Second Quarter Report 2011
Sell in May and go away! That phrase is an old Wall Street saying about the stock market and for this year it has been very accurate. The stock market was down for seven straight weeks before rallying the last week of June. Our accounts that we manage for you took a hit in June as well and we will go into detail about what we think we will be doing next. Our long-term view of the economy and the stock market hasn’t changed (we think it goes up), but after the market mess in June we need to elaborate a little about our market views.
So what has the world so scared these days? The answer would be Greece and we don’t mean the movie but the country. Greece has been in default on its public debt for about half of the last 150 years. The country has been a fiscal basket case for years and it continues to be that way today. Greece is bankrupt and there are no easy solutions to fixing this problem today. We have a view on how all of this is going to play out. We will use the last country to go through a mess like Greece is in today which is Argentina as our case study. We think the timeline for what happened in Argentina in 2001 will be fairly similar to what Greece is going to experience. To stop inflation in Argentina their government adopted a currency peg in 1991 that linked the value of their peso to the U.S. dollar. Each peso was worth a dollar and this peg kept their central bank from printing more pesos than they would have if they hadn’t linked it to the dollar. The problem with a system like this is that unless you link your fiscal policies and monetary policies to the country with which you peg your currency to, a peg system will not work. An everyday analogy of this mistake would be linking my bank account to Warren Buffett’s in how much money we can spend; there is a slight difference in what he can spend at Tiffany’s and what I can spend. The Greek country was admitted into the Euro without linking its fiscal or monetary policies in 2001. Each Greek Drachma was exchanged for a Euro at the time of the monetary union and the Greek drachma ceased to exist at that time. For about eight years each country enjoyed low inflation and low interest rates and life was good. To enjoy this new found prosperity the people of Greece and Argentina decided to borrow more money than they should have. The markets were willing to lend them the money based on the idea that each peso or drachma was worth a dollar or a Euro. Both countries’ piled on more debt than they could pay for and eventually the markets noticed. At this point the powers that be called in the IMF (International Monetary Fund) to try and fix this problem. The IMF decided it would lend more money to Argentina in 2000 IF THEY would adapt austerity measures (i.e. cut spending and raise taxes). The IMF showed up with the same plan in Greece in 2010. Both countries quickly passed austerity measures that were not popular with their voters but they did it to get new money from the IMF which would keep them from defaulting on their debts. The markets cheered and the crisis was declared over (except it wasn’t). Starting in 2001 the austerity measures that Argentina passed didn’t pan out and their economy continued to do very poorly. The same thing happened to Greece in 2010. Starting in late 2001 the Argentine people started pulling their money out of the banking system in Argentina and sending it overseas before the Government could stop them. Starting in December of 2001 the Argentine government froze the public’s bank accounts and said “You can’t send dollars out of here anymore to overseas accounts”. This act was the beginning of the end of the peso/dollar peg. The
public in Argentina which was already fed up with austerity measures to pay the foreign banks rioted on December 19th and 20th. The riots were so bad the president of the country resigned. On January 1st of 2002 the Argentine congress elected a new president. On January 6th the dollar peso peg was broken and the crisis ended three months later.
As I write this the Greek public has pulled between 8 to 20% of their money from the Greek banks depending on whose estimates you want to use. If the Greek monetary authorities do what the Argentines did we are going to see a freeze on bank withdrawals from Greece sometime this year. Once that is done the next step will be for the Greek government to convert those Euros to drachmas and pull out of the European Union. In Argentina each dollar in 2002 was converted to 1.40 pesos if you left the money in the bank. If you were smart enough to pull the money from the bank before they froze your account you could get 3 to 4 pesos per dollar in the black market. This conversion disparity is one of the main causes that sparked the riots in Argentina that toppled the Government. If you watch the evening news today you know they are already rioting in Greece but their banks have been kept afloat with loans from the European Central Bank which is a plus that the Greeks have that the Argentines did not. That said, the Germans and the French who control the European Central bank don’t want to give Greece anymore money and neither does the IMF. So as I write this, the world is waiting to see how it all plays out. Our best guess is that the Greek politicians will pass another austerity measure; the people will riot worse than they have ever done later in the year, the president will resign and Greece will leave the Euro which is what happened in Argentina. We don’t see any PAINLESS way out of this mess for Greece unless the other members of the Euro want to give Greece money for the next 50 years to help pay off their debts. I don’t see that money transfer happening for long but for now the market thinks it will happen. Under certain circumstances we will try and buy some stocks in Greece depending on how this divorce occurs. We will keep you abreast on what we do there if anything.
