"A Chicken in Every Pot and a Car in Every Garage"
THIS QUOTE,attributed to President Herbert Hoover’s 1928 election campaign, epitomizes the mass psychology characteristic of the Roaring ’20s. In a country that had long enjoyed a remarkable period of prosperity, it was felt that the trajectory of the boom’s trend would eventually lead to an eradication of poverty.
The Industrial Revolution brought about a tremendous increase in productive capacity and living standards beginning with its origins in the mid-19th century. But the advent of consumer installment credit in the Roaring ’20s was the mechanism that shifted business into overdrive. Entrepreneurs all along the chain of production, from commodities to retail, geared up for demand that, in hindsight, was short-lived.
With the onset of the Great Depression, priorities for many gradually shifted from return on capital, to return OF capital, to concern that modern industrialized society was unraveling at its seams.
The Consequences of a Credit Bubble
As the panic that engulfed Wall Street spread to the banking community, pain that was previously only felt by those involved in the speculative stock market quickly consumed the business community. Consumers reined in spending, so business owners rationally cut expansion plans and investments in inventory.
Bankers comprised the heart of the capital allocation function of the time period; in the modern global economy, it’s quite another story, as the business of providing credit has shifted toward such institutions as hedge funds, private equity, and government-sponsored enterprises like Fannie Mae. Also taking share from bankers has been the secondary market for credit derivatives, including mortgage-backed securities, collateralized debt obligations, and collateralized loan obligations.
Take the example of mortgage-backed securities: pools of mortgages of similar size, credit risk profile, and loan-to-value ratios that provide a yield similar to that of a bond. It used to be that you’d apply at your local community bank for a 30-year mortgage where you’d make monthly principal and interest payments over the entire life of the loan. The banker carefully weighed the risks of extending the mortgage on the home you sought to purchase and the sustainability of your present income because he would have to live with the consequences of default.
Over the course of the past 5-10 years, however, the financial system has evolved to the point where bankers have more incentive to sell the right to collect your future monthly payments into a secondary market. This secondary market is created by large Wall Street firms who make commissions and fees in a fashion similar to that of the stock market. Therefore, the local banker has been transformed into an agent of institutional and individual investors looking to invest in an income-producing security that pays a yield greater than Treasury bonds.
How have the priorities and incentives of your local banker evolved? Think volume, not thoroughness of credit profiling. At the extreme, this could lead to the following scenario: a Japanese saver takes out a policy at Sumitomo Mutual Life Insurance Co. Sumitomo, seeking investment income higher than that paid by Japanese government bonds yielding 2.5%, invests the increased float from its new customer in a mortgage-backed security created by Lehman Brothers that yields 6%, or a 1.5% premium over U.S. Treasuries at the time.
Lehman creates this higher-risk MBS by pooling together mortgages on properties purchased by 28-year-olds with median incomes in hot markets like Miami and Las Vegas. The purchases occurred near the peak of these markets in 2005 and were based on "aggressive" property appraisals that would have been 50% lower just two years prior. A recession appears on the horizon and the purchasers’ employers enact layoffs, causing them to default and the value of the MBS to take a great hit, falling to only 60% of face value, much like a junk bond would in the case of default. The one ultimately left holding the bag is the Japanese saver, as the capital of Sumitomo Life is called into question after write-offs of bad investments.
This scenario, while extreme, can be multiplied to include the MBS exposure at institutions like hedge funds, pension funds, other insurance companies, Fannie Mae, fixed-income mutual funds, etc. The further the provider of savings is removed from the ultimate user of savings, the more opportunity there is for mistakes and fraudulent appraisals to occur. A serious "moral hazard" has developed in the mortgage market where the solvency of the global financial system takes a back seat to growth in mortgage originations and fees.
These speculative vehicles have revolutionized the traditional credit allocation system by dividing credit risk up into smaller and smaller slices, essentially socializing risk. So when Fed Chairman Bernanke dons his fireman’s hat to put out the next conflagration in the financial system (Asian currency crisis in 1997, LTCM in 1998), the fires may be far less intense, but they will be harder to locate and nonetheless add up to inflict the same amount of damage. The pools of liquidity resulting from his fire-hose bailout will ultimately be manifested in further increases in commodities and consumer prices (stocks are likely to be flat in real terms because investors have not historically paid high P/E multiples for inflation-generated earnings growth — see the returns of the 1970s).
