Sock it to 'em Sarkozy

Nicolas Sarkozy won a bruising battle over his socialist rival Segolene Royal for the Presidency of France with 53% of the vote to 47%. This was as the polls and the betting parlors were predicting. I will limit my comments on the elections because I have written two previous pieces on the importance of the French elections to the global economy, but I would like to comment on the commentators. The main stream media in the US and abroad is essentially saying that Sarkozy's election does not mean much because the French are the French, and they have it pretty good. Nothing could be farther from the truth. France is bleeding from both ends of the financial spectrum and they know it. There is virtually no hope of landing a meaningful job for young immigrants in the country. They have become a permanent non-working class, and increasingly violent. Yet, their existence is subsidized by the wealthy, where taxes can reach as high as 72% of income. In recent years, the wealthy have been voting with their feet and moving to lower-tax countries. Sarkozy is very direct and he believes he has a mandate to get people off the dole and put them back to work. This will not likely be an easy job in a country that has large segments of the population that are anti-capitalist and rally under the banners of communists, socialists, and, yes, even anarchists. France is a colorful nation in every way, even in it politics. I am more optimistic than many and my reason is this. If the French are anything, they are proud. Indeed, they are the originators of the products that epitomize fine living: perfume, wine, design, architecture, cooking, etc,. Increasingly, these products and services are beyond the budget of the average French citizen, and there is a growing recognition that the bon vivant lifestyle that the French brought to the world is now slipping from their grasp. Sarkozy will have a very difficult time in putting France back to work, but he is said to be a very tough minded person, and I believe he will bring increasingly seen by the French as a man who can help them reclaim their glory. Recently, we bought our first French company, Axa, one of the world's largest insurance companies. We see two or three other French companies that we like, and if we can get them at our price, we will add them as well. Blessings,

Slowing Economy, Rising Stock Prices, Part 2

Greg Donaldson and Mike Hull write:

In our October 27, 2006, blog we wrote that while the economy would likely continue to slow, US and international blue chip stocks would likely continue to rally. The following is a quote from that piece:

"Markets seldom feel right because we human beings have a habit of projecting today's headlines onto tomorrows stock performance. Remember, the stock market is not a democracy. Prices move in the direction that big money pushes it. Fortunately, big money is normally rational and understands economic cycles and the power of the Fed to slow and speed up the economy.

Big money has a problem. The places where it has been treated well over the past few years are all rolling over. Treasury bonds yield are under 5% in most of the major industrialized nations of the world. Bonds simply are not competition to stocks. Real Estate and commodities are no longer competing effectively for investors against stocks because they are now in downtrends.

Blue Chip stocks, alone, stand out as a value now that bonds, real estate, and commodities have become over owned and over valued. Finally, blue chip stocks are in an uptrend. This positive momentum is a rarity in today's world's financial markets. As long as earnings growth holds near 10%, stocks will continue their strong advance."

Since we wrote that piece, stocks, as measured by the Dow Jones Industrials, have risen nearly 12%, including dividends, (an annualized return of over 20%) while the US economy has slowed to under 2% real growth.

And here's the answer to the question we are asked most often: Yes, stocks have room to go higher and the path of least resistance is up for the same reasons we explained in our October 2006 piece -- stocks are still cheap and they have no competition from other forms of investment. In addition, with economic growth having slowed and inflation cooling, the Fed is poised to begin lowering rates sometime in 2007.


The chart below shows our most recent update of our proprietary Dow Jones 30 Dividend Valuation Model.


As you recall, the Dividend Valuation Model is a single formula that is constructed from the associations between dividends, interest rates and prices. You might think of the green bars as the values predicted by the normalized relationship among the data points. The actual prices are shown as a blue line.

It is important to keep in mind that every green bar on the chart, which goes back 25 years, is produced by the same formula. By comparing the green bars, which we call "value steps," and the actual prices, it is clear to see that the fit is very tight.

The key areas to note on the chart are the late 1990s, when the value steps clearly showed that prices were overvalued, and the DJ 30's turn in 2002, which occurred almost precisely on the predicted "value step."