The reason the world stock markets have been going down since May is the fear that when Greece defaults on its debt we will have a run on the banks similar to what happened when Lehman brothers went under in 2008. We don’t think that is going to occur because the world monetary authorities are printing plenty of money to stop a run on the banks right now. As a quick reminder, virtually ALL of Latin America went bankrupt in 1982. The majority of our major U.S. banks were fully invested in those countries and yet the U.S. stock market was up 50% two years later. Our banks were bankrupted if they marked those loans to market in 1982 but the politicians/regulators just lied and said those loans were good until the banks could deal with them six years later. The same scenario happened during the Asian crisis in 1997 with our market going up 50% two years later and the regulators postponing the recognition of losses for years. Our guess is that when Greece acknowledges that they are broke the accounting authorities will still recognize the Greek debt at an artificially high value to keep the banks from having to write them down. We have case history on our side on how they will deal with this and I don’t think they will rewrite the playbook this time.
Let’s talk about our stocks for the first time in awhile and get off of world affairs for once (and the crowd cheers). In our year end letter we threatened Level3 with the following comment, “For the record we think they need to grow their CORE REVENUE by about 2% EACH quarter to make us happy”. In their first quarter which is their weakest quarter of the year they grew revenue by 1.3% which made us smile a little bit. What has cheered us up on this company is the merger they announced with Global Crossing in April. This deal is going to fix their balance sheet and finally put us on the road to some pretty big growth rates if they don’t screw it up. Level3 is going to have some money to spend to grow this company and there are a lot of companies who need bandwidth right now. We also think the merger allows them to consolidate the long-haul business in a way that gives them pricing power down the road when they negotiate their contracts with Google, Facebook and Netflix. We hate to say anything nice about Level3 since our angry statements were made when the stock was 98 cents and its now $2.29. They appear to respond to threats so we will shut up and report on them more after they report earnings in July.
We have been waiting five years to buy a housing related stock and we finally got the signal to buy one this quarter. Our first purchase was USG at around $14. They sell wallboard and housing related stuff for the construction business and their orders collapsed when housing collapsed in 2007. We are making a call that the housing market is bottoming out and we wanted to pick a company that is very sensitive to a turn in new construction. Forty percent of USG’s sales are to new homes and we think the bottom is in for how bad residential real estate can get. We have been working on the housing industry since 2007 to predict when the bottom might come and our indicators say it’s here. We don’t think that in this cycle we over built homes this time like we did in the cycles of 1973 and 1991. We actually think we built fewer homes nationwide in this cycle than we did in previous cycles which may surprise some of you. The BIG difference in this cycle is that Wall Street allowed you to over leverage your home to a ridiculous degree which we didn’t or weren’t able to do in 1973 or 1991. It is this over leveraging or extending of credit using your home as collateral which has caused home prices to plummet more in this cycle compared to the others. We have been at 60 year lows in housing construction now for about two years so the supply of new homes has dried up dramatically. As the U.S. dollar declines in value we are also seeing foreign buyers come in and buy houses for cash which is helping to soak up excess homes in California, Arizona and Florida. We have mentioned our new found bullishness on housing to a few clients and friends and so far everybody thinks we are nuts. Nobody likes this idea right now. This is usually a good sign that we are not over paying for these companies because nobody else wants to buy these stocks. Our timing might be early but we like our odds of being right here long-term. We plan to increase our exposure in this area over the next year by selling some of our current holding to buy into this area. Two of our poorer performers this quarter were Berkshire Hathaway and Corning. Berkshire is a very large position of ours and we don’t like it when it goes down but we are not concerned with them. We think the decline in the stock is linked to how many catastrophic disasters there have been this quarter that will hurt them on the insurance side of their business. From time to time this happens and it’s just the risk you have in running an insurance company when a 9-11, Katrina or Tsunami occurs. In the past when these disasters hit the insurance industry raises prices to recoup their losses and Berkshire ends up making more money than ever. If you want proof of this type of behavior wait until you get your renewal rate in Missouri for your home and car insurance after what happened in Joplin. I doubt your rates go lower. Berkshire also has a lot of housing related investments that have been doing poorly
lately but as you now know we think that is turning around. As for Corning the market is worried about saturation in big screen TV’s in the U.S. I think there is some truth in that but I think the stock price adequately reflects that risk. One of our fine employees just bought a 70 inch big screen TV so in the U.S. we may not be buying as many TV’s as we use too but we sure are buying bigger ones that use Corning’s glass. Corning also has a new product coming out for big screen TV’s called gorilla glass that we think will help their sales as well. So for now we continue to buy more Corning while betting on moderate growth in big screen TV’s in the US and Asia.
