teenage pregnancy and raise participation in retirement-savings plans.” The authors of the study quantified that the impact of swapping an average teacher in place of a teacher at the bottom of the value-added spectrum raises the collective lifetime income of each class they teach by $1.4 million. A study by the Bill & Melinda Gates foundation further supported the importance of teachers by concluding that, “some teachers can produce test-score gains regardless of the past performance of their students.”

In Coming Apart, Charles Murray depicts our society as one in which the new upper class has segregated themselves from others and leads a life that does not intersect with other socioeconomic groups. He traces this trend to the significant increase in cognitive ability at top tier colleges in the late 1950s and early 1960s. Men and women at these top tier colleges then married and had children. The parents’ high income levels allowed both nature and nurture to take effect and spawn a group of highly intelligent and motivated children with parents that would invest great sums of time and money in their education. Many social economists fear the self-perpetuating nature of this cycle. The question is not a matter of inhibiting this cycle, but rather how do we raise the standards of education for those that were not born with the same resources.

I believe the answers to increasing the equality of opportunity lie in a combination of increasing pay of our good teachers, allowing school districts to terminate underperforming teachers, and giving families choice in which schools to attend. I believe these three steps will strengthen our education system and lay the groundwork for future economic growth. Admittedly it will take time and patience before we see any effects of these efforts, but we should focus on what we can control, not on what is out of our control. Let’s provide a wonderful opportunity for all. The outcomes will follow.

Goose Bump Stuff

John Grisham once said in an interview that one of the keys to being a successful author is to write about topics you know a lot about.  He has a background in the law hence his books about lawyers and law firms.  Sitting next to him during this interview was Stephen King.  Grisham joked that one can only wonder what goes on inside the mind of Stephen King…

During a typical day in my world, I read, write, and think about the markets, politics, and the ebbs and flows of the overall economy.  It’s what I know, or at least am supposed to know.  But for this edition, I’d like to begin by highlighting two fascinating stories of scientific discovery, in areas in which I have very limited understanding.

A recent article in the Wall Street Journal described how researchers at Stanford University recently introduced the first computer built entirely from carbon nanotube transistors.  This is an important discovery as the electronics industry approaches the limits of conventional silicon transistors, essentially the brains of existing computers.  Carbon fibers are incredibly strong and carbon nanotubes are 10,000 times thinner than human hair.  Computers based on this exciting new technology will potentially have much smaller components requiring significantly less energy to run.  Scientists and engineers working in labs around the world are producing ever more powerful computers using less and less energy, a critical dynamic that will drive the future of the electronics and technology industries.

In the same edition of the WSJ, there was another interesting scientific breakthrough where a man, “successfully controlled movements of a motorized artificial leg using only his own thoughts.”  This incredible technology may be a life-changer for the more than one million Americans who are living with amputations.

Scientific research and discovery has always been a fascinating component of our country, from Benjamin Franklin to Thomas Edison, to NASA to Nanotechnology.  Driven by our innate curiosity and astounding collective brain power we are always one discovery away from exciting new products, companies, and industries.

There is great hope in this never ending quest.  It means we are never stuck where we are, as individuals or as a country.  Essentially, we can think our way to a better way.  Yes, it takes perseverance, courage, and resourcefulness to battle through the inevitable obstacles that emerge during the process, but what exactly, isn’t possible?

The American journey is really imagining the impossible and then pursuing a solution with dogged determination until one is found.  Shooting for the stars and hitting the peaks of the mountains is at the core of the American psyche.  For me this is goose bump stuff.

From a portfolio perspective, we try to incorporate this enduring hopefulness by searching for companies which continually strive for excellence.  Many industry-leading companies stay at the top because they are constantly looking for ways to improve, while competitors lose their edge.  Harnessing technology, driving innovation, and improving efficiency, are all areas of primary focus for successful, well-established companies.