Since 2002, the chart shows that, even though actual stock prices have risen sharply, they have remained consistently in undervalued territory. The model currently predicts that fair value is near 14,100. That would be our best guess of where the market runs out of value, and where we would become less bullish about blue chip stocks.

Finally, the recent run up in stocks has been met with fear and not greed, as is the usual case in run ups. Everyone is now talking about pullbacks and the old adage of,"sell in May and go away." We have found that when USA Today or your local newspaper starts telling you to "sell in May and go away," that it might not be a bad idea to "buy in May have a nice payday by Labor Day." Granted its not as catchy as the original adage, but we suspect it will be more profitable approach this year.

Blessings,

Why the French Elections Matter

From an economic perpective, France matters because the European Union (EU) matters and the EU matters because it now totals 495 million people in 27 countries and has an economy larger than that of the US. The European Union is fast becoming a power in the world's economic order. Yet, while it has mass and some clout, because it comprises 27 different countries spread over thousands of miles and many languages, it does not have a unified political or economic structure that has been able to drive the big ideas in the world. France is not one of the largest members of the Union, but it has a prominence in the EU that gives it a cachet far greater than its size. France's prestige and importance come from three things:

1. It was an originator and charter member of the EU 2. France has long promoted the "third way" or middle ground between the US and its foes around the world. 3. France is a squeeky wheel in terms of its culture, language and desire for a position of power on the world stage. While France has authentic prominence and a clear desire to lead the EU, it's leadership has been thwarted because it has lagged most of the other nations in the EU economically. I described the reason for that last time: a lack of faith in the free and flexible markets for commerce and labor. Many observers now believe that the economic malaise in France has reached the proportions that the French people are willing to give up some of their state-sponsored security blanket for the greater economic growth and employment gains that they see bubbling up in countries that are following a more free market approach. If France moves politically and economically to the right, by electing pro-business Nicolas Sarkozy over socialist Segolene Royal, the entire economic world will be the winner, and Sarkozy will assume almost an immediate leadership role in the EU, and consequently the world.

France and much of Europe has tremendous untapped growth potential that is likely to blossom if Sarkozy can lower taxes on entrepreneurs and deconstruct France's maze of job-stifling limits on employers' hiring and firing flexibilities.

Over the past decade, the EU has grown at only about half of the rate of the US, England, Canada, and Australia, where more pro-business policies are in place. With a pro-growth President in France leading the way and offering the proper incentives, the EU could increase its rate of growth by nearly a third.

Finally, as country after country in the EU has adopted more business friendly policies, we have shifted more funds into companies in the region. We now hold between 15% and 20% of our equity assets in European companies.

If Sarkozy wins, we believe the opportunities for continued stock appreciation from companies in the region are greatly enhanced.

Below is the most recent Intrade.com betting line on a Sarkozy win in the election. It has risen from near 70% last week to near 80% today. Bettors are not necessarily voters, but these betting lines have been remarkably accurate in recent years.

I'll keep you posted on the outcome.