Back to the Roaring ’20s
Once consumers had reached the saturation point of installment credit, companies like Ford had the capacity to produce far more cars than the market demanded. Bankers, fearing defaults on their riskiest loans, called them in just as the ability to pay them off had vanished. The combination of falling asset prices (factories, inventories, real estate, etc.) and bank runs was lethal. The country witnessed an enormous number of bank failures in a short period of time.
President Hoover’s interpretation of the authority granted to his office by the Constitution did not square with that of the business and investor communities clamoring for a bailout. The measures he took to clean up the mess left by a burst bubble, in which millions were complicit, were not perceived as radical enough under the circumstances.
In 1932, President Franklin D. Roosevelt was elected in a landslide on promises to take swift and decisive action. The foundation of this recovery involved devaluing the U.S. dollar against its gold backing, and basically amounted to currency debasement and deficit-financed make-work programs. The cost of the New Deal — the brainchild of British economist John Maynard Keynes — was foisted upon future generations.
When confronted with these long-term costs and the necessity of running budget surpluses to pay off debt incurred by his "demand management program," Keynes casually dismissed this critique with the statement that "in the long run, we are all dead."
Well, it’s safe to say that we have reached what would be considered "the long run" and, no, we are not all dead yet. The only thing that has sheltered the current working generation from the financial consequences of government debt growth (taxes, runaway CPI inflation) is the fact that America successfully "dollarized" the rest of the world in the post-World War II period.
This is not to say that we will escape unscathed. International accounts will be settled through further destruction in the value of the dollar. It must, and the Fed will do everything in its power to ensure the dollar’s future devaluation. Whether it will be "successful" remains to be seen, but you can be assured that painful consequences will accompany unconventional Fed policy.
Does anyone really stop to think about what would happen to the current economy if Congress enacted a plan to pay off the gargantuan federal debt, not to mention fund the trillions in unfunded Social Security and Medicare promises made?
The consequences of such an action would lead to a second Great Depression. Federal spending that for generations has greased the wheels of commerce cannot be reduced in the face of the gargantuan debt obligations that must continually be paid or rolled over. Widespread default is not an option in the mind of the Fed.
For a more in-depth examination of "how we got here," I refer you to Bill Bonner and Addison Wiggin’s Empire of Debt .
In my mind, the important lessons of the Great Depression lie not in the New Deal’s remedies to its fallout, but in tracing its origins back to the seeds that were sown by post-World War I Fed policies: credit that is controlled by government institutions, rather than the free market, can lead to egregious misallocations of capital. In the 1920s, it clearly did.
What do the Hoover campaign themes of seeking to universally end hunger and promote material prosperity have to do with current market psychology?
Mania vs. Rationality
The efficient market hypothesis (EMH) basically states that current stock prices reflect all available information, so you are wasting your time attempting to take advantage of extremes in prices. "The market" is lifted to the status of an omniscient capital allocation machine. In theory, it works, but when the human emotions of greed and fear are involved, it’s amazing to behold the irrational pricing that can develop at either extreme.
I can’t think of a better real-world refutation of the EMH than the tech bubble, yet in its aftermath, it is still included in the mainstream of financial theory. For example, the bubble in the stock prices of fiber-optic equipment manufacturers might have been close to accurately pricing in the future growth of Internet traffic, but bubble stock prices were clearly not pricing in the reality that the race to build out fiber-optic capacity sowed the seeds of rapidly approaching profit-margin free fall.
When the powerful emotions of greed and the fear of being left behind combined to produce jaw-dropping rallies, sell-side analysts responded by publishing ridiculous discounted cash flow models in order to justify current prices. Remember the "click count" and "eyeball" methods of valuing triple-digit Internet stocks that ultimately crashed and burned?
A principle of financial theory that withstands the rigors of real-world experience is that the value of any stock is equal to the sum of future free cash flows generated by the underlying business. These free cash flows can be used to pay dividends or to repurchase shares and must be discounted back to the present time using a "reasonable" rate in order to arrive at a current value for the stock. This is where it gets really tricky, with wild swings in stock value resulting in changes to the discount rate.
For individual investors, the important thing to take away from discounted cash flow (DCF) models is that future sales growth (or contraction) rates, costs of production, overhead, competition, and the availability of financing are all huge, unpredictable factors in the DCF calculation. Take an unreasonably optimistic view of these future assumptions, and voila: instant mathematical justification for bubble valuations.
The Greater Fool or Long-Term Investment
Approaching the peaks of bull markets, investors tend to aggressively bid up the prices of those stocks with the most egregious assumptions about future sales and earnings growth and tend to ignore threats to those assumptions, including competition, inflating expenses, and, often, the ready availability of financing. Due diligence often consists of A) my neighbor just made a fortune in this stock, B) the chart shows that it’s a clear path to riches, and C) I’ll get out before the top by selling to a "greater fool."
Consequently, in the early stages of bear markets, investors tend to flock toward safe havens with rock-solid balance sheets and business models with more predictable assumptions, like consumer staples.
While traditional safe havens may continue to fall in price, you can be reasonably confident that they will fall less dramatically than the most speculative stocks and aren’t going to flame out to $0. This, combined with solid grounding in macroeconomic trends, can in fact lead to profits in an otherwise choppy, downtrending bear market.
Two Examples of Speculation vs. Investment
The recent movements in the stocks of NutriSystem, Inc. (NTRI: NASDAQ) and Occidental Petroleum Corp. (OXY: NYSE) provide valuable clues about the speculative nature of the current market environment.
Both companies posted impressive first-quarter earnings results on April 25. Both stocks have produced bubble-like returns for long-term shareholders over the past five years; pull up charts covering that time frame and you’ll clearly see what I mean. The key difference lies in the assumptions investors are making about the future prospects of these two very different companies.
NutriSystem, Inc. has all the characteristics of a "fad diet" rolled up into one convenient speculation. This business model does not involve providing "a chicken in every pot," but goes to the extent of shipping prepackaged meals for an entire month to dieters at a rate of about $80 per week. While I don’t doubt that the service has produced incredible results for many satisfied clients, this business model is highly reflective of modern American prosperity and demand for convenience. The kind of psychology that drives fads can easily reverse this contagious trend. Convenience will be near the top of the list of household budget cuts in harder times.
Prepackaged meal shipment is certainly not a proprietary operation, and analysts are giving short shrift to this consideration. Competition in the meal-planning diet business, where home delivery is now offered as an option, includes the Zone Diet, Jenny Craig, eDiets, Atkins, and many others. So the anticipated future parabolic sales growth rate implied in the current stock price is giving minimal consideration to the probabilities of future fad shifts, competition, or recessions.
Concerns about operating expenses don’t seem to be a factor, either. The key future numbers that must be discounted back to determine present value are free cash flows, not sales. Free cash flows roughly equal net income, plus depreciation, minus maintenance-level investments in working capital (like receivables and inventory) and in fixed capital (like plant and equipment). This is a far cry from sales.
Wall Street is enamored with the idea that NutriSystem has a largely outsourced business model, implying minimal exposure to cost inflation or commitment to heavy capital investment. However, the company cannot forever escape the new reality in energy pricing. Existing fulfillment contracts and shipping costs will likely be headed up in the future. This must be added to the product liability and false advertising legal risks that any company involved in the food and diet business must bear.
Insiders, comprising the executives and the board of directors, have sold well in excess of $100 million in stock since the beginning of 2006. It’s interesting that CEO Mike Hagan, who initiated a turnaround plan at NutriSystem in 2002, was a co-founder of Verticalnet, an Internet B2B bubble company currently selling for 40 cents per share, off of a split-adjusted high of $1,483 per share reached in 2000.
In addition to that experience, he is a CPA and held a senior position at Merrill Lynch Asset Management, so he knows the value of the company he is running as well as anyone. The fact that he has sold roughly $82 million worth of stock since last summer is rational considering the near-vertical trajectory of the stock price, but he wouldn’t be selling so aggressively if he really believed the financial models that Wall Street is using to sell NutriSystem stock to the public.
I am in no way advocating the short sale of NutriSystem, because these types of stocks tend to be the most dangerous short candidates. The speculators who sold TASER Intl. (TASR: NASDAQ) short at $20 in fall 2004 were just as right as those who sold short at the $33 peak that December. The key difference was whether the earlier short-sellers could sustain another 65% increase in the stock before getting a margin call from their brokers! Ditto for those brave enough to short Enron and Tyco in the late 1990s. Timing, nerves of steel, and emotional detachment from money are essential to being a good short-seller.
Occidental Petroleum Corp.
The valuation case supporting Occidental Petroleum is far easier to make and has behind it one of the most powerful trends transforming the global economy — the increasing demand for fossil fuels. This company’s activities have helped make "a car in every garage" economically feasible in 20th-century America.
This increasing global demand is coming at a time when the rate at which crude oil and natural gas can be extracted from the earth cannot quite seem to meet the rate demanded by the market.
As longtime Whiskey readers are well aware, the prospect of Peak Oil stands out as one of the most, if not the most, daunting 21st-century challenges to societies and economies around the globe. I refer you to Byron’s April 26 piece, entitled, "Letters to the Editor: Planning, Policy, Strategy, and Energy."
Good planning by management has led to the fortunate situation whereby Occidental has forecasted hydrocarbon production growth in the 10% range in 2006-2007 and in the 6% range from 2008-2010. This is something that can be predicted a few years out with a relative degree of certainty (not counting political risk) by various parties, and the actual demand for the finished products is not going away.
Competition in the business of extracting oil from the earth is dominated by the overwhelming market share of national oil companies (NOCs), not greedy oil companies conspiring to rip us off at the gas pump. The NOCs, particularly those who are members of OPEC, would have flooded the market with oil a year or two ago if they were capable of doing so, given the highly profitable pricing environment. Again, Byron’s article gives a succinct summary of why this has been the case.
Libya is not on Byron’s list of major oil exporters facing serious problems. In fact, the country’s fields had minimal exploration during the 1986-2004 period, when the United States imposed economic sanctions on Moammar Gadhafi for his regime’s support of terrorism. Gadhafi’s eventual public abandonment of WMD programs led to the lifting of sanctions and allowed Occidental to return to its producing interests in summer 2005, on the same terms that the company signed with the Libyan government in the 1980s.
On a base that consists of stable, long-lived fields in the Permian Basin of West Texas, management has committed shareholder capital to attractive high-growth potential oil and natural gas projects in Oman and Qatar and remains an active buyer of lower-risk acquisitions in their core geographic areas.
Occidental’s proposal to construct an LNG terminal near Corpus Christi, Texas, was recently approved, and construction is planned for later this year. Shipping LNG from Qatar, where it is cheap to extract, to the United States, where it is expensive to extract (and where the "low-hanging fruit" of domestic wells has already been picked), will help alleviate future spikes in U.S. natural gas prices and likely be judged as a very insightful and profitable use of shareholder capital. The chemical segment is more correlated to the global economy and feeds end markets that consist of plastics and resins, but it consistently generates free cash flow.
Risks to future free cash flow include declining oil and natural gas prices and inflating expenses, primarily driven by the availability and terms of drilling rigs and the generalized inflation occurring in the market for oil field capital equipment and labor.
The stock is highly levered to the price of oil: Crude represents 85% of its hydrocarbon production. Management has also communicated that future acquisitions will take priority over dividends and stock repurchases when they decide upon free cash flow uses.
Peak Oil would gradually transform Occidental into a company that produces such dramatic growth in free cash flow that it could be viewed as a bond whose coupons are continually reinvested in high-rate-of-return projects. The value of such a bond would be significantly higher than the current market price of $105 per share, only I would expect it to be recognized over a long period of time, rather than overnight.
Based upon the company’s 2005 free cash flow generation of roughly $2.9 billion, or $7.12 per share, this amounts to a yield of 6.8%. Only instead of shareholders receiving this entire dollar amount as a cash dividend, most of it will be reinvested in future growth.
Even with the consideration of all its risks and the probability of a short-term drop in the price of oil, this stock is a more sound investment than buying and holding 30-year Treasury bonds, currently yielding 5.2% (coupon payments from bonds are fixed in the future, and are guaranteed to have their value eroded by future inflation).
And in Conclusion…
So what was Wall Street’s April 25 reaction to NutriSystem’s and Occidental’s excellent earnings announcements? NutriSystem stock was up 34% as short-sellers scrambled to cover their positions, while Occidental stock was down 1%.
What does this tell you about speculation versus investment in the stock market?
Maybe "a chicken in every pot and a car in every garage" was a good enough aspiration for the economy of the Roaring ’20s, but it looks like a campaign slogan for the new millennium should be modified to "convenient, tasty food delivered to every doorstep and unlimited cheap oil to fuel multiple cars in every garage."
Dan Amoss, CFA
May 3, 2006