At the same time, it is important to also own emerging companies with leading-edge technologies in above average growth areas.  We typically focus on the Health Care, Technology, and Industrial sectors to find the next generation of leading companies.  In addition, given that these three sectors represent over 40% of the S&P 500, it is important to monitor potentially disruptive technologies and how they may impact the current industry leaders.  This combination of established success and emerging success within an equity portfolio provides outstanding potential for sustained long-term growth.

The overall domestic economy is growing very slowly and has been for several years.  Based on recent trends, I do not envision economic growth will improve much over the next few years.  Despite this sluggish macro picture, there are pockets of growth in our diverse economy.   However, identifying sustainable growth stocks, in this frustratingly slow overall economy, and buying them at a reasonable price, is no easy task.  Just as precious gems are highly priced because of their scarcity, so too will growth stocks command higher valuations.  But through insightful, yet patient research, and disciplined valuation analysis, undervalued growth stocks can be identified.    For me, this too, is goose bump stuff.

Notable Lines

One of President Obama’s most notable lines, “you didn’t build that,” sent chills up my spine when I first heard it.   As an entrepreneurial-minded business owner, I found that statement shocking, to be honest.  But maybe there is some truth to it…

In a relatively new book – The Entrepreneurial State, author Mariana Mazzucato contends that the government has assumed most of the risk as well as the necessary initial funding for most of the innovations that have benefited society since the end of WWII.  Our federal government does indeed spend more on research than most of the rest of the world, particularly through the Department of Defense, but also through various agencies including: the National Institutes of Health, the National Aeronautics and Space Administration, and the Department of Energy, to name but a few.

However, in more cases than not, it is the private sector, not the government, that transforms scientific discoveries into wealth-creating businesses.  The private sector has a much greater level of monetary incentive to commercialize innovation than does the federal government.

So, perhaps President Obama should have said, “you didn’t invent that.”  On that score he might have been more accurate.  Without question, the government’s ability to fund basic research is vitally important to our future economic growth.  Research, by its very nature, requires risk taking, with failure occurring more frequently than success.  No one knew that any better than America’s greatest inventor, Thomas Edison, who uttered this notable line during his quest to invent the light bulb – “I have not failed.  I’ve just found 10,000 ways that won’t work.”

During the last seventy years, as America has dominated the world economy, there has been a reasonably efficient partnership in the area of research and development between the federal government and the private sector.  During that time period, our country has created more wealth than has been created in the history of the world.  By this measure, the capitalist system worked, and it worked better than any other system ever devised.

But has it worked too well?…  The focus, it seems, is no longer on research and discovery, as much as it is on who reaps the benefits of innovation and wealth creation.  Free market economists contend that the private sector deserves to capture a significant percentage of the wealth created, while the other side is more concerned, and rightly so, with the growing income and wealth disparity between the rich and poor.

This brings me to one final notable line…  The goal is to strengthen the weak, without weakening the strong.

Our economy will continue to struggle as long as the private sector and the federal government remain antagonists.  Government’s ever changing rules, higher taxes, onerous legislation, and executive overreach has corporate America on the defensive.  Corporations fight back by hoarding cash, cutting costs, taking as few risks as possible, and operating well below full employment.  The result of this contentious relationship is very slow economic growth and frustratingly high unemployment, which has been the case over the past five years.  Worse over, in this highly polarized environment, the gap continues to widen between the rich and poor.

We need a new paradigm… Perhaps our greatest challenge as a nation is to provide opportunities for the economically disadvantaged, instead of handouts. Too often, I fear, we all rely upon government for the solutions, but a top-down approach will never work to solve a relational problem.  Breaking the cycle of poverty and dependency requires one-on-one relationship building, and consistent, long-term mentoring.  Individuals can do this.  Government agencies are not set up in this manner.

Who, or what, can motivate us individually to make this paradigm shift in thinking?

I really have no idea.  But if it happens, look out!  Our country and our world will never be the same.

Second Half Challenges

One of the most challenging aspects of managing portfolios is to process the endless information flow and determine what impact it will have, if any, on the markets. Some information, while interesting to read about, has virtually no impact on the future direction of stock and bond prices. Other information may not have an immediate impact, but it may be impactful in the future. This, delayed-impact information encompasses the vast majority of information that surfaces on a daily basis.

Case in point – Having gone to business school in Michigan, or that state up north as Woody Hayes would say, I have always been fond of Detroit. When I was born in 1959, Detroit was very near the top of the economic ladder, sporting one of the highest levels of per capita GDP in the entire country.

Essentially, Detroit’s politicians have made financial promises over the last several decades that it can no longer keep. Does this historic collapse of one of our greatest cities mean anything to the future of our economy or country? Cities throughout America are wrestling with the issue of underfunded pension obligations. Given our aging population, over time, other cities may face similar financial difficulties that Detroit now confronts.

From an overall economic perspective, recent statistics show a domestic economy that is growing around 1%, well below what is required to meaningfully improve employment and personal income, two engines of a healthy, expanding economy. Meanwhile, government spending, national debt, and taxes are increasing much faster. As we have witnessed the last five years, during the weakest post-war recovery on record, we simply cannot have both an expanding government and rapid economic growth in the private sector.

One of the bright spots in this persistently weak economy has been the recovery in housing. Yet, below the surface, there are disconcerting trends here as well. First of all, the number of first-time home buyers is well below historic averages, while the percentage of younger people living with their parents has climbed well above the norm. Neither of these trends bodes well for the sustainability of the housing recovery.

 

Another seemingly bright spot has been corporate earnings. But again, a look below the surface reveals fundamental weakness. In the most recent second quarter, corporate earnings grew modestly, despite flattish top-line revenues. Profits were driven by margin expansion, as corporations were able to reduce expenses, squeeze suppliers, and improve productivity. While the stock market has rallied reflecting higher earnings and strong cash flow, there is a limit to how long this can continue in the absence of acceleration in the overall economy.

 

Over the next several months political battles will be fought over immigration, tax reform, gun control, implementation of the Affordable Care Act, entitlement reform, Internet privacy and electronic communication, raising the federal debt limit, and the overall level of government spending. At the same time there is a growing battle being waged over states’ rights and an expansive and intrusive federal government. At the very least, all these issues are delayed-impact events. Some will affect the markets in the short term, but all of them will over time. And in this sense, if we do not shrink the federal government, reduce our national debt, and free up the entrepreneurial spirit of corporate America, the economy will not accelerate from its very slow growth rate. It simply will not happen.

With this as a backdrop, we are a bit cautious for the remainder of the year, especially after the relatively strong rally in stocks through the end of July. Stock selection will be critical going forward. For companies to buck the slow growth trend they will have to continue to drive productivity and new product innovation, while developing strategic partnerships to outcompete their rivals. In this difficult environment, average companies may survive, but only the best managed ones will thrive.

At the heart of our stock selection process, we will focus on identifying companies that have sustainable competitive advantages over their peer group in these areas: Cost control, technology, financial strength, cash flow, strategic vision, consistency and deliverability of earnings, and overall executive leadership. Unless the overall economy accelerates, the list of companies that hold these sustainable competitive advantages is likely to shrink, making gains in the overall stock market harder to achieve.

The Root System

Last week my beloved peach tree inexplicably toppled over, destroying what was certain to be a bountiful crop. It was a favorite hobby of mine, to spend hours pruning, thinning, fertilizing, and spraying the height-challenged tree in order to produce a couple bushels of scrumptious peaches in early July. Yet this year I goofed. My plan for growth was flawed in that I failed to diagnose an infestation of peach borer which was weakening the root system. Once the internal strength of the tree was compromised, the tree was doomed.

In an article in the June 6th edition of The Wall Street Journal, “Capital: Sequester Headlines Scarier Than Reality – So Far,” the closing paragraph was particularly apropos in the context of our ongoing economic struggles:

Virtually every Willingdon Views newsletter I’ve written over the past few years has focused somehow on this pivotal battle between an ever expanding government and a besieged private sector, and the subsequent impact on our economy, markets, and everyday life. Is there really anything else to write about that matters?

No there really isn’t. And although I would love to share insights on other important issues, my thoughts always return to this epic debate. It is simply impossible to ignore it, unless one never reads, watches TV, or surfs the Internet. We may want it to go away, but it never does. It makes me wonder if we are stuck with it forever?…

No, we aren’t and I know which side will win… The government leviathan will eventually die. The root system has been compromised and its demise is inevitable. Even if it grows larger under the current administration, it will become increasingly inefficient and ineffective. As we are witnessing nearly every day, isn’t it already too big to manage? All people, if given a choice, will choose freedom over tyranny. In other words, the American people will eventually decide that they want control over their own destiny and will demand less government intrusion. The shrinking process will be quite an event, will not be smooth, but it will happen, and I think the seeds of this major event have already been planted, fertilized by scandals, lack of accountability, spin doctors, and a pervasive lack of integrity in Washington.

Meanwhile, our economic struggles are likely to persist. Month to month, there will be ebbs and flows between economic acceleration and deceleration, with no clear sustainable trend. It will be frustrating for the markets as well. During periods of positive economic news, growth stocks are likely to lead. Conversely, when signs of slowing return, higher-yielding securities are likely to rally. A portfolio structured with the appropriate balance between growth and yield would be a prudent approach during these uncertain times.

Eventually, the entrepreneurial spirit inherent in the private sector will re-emerge to lead a new era of economic growth. There are already signs of this in emerging technologies related to fuel efficient cars, biotechnology, and energy exploration. Meanwhile, corporate America continues to generate higher earnings and record cash flow despite the slow growth environment. Moreover, corporations, in general, are increasing dividends faster than earnings are growing, which enhances shareholder value.

Someday I’ll plant a new peach tree. I’ll watch more closely for the insidious borer, and hopefully provide the tree what it really needs to make the root system strong. For if the foundation is strong, a bountiful crop will surely follow.

Uncomfortable With The Debate Of Our Times

A relatively weak first quarter earnings season is winding down, while major stock market indices are reaching all-time highs. This doesn’t quite add up, does it? Overall, corporate profits advanced at an anemic 2.5% in the first quarter, well below the long-term average of 7%. Worse over, revenues were actually flat in the first quarter, below expectations in most cases. On top of that, most companies that have reported earnings have also lowered estimates for the remainder of the year. Clearly, the economy is struggling, and is likely to do so as it digests the numerous tax increases, burdensome compliance, and regulatory changes in this great wave of governmental overreach.

How, in this slow growth environment, can stocks continue to grind higher? Valuations are largely driven by three variables, and two of the three remain quite positive.

  • First, interest rates are at historic lows and are likely to remain so for the next couple years.
  • Second, inflation remains benign, with few signs that it will become a problem any time soon.
  • Third, earnings, although weak, are still growing.

In other words, while an accelerating economy is unlikely near term, the probability of a recession is just as remote. Combined, these three pivotal drivers of stock prices allow for a volatile, grinding-higher scenario for stock prices.

Is this the best we can expect?… I spent a delightful evening last night at the 10th Annual Davidson College Men’s Basketball Awards Dinner. This event was highlighted by the speeches given by the graduating seniors. One closing quote delivered by a remarkable young man, JP Kuhlman, resonated with me. “The ways of the Lord are not comfortable, but we were not created for comfort, but for greatness, for good.” Pope Benedict XVI.

Our country was not created to be comfortable either, but to pursue and achieve great things, to be a shining light in an increasingly dark world. But just as the economy is struggling, our country itself is struggling to fulfil this calling. Our inherent entrepreneurial spirit is under attack from an ever growing government bureaucracy. A recent example of this frustrating trend was documented in the May 6th edition of the Wall Street Journal article, “Backroom Internet Tax Ambush.” Essentially, the Senate recently passed legislation to give state and local governments the power to collect taxes on Internet sales. Within this bill, Senate Majority Leader Harry Reid altered the wording of the bill to include “any tribal organization” as an entity that has the power to audit any business with Internet sales. According to the House Natural Resources Committee there are several hundred federally recognized tribes, which means instead of a
manageable 50 state auditors, small businesses may have to wrestle with approximately 600 audits related to Internet sales.

