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.

John Burr Williams: Investing Versus Speculating

John Burr Williams believed that the stock market was far more volatile than the long-run dividend paying abilities of the underlying companies would justify. This fixation with the short-term, led to periods of gross over and undervaluation in stocks, which, in turn, led to booms and busts in the economy. Williams believed that the cycle of booms and busts caused many people to lose faith in the free market economy and the markets, which ultimately led to the socialist-like economic policies of the 1930s. His book was not about beating the market, or getting rich in the market, it was really a wake-up call to the investment elite of his time to offer them a theory of investment value that would encourage more long-term investing and less speculation. Williams realized that speculators would always be with us, and were a legitimate enterprise, but he wanted to provide tools for investors to aid them in making decisions based on the “investment value” of a company, not just its price momentum. Williams postulated that investors’ inability to properly value stocks, increasingly, led them to become speculators. Most people would not admit that they were speculators, but when they were asked to explain their buy and sell decisions, it was clear that they were not appraising the intrinsic value of companies, but betting that they knew something that the market did not. In one of Williams’s most insightful observations, he makes the following statement: “To gain by speculation, a speculator must be able to foresee price changes. Since price changes coincide with changes of marginal opinion, he must, in the last analysis, be able to foresee changes in opinion. Successful speculation consists in just this. It requires no knowledge of intrinsic value as such, but only what people are going to believe intrinsic value to be. . . . Hence, some old traders think it is a handicap, a real handicap, to let themselves reach any conclusion whatsoever as to the true worth of the stocks they speculate in. How to foretell changes in opinion is the heart of the problem of speculation, just as how to foretell changes in dividend is the heart of the problem of investment. Since opinion is made by the news, the task of forecasting opinion resolves itself into the task of forecasting the news. There are two ways to do this: either cheat in the matter, or study the forces at work. Cheating has been outlawed, so far as can be, by the Security Act of 1934. The other way to forecast the news, and thus the change of opinion and the movement of prices, is to study the forces at work, in the belief that ‘’coming events cast their shadows before.’ But, rare is the man so sagacious as to foresee, so certain as to believe, and so steadfast as to remember; he who is makes a good speculator. Every speculator’s life is strewn with regrets, vain regrets for the news that he did not understand until it was too late. That ‘time and tide wait for no man’ he knows full well; like a bird on the wing must be shot in a jiffy, or she flies out of range forever. Hence, the first speculative opinions are usually wide of the mark, and as such, they usually need to be revised by the later trading of those who have had time for a sober second thought.” John Burr Williams was not condemning the speculators, but he was trying to open the eyes of investors to the fact that, as Ben Graham said, “In the short run the market is a voting machine (popularity contest), while in the long run it is a weighing machine (measure of value).” This is the sum total, essence, bottom line, and raison d'etre of Donaldson Capital Management. Long-term values of companies are determinined by what you can get out of them. That is why we scrutinize dividend levels and dividend growth. This is where value is created. This is where value can be measured. Finally, this is where we can find opportunties. Opportunities that are being shunned because today's news is not positive or is murky, but opportunities that have already discounted all the bad news and now stand ready to rise, driven by the intrinsic value of the company. Amen

The Fed Still Listens to Mr. Greenspan

As expected, the Fed just announced that they are leaving interest rates unchanged. What did bring a smile to the markets' and to former Fed Chairman, Alan Greenspan's lips, was the very slight change the Fed made to their "leaning" language. For the last six months, they have proclaimed a balanced attitude between the forces of inflation and economic growth, and that "leaning" caused them to end their long string of rates hikes. In today's announcement, their "leaning" language shifted ever so slightly to more concern about slowing economic growth than inflation. As I said in my last post, that is what Alan Greenspan has been advocating, and, apparently, Mr. Greenspan's former charges were looking at the same economic data he was. Even this morning, I read where several noted economists were advocating a rate hike because of the high core CPI rates. They don't live in the real world. The economy has entered a slowing phase which often causes inflation to blip higher because of lost productivity. Thus, to look only at inflation statistics is to look in the rear view mirror. The real picture is being played out in the unfolding crisis in the subprime lending arena. The Fed and Mr. Greenspan know that this crisis will spillover in some way at some level into the prime real estate market and slow the overall economy. Remember this: Greenspan does not use one of those fancy GPS navigational instruments to pilot his car. He watches the road. The road is a lot more unforgiving and confounding than the GPS map, which does not show pot holes, stoplights, or other two-ton cars that may have lost their way. I believe the Fed has now signalled that they will soon cut rates. This poses a conundrum. The economic news and corporate earnings are likely to soften over the next year, but US stock prices are likely to continue rallying. Just as core CPI lags the actual underlying trend of inflation, US GDP growth lags changes in interest rates. If the Fed is poised to cut rates, that will be favorable for stocks even if the economy and earnings begin to slip.