Ronnie,Maggie, and . . . . . . Sarko

The French go to the poles in the first of two rounds of voting for a new President this Sunday. The stakes could not be higher for this fading member of "old Europe." The twelve candidates running in the first leg of the voting, who represent everything from communists to Joan of Arc, will be pared down to a short list who will then face off again in two weeks. There are three candidates who are leading in the poles, Socialist Segolene Royal, Francois Bayrou, the centrist, and Nicolas Sarkozy, the conservative. There are more twists in this election than we would have in the US in five elections, but I want to comment on the eventual winner, who I believe will be Sarkozy(nickname Sarko). He is speaking Reaganesque, and the average Frenchman, no matter what they think of the US or Sarkozy, for that matter, knows that he is telling them the truth -- they live in a failed economy. French economic growth is among the weakest in Europe and less than a third of that of the US; unemployment is near 8.5%, almost twice that of the US and England, and their brightest and wealthiest citizens are leaving the country for lower taxes in Belgium and around the world. In an interview with the "New Yorker," Sarkozy said the following: " “In this country, work isn’t encouraged, it has no value. We’re in a crisis that comes from a very false idea of solidarity—the idea that you have to give as much to the person who doesn’t work as to the one who does. The élites have been wrong about this for decades. They have betrayed the idea of equality and given us egalitarianism.” I[ the "New Yorker" author speaking] brought up the grim projects across the ring roads of every French city—hundreds of neighborhoods where young people are so disaffected and angry that the police are reluctant to enter, and where Sarkozy himself is largely unwelcome to campaign. “The voters there aren’t scared of me,” he said. “They are the ones who ask me to do something. Why else am I in first place in the polls? I have been interior minister for five years. I am efficient. I get things done. I say this in my campaign: the risk isn’t change, the risk is to refuse change.” Sarkozy is saying exactly what Ronald Reagan and Margaret Thatcher said in the 1980s: that too many people are riding on the wagon and too few are pulling the wagon. France, absolutely, must give incentives for people to get off the government dole and disincentives for them to stay on it. Sarkozy is the only major candidate who remotely understands economics. He is the last best hope for France. If he loses, France, as we know it, may become nothing more than a kind of Disneyland of Europe -- beautiful old buildings, immaculately cared for, with lots of visitors, but everybody goes home at night. If the bettors can be believed, Sarkozy has a commanding lead. The chart below shows that at the online betting site, Intrade.com, he is favored by nearly 70% of the betting crowd. For the entire world's sake, let's hope they are correct. The French may be finally coming to terms with the abject falsehood of Leon Trotsky's assertion that capitalism would die under a workers' revolt. It is ironic that there now appears to be a "non-workers" revolt underway in France that will drive a stake in the heart of Leon, Karl Marx, and Frederick Engels.

US Bank's 80% Pledge -- A New, Old Idea.

US Bank (USB), the big Minneapolis based bank, has a continuing pledge, which they reiterate periodically, to return to their shareholders 80% of their earnings in either dividend increases or share buybacks. I know of no other company that has this specific a pledge. REITs, of course, by law must pay out 90% of their earnings, but USB is unique, as far as I know, in communicating a commitment to shareholders that even my elderly mother sitting in a small town in Indiana can understand. Pledges like USB's were common place in the early days of stock trading in the US when early traders on Wall Street gathered under the buttonwood tree. They had none of today's ever lengthening list of rules and regulations. Yet, somehow they made deals and bought and sold securities based on the "word" of the men who ran corporations in those days. Those were the days of "a man's word is his bond." Today things have changed. Now its "A man's bond is his contract, unless he or she can find the loop holes." I personally believe that salt-of-the-earth Americans are near a tipping point in their level of trust for corporate America and Wall Street. The images of both have been sullied by the incessant news of broken promises and broken laws by the people we have hired to run "our" companies. In company after company "fast and loose" is not a bad word; it is a way of life. The attitude seems to be: "D__n the shareholders. "Whose company do they think this is, anyway?" US Bank with their Midwestern mindset must be hearing the same things we are, and they are responding the way plain talking Minnesotans and Hoosiers do, by eliminating as much "maybe" from their conversation with their shareholders as possible. I think USB's 80% pledge will catch on with other companies trying to distance themselves from the bad actors. USB is a AA rated company that is currently yielding 4.7%, and over the last 5 years, they have raised their dividend by an average of 15% per year. We have been buying USB in our Income Builder style of management.

Pssst, You Wanna Buy a Company?

There are three forces driving the incredible buy-out binge of the private equity firms: 1.) low interest rates, 2.) strong free cash flow growth of corporations, and 3.) the Enron-Sarbanes, Oxley effect. The first two forces are self explanatory and offer the opportunity for the buy-outs. Point three needs some discussion, but at its end, provides the motivation by all parties to do the buy outs. Sarbanes Oxley is the law that, among other things, requires CEOs and CFOs to certify all financial results under threat of criminal penalties. This law was passed by Congress in response to Enron, Worldcom, and the other corporate and accounting scandals that came to light in recent years. In short, Sarbanes -Oxley's only reason to exit is investors' mistrust of accounting and financial reporting in corporate America. Indeed, this mistrust of corporate America, which is both real and growing is the linchpin that holds the private equity juggernaut together. Is it any surprise that the recent explosion in private equity buyouts has coincided with the latest corporate scandals involving the back dating of executive options. The legacy of Enron, et al., means that investors must "discount" all corporate financial reporting for the possibility that what they are seeing "ain't" what they are getting. This discount is imposed on the entire market in a "one-bad-apple" effect and dampens how much investors are willing to pay for earnings. My PE model indicates that the Dow Jones Industrials should be trading at about 17 times earnings. It is now selling at under 15 times 2007 earnings. Now comes the private equity crowd with solutions aplenty. They offer to pay a premium for the "good-apple companies," which pleases the shareholders. (In truth, however, they are really only paying what the market price would have been in ex-Enron days.) "Good apple" corporate managers, who in another day would be fighting the private equity crowd, now become their apologists because they are offered their current jobs and bonuses, and they can leave Sarbanes-Oxley behind because its onerous rules do not apply to private companies. Finally, the private equity firms make their investors happy because they are buying companies on the cheap, and in 3-5 years, they will be able to resell the same companies back to the same shareholders for a 100-200% profit. Einstein is reported to have said that the greatest invention of all time was compound interest. He obviously had never heard about these private equity deals. I make the private equity crowd out to be sharks. They are not. They are just shrewd capitalists taking advantage of the fears and doubts of post Enron investors. But there is a sign that the perfect storm that the private equity firms have been riding is coming to an end. Blackstone, one of the largest private equity firms is going public. Let me say that another way: Blackstone, one of the smartest outfits on the planet is now willing to sell a piece of itself to the public and thus, become a public company, governed by Sarbanes-Oxley. I wish Mark Twain were alive today to give us a pithy quote.

A Few Thoughts About Private Equity

As I write this I am admiring the Cascade Mountains of Oregon. It is 17 degrees outside. It was 80 when I left Indiana. Gee, you mean you can't believe the Weather.com's predictions for Oregon's mountain country? With all this time on my hands that was supposed to be dedicated to learning to fly fish, I find myself just staring at these magnificent mountains while random thoughts flow through my mind. The thought that keeps appearing most often is,"What do all of the private equity deals mean?" Are they a good thing, or a bad thing. Are they an indication of just how cheap the market is, or are they just one more Wall Street gimmick that is going to crash and burn one day? Obviously, our firm has been collectively thinking about this for a long time. But in recent weeks, the buyouts have reached the point where Kohlberg Kravis Roberts, Blackrock, and Texas Pacific seem to be buying a company a day. These are high risk players, but they are obviously not fools. If you would have told me a year ago that companies as diverse as Biomet, TXU, The Tribune Companies, First Data, and Equity Office Properties would all be bought out by private equity firms in the span of six months, I would have told you that the Dow Jones Industrials would be over 14,000, maybe pushing 15,000. Something just does not add up about the rampant, almost frantic, pace of the buyouts and stock market's apathetic attitude towards it. Let me see, last month the markets sold off 5.5% in about a week. At the very same time, large buyouts were being announced almost everyday. Don't investors realize that the private equity money is only buying companies where cash flows over the next 5-10 years are expected to produce an annual rate of return of 15%-20%. Don't investors realize that this onslaught of private equity buyouts is going to keep rolling until prices of US stocks are much higher, and thus, puts a floor under any big market correction? But, as I sit here pondering the disconnect between big money buying everything in sight and the stock markets trading at PE multiples about the same as they were at the bottom of the bear market in 2002, I catch a beauty of a thought. If it's correct it might answer both behaviors. Let me sleep on it and I'll see if it still makes sense tomorrow. My wife just came in with snow shoes and a hiking map. She says we are adapting.