While large companies like Amazon can handle the additional cost and complexity involved in the hundreds of potential audits related to Internet sales, this legislation could be the death knell for many small businesses. And it is small businesses that create the vast majority of new jobs in our country. Tax increases, burdensome compliance regulations, and regulatory controls are crippling small businesses and therefore our economy’s ability to break out from this frustrating slow-growth environment.

Stocks can continue to grind higher as long as interest rates and inflation remain low. While this trend can persist, it can’t go on forever. Our economy will either sink from the weight of an uncontrollable government behemoth, or it will find a way to live within its means, reduce the federal deficit, and rekindle the entrepreneurial spirit. Ultimately, we will travel one of these paths.

Balancing portfolio strategies… In the meantime, while this far-reaching, debate of our times plays out, there are portfolio strategies that can leverage the low interest rate environment, while also taking advantage of pockets of growth in the overall economy. Outperforming stocks are likely to include companies that pay above average dividends as well as companies that produce above average earnings growth. A flexible, barbell approach, with an emphasis on higher yield on one end and above trend earnings growth on the other end, makes increasing sense in our view. Our research efforts are focused on both of these strategies in order to identify attractive yield plays as well as companies that can outgrow their peer group through product innovation and superior strategic decision making. This is a painstakingly difficult process, but the path to investment success, greatness if you will, demands flexibility and balance. Even if it makes one uncomfortable.

Patton, the Pope, and Skylar

In the powerful opening scene to the movie, “Patton,” the famous general stands before his troops and boldly states, “Americans love a winner, and will not tolerate a loser.” It’s hard not to stand a little straighter when you hear a line like that. We do like to think about ourselves as the greatest country in the world. Certainly in economic terms the United States has accomplished more than any other civilization known to man.

It’s lonely at the top… Movies are rarely made today that boast about America. Has our country changed or is it just the world’s perception of us that has changed? Has our competitive nature weakened? Perhaps there are competitions in which America should strive to win, while winning in other areas might be less important.

So, which global competitions should America commit to winning? And which can we accept losing? I wonder how Pope Francis would answer these questions… The newly appointed Pontiff has raised a few eyebrows by not following papal customs. His highly publicized washing of prisoners’ feet has reverberated throughout the world. Perhaps there is an important message here for all of America…

Servant leadership is incredibly powerful and can change relationships at all levels, from households to communities, to international relationships. It is also extremely difficult to do on a consistent basis, as it requires putting the interests of others before our own.

What would the world look like if America committed to win the battle of being the greatest servant leader in the world, if our rallying cry became this… Americans love to serve, and will not tolerate selfishness.

Over time, the difference would be a lot more radical than the Pope kissing the feet of social outcasts. Effective and pervasive servant leadership would over time, virtually eliminate any threat of class warfare locally or terrorism globally. An idealistic overstatement? Perhaps. But is it very hard to hate someone that is sincerely and consistently serving you.

So, how should America respond to Pope Francis’ call to service? Let’s start with these five things.

  1. First, we should establish term limits in Congress. Give them all six years then send them back to the private sector. I believe this would go a long way to eliminating crony capitalism and the special interest influence that has so tainted the political process.
  2. Second, Fortune 500 CEOs should all agree to live a more modest lifestyle and refrain from excessive compensation. This has to be self-imposed for it to be effective and meaningful as a means to diffuse class warfare resentment. We all have our own ideas about what is reasonable compensation and what is excessive. Surely these influential business leaders can agree upon an appropriate range. As a guide, the $17.6 million in total compensation earned by Wal-Mart CEO Michael Duke seems more reasonable than the $378 million paid to Apple CEO Tim Cook (based on 2011 data). At least it’s a start…
  3. Third, churches of all denominations are encouraged to unite within communities to identify and help all people who are economically challenged in a grass roots, 100% bottom-up, privately-operated program. The resources are there now, remember, we are the richest nation in the history of the world.
  4. Fourth, our federal government must live within its means. Period. No raising the debt level, no kicking the can down the road time after time. We get our fiscal house in order. Now.
  5. Fifth, all Americans do the best they can to get in the best possible physical shape they can.