Two other stocks that I want to mention that have been struggling lately have been Wells Fargo and Wal-Mart. Wells Fargo is also a company that will benefit from a return to residential construction. The company has done ok on the earnings front since the crash without any help from the real estate market but investors don’t seem to care right now about that. Wells Fargo has no Greek bonds or assets but in Wall Street’s eyes if Greece fails so will a lot of U.S. banks and Wells is a bank. As you know from our writing above we disagree with that logic but right now the market doesn’t care what we think. We think Wells is a great bank and will do better and better as the economy turns around and Greece gets fixed. Because Wells Fargo is also the largest originator of home loans in this country it’s also a sneaky way to bet on housing. Another negative factor this quarter for the large banks has been fear of what the new regulatory capital requirements will be for large (too big to fail) banks. The largest banks in the world may be FORCED to raise more capital in the next five years to back up their loans. This never ending regulatory assault on banks has slowed down the world economy because the banks have slowed down their lending of money until they know how much money they need to hold on their balance sheet to back up each loan. If banks don’t lend, the economy doesn’t grow. For better or worse we should know in Q3 of this year what the new capital levels are which should increase bank lending once they know what the new rules are. Wal-Mart has been frustrating for us lately. Every once in awhile big company’s do dumb things and Wal-Mart is in one of those spells right now. About three years ago they decided to limit the amount of inventory they carry to increase their inventory turns and speed up their cash conversion cycle. To help tick off their clients even more they also decided to raise prices on their non sale items. The problem with limiting your inventory is that as Wal-Mart limited the selection that their customers had, their customers started shopping at other stores to get those items and their store foot traffic declined. The limiting of inventory in their stores was a dumb idea by upper management (Why build big stores and then not fill them?) and they realized it this year and made changes to bring the extra selection back to their customers which will take time to implement. It also takes time to get those customers to come back and look for those items you discontinued. The other mistake they made of raising gross margins to make more money is also coming back to bite them. By raising prices they have allowed Dollar Tree, Dollar General, Aldi’s and a host of other “dollar like” companies to come in at the low end of the market and attack them. They swear they are going to stop this by lowering gross margins to fight their new found competitors. As we see it, this is going to take about a year to show up in their U.S. returns because of how big Wal-Mart is. When you are as big as Wal-Mart your sales growth will be in line with what the unit growth of GDP is in this country, which is around 2% right now. If you cut prices by 3% and your unit growth in the U.S. is only 2% you are going to have a negative sales comparison until the year is over. This is what we think is happening to Wal-Mart in the U.S. and in about 12 months we should be passed this. Fortunately Wal-Mart is doing well internationally which is around 30% of their sales and that should carry us until we get passed this period. The stock is cheap and we will continue to hold it until they get passed this self induced mistake. Wal-Mart currently pays a dividend equal to the ten year Treasury note which does help us while we sit and wait.
In closing it has been a messy second quarter very similar to what we went through last year with Greece and the Flash Crash. We will sit through this period owning stocks like we didn’t last year because our macro system is still very positive and our valuation system for common stocks is still cheap based on the last 20 years of history. We think the stock market this year, like last year, is a better place to be than bonds, cash or commodities. If you have any question on any of this please give us a call (417- 882-5746).
One house keeping note, Mark is going on his first two week vacation of his life in August to celebrate his 30th wedding anniversary. He will be in Europe the second and third weeks of August. Though he will have internet access somewhere in Europe he probably won’t use it much or there won’t be a 31st wedding anniversary. Kelly will be gone the first week of August and we are waiting to hear what Brandon is going to do. We don’t anticipate any macro changes that will need to be made during this time frame but we wanted to let you know when our vacation time is if you want to get a hold of us ahead of time.
Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR