Archive for April, 2010

Headwinds and Tailwinds

In the last Peachtree Quarterly, I discussed the strength of the recovery in corporate profits and how that recovery can lead us to continued healthy gains. Now, in order to give proper balance, I think it is only prudent to discuss some of the headwinds we are facing, cyclically as well as structurally. I call these the Triple Cs.

Congress

With the passage of the health care reform bill, we are witnessing a reshaping of our health care system by our government. I think this issue can be broken into two parts: the concept and the execution. Whether you support Obamacare or not, I hope we can agree on the validity of the concept. For our society to function properly, we must ensure that our citizens have access to health care. As I see it, the question is not whether this humanitarian concept is good; the issue is execution. It remains to be seen whether our government actually will streamline the costs of future health care with this new, far-reaching program.

The cost of bigger and bigger government programs, including health care reform, is structurally large deficits as far as the eye can see. It doesn’t seem to matter whether it’s the Democrats or Republicans in office; our elected officials are spending our hard-earned tax dollars like drunken sailors. When the country is running trillion-dollar deficits, it is difficult for foreign buyers to have a great deal of confidence in our marketplace. If health care reform fails to live up to its cost-saving and deficit-reducing promises, it will add to this deficit problem, which threatens our short-term recovery as well as the long-term financial stability of the nation.

On the other hand, I think there is at least a possibility that the health care changes might have benefits for the economy in ways that are not yet obvious. For example, many middle-aged Baby Boomers are holding onto jobs because they are worried that they could not get insurance on their own. Some of them might decide now to retire or to consider an encore career, which would open more jobs for younger people. Similarly, how many people of any age might feel free to explore their entrepreneurial ideas, once their concerns about health care are eased?

Of course, health care is not the only item on the agenda for the president and Congress. They are being very proactive on the legislative front, considering a number of new programs as well as regulatory changes. And let’s be honest, reducing the deficit almost certainly will require some combination of cutting spending and raising taxes. We hope that this ambitious agenda does not result in any serious policy mistakes.

Consumer

Consumers are too often underwater and rehabilitating only slowly. New home sales hit another all-time low in February. Gas prices are once again climbing in advance of the summer driving season.

With high unemployment, banks still stingy to loan money to small businesses, and a continued lack of confidence about the future, it will be difficult for this part of the economy to lead us to prosperity in the short term. Coming tax increases will only serve to further slow the consumer recovery.

Corporations

It is a different story with corporations. Across the globe, industrial activity continues to recover. Profits and assets in cash are literally exploding for corporations. Corporations ended last year with 11.4% of their assets in cash. As of this writing, S&P 500 corporate profits are projected to grow more than 30% in 2010 over 2009, and another 21% in 2011 over 2010.

According to an analysis by Deutsche Bank: “Export growth has been unprecedented and will provide a powerful offset to sluggish consumer spending, at least relative to past economic recoveries. In point of fact, real export of goods and services grew at a 17.8% annualized pace in Q3 2009 and then accelerated to a 22.4% annualized pace in Q4 2009 for a two-quarter annualized change of 20.1%. This is the fastest two-quarter increase since Q4 1979 and the largest percentage gain immediately following a recession on record.”

As of this writing, earnings