Let’s recap the results of these five initiatives. Smaller, more effective government, less resentment toward the rich, more support for the poor, reduced risk of becoming the next Greece, lower overall health care spending, which along with other entitlements is threatening to bankrupt our country. This isn’t rocket science, and it is all doable.

Which brings us to Skylar… With all due respect to Britteny Griner, the best women’s college basketball player is Notre Dame’s Skylar Diggins. One of the things that makes her such a special competitor is that she hates to lose more than she loves to win. America must change or we are going to lose. And I hate the thought of that. We are going to lose the opportunity to lead, to serve, and to be all that God created us to be. And I hate the thought of that, too.

Horse Feathers

While wisdom and experience are certainly very important to long-term investment success, I do believe it is also necessary to begin each day with an open mind. Flushing the senses, so to speak, allows new information to be processed through an unbiased filter. In short, markets change, and investment thinking must be adaptable.

The timeless challenge is to sort through the constant flow of information and determine what is relevant and what should be discarded. The latter, I think, is easier to do given our penchant for making the innocuous seem significant.

An example… The February 20, 2013 edition of the Wall Street Journal had an article titled, “Horse Meat Found in Nestle Products.” I’ve never tried horse meat before, but is it so bad? Lewis and Clark may not have survived their historic journey in 1805 had it not been for horse meat. Yes, I know, if one buys Beef Ravioli, one expects beef not horse meat, but if I owned stock in Nestle, I would not sell it because of this story.

For the record, I did not watch the President’s state of the union speech. Nor did I listen to any of the rebuttals offered by the other side of the aisle. What happens in Washington matters, what is said in Washington less so. In the Marx Brothers movie, Horse Feathers, Groucho Marx, cast as Professor Quincy Adams Wagstaff, the newest president of Huxley College, offers this line in his introductory speech before the assembled student body – “As I look out among your smiling, eager faces, I can readily understand why this college is flat on its back.” That sums up rather well, how I feel about our polarized political process.

But some news stories really do matter… Cyber attacks to our computer systems are a big deal. Our economy relies upon the accuracy and confidentiality of information at many levels. It seems that many of these attacks may be tied to the Chinese military. How this plays out will impact global trade, military spending, as well as peace in the Asia-Pacific region. From an investment perspective, companies that can offer leading-edge security products and services may be interesting investment ideas to research.

Meanwhile, merger and acquisition activity is heating up. This positive development is being driven by two factors. First, corporations are becoming increasingly pressured to invest their record levels of cash. Higher dividends and share buy-backs have relieved some of this pressure, but corporations seem focused on making more significant investments. All these trends are positive for the stock market.

Second, the exponential growth in government regulation, executive orders, and higher taxes, continue to pressure the private sector. Smaller companies, in particular, are increasingly burdened by government’s heavy hand, and may be forced to combine with larger partners to survive. While this is good for stock prices in the near term, it is not good for future job creation.

The Federal Reserve’s zero interest rate policy is another tonic that may be good in the short run, but harmful in the long run. And that is my real concern, that too much of what government is trying to do is short-term focused, with potentially negative effects over time.

On this note, how will the world adapt as the only global military superpower shrinks from the world stage? Does it make the world safer, or does it embolden despots in places like Iran and North Korea?

And how will the drive to redistribute wealth end up? Will we reach a tipping point when the weight of entitlements and higher taxes sink the economy?

Or perhaps the story will change… Over the next few years the core values of our country will be tested, perhaps redefined. The next few years will also test our resiliency. I don’t believe there is much chance any of this can be avoided.

More Horse Feathers… In that same movie, just before Chico Marx launches into his obligatory piano solo, Groucho saunters up to the camera and growls – “I’ve got to stay here, but that’s no reason why you folks can’t go into the lobby until this thing blows over.” If only we could…

Investment Basics

I’ve always been curious about how famous people would have done had they pursued completely different careers. Some of our former presidents make excellent examples. For instance, Abe Lincoln towered over his contemporaries. I wonder how he would have fared as a basketball player had the game existed during his life. Our heaviest president, William Howard Taft weighed well over 300 pounds. Had football risen to prominence a few decades earlier, could gridiron greatness have been part of his resume?

Athletes, as well, are interesting people to speculate about. John Wooden, the legendary basketball coach from UCLA, would have been an incredible money manager. Coach Wooden knew the importance of focusing on basic fundamentals, especially during the most important times of the season. In fact, when asked what he concentrated on as his team approached the Final Four, Coach Wooden explained that his team stressed the basic fundamentals even more. When other teams panicked, his teams played with poise built upon a rock solid foundation of fundamental skills.

Time to roll up your sleeves… And that is what I suggest investors do in order to get a sense where the stock market may go in 2013. In the short run, CNBC sound bites, political hyperbole, and the never ending stream of real-time noise perpetuate a volatile stock market environment. But on a long-term basis, actual earnings relative to expectations is the critical driver of stock prices. Underlying economic factors including: inflation, interest rates, monetary policy, government spending, and taxes are all inputs that determine the relative strength of earnings, as well as future earnings expectations, within industries and across the economic spectrum.

Research efforts, therefore, must be spent analyzing earnings growth forecasts, while developing a sense of the sentiment, or the level of expectations related to specific company forecasts. Expectations reflect the underlying confidence in the predictability and sustainability of earnings.

Astute investors are constantly searching for companies that have a relatively high probability of achieving earnings growth well above expectations. As the Internet provides a 24/7 flow of information to individual investors as well as Wall Street professionals, this search for valuation anomalies requires thorough analysis of current trends related to new product innovation, changes in business strategy, operational efficiency and profitability, shareholder friendly initiatives, and overall management vision. All of these factors for each company must be analyzed relative to a specific peer group and also in some historical context. The goal, in a nutshell, is to identify companies that are distancing themselves from their peer groups, while becoming better companies than they were in the past. Investors who discover these situations earlier than consensus usually win.

No rising tide… In our view, we may be in for an extended period of relatively slow economic growth and stubbornly high unemployment. We simply cannot have expanding government spending and deficits and still have strong economic growth. We can only have one or the other.

Stock selection is the key… The age old saying – it is a market of stocks not a stock market– clearly rings true today. I expect the gap between successful companies and struggling companies will widen as long as this slow growth economic environment persists. If this is the case, then it will be very important to focus on stock selection, and not spend too much time trying to forecast the unpredictable swings in the overall market. Some of the statistics we analyze in our stock selection process include trends related to: margins, market share, dividend growth, cash flow, and new product success rates. Again, all these factors are analyzed relative to competitors and relative to historical trends.

One big picture theme to look for… Over the last few years, corporations have been reluctant to hire and invest, preferring to build record levels of cash to prepare for higher taxes and increased expenses related to health care and expanding government regulation. As these costs are digested, companies will increasingly look for ways to more productively deploy cash to expand profits as well as to improve their competitive position. As a result, we are likely to see heightened merger and acquisition activity this year. Generally, this should have a positive impact on the stock market, but each situation should be looked at very carefully.

Nervous about the future… Given the uncertain world we live in, investors are nervous about the future. I’m often asked what I think about the market and what everyone wants is a level of comfort about the future. I do too. Yet, comfort can be built in multiple ways. For the remainder of this year we are going to follow Coach Wooden’s example. We are going to focus on the basic fundamentals and not be negatively affected by the emotional gyrations in the market. So, while I may not be able to supply an eloquent sound bite about where the overall market is going, I can articulate why Coca Cola, with its international breadth, may have strategic advantages over its primary competitor, Pepsi, or why a super-regional bank like US Bancorp, might have advantages over more global players like Citigroup. Winning these stock selection battles, one industry at a time, will be critical to investment performance.

We hope we can provide comfort by building portfolios of strong, high quality companies. Ones that never let the emotion of the moment overwhelm the task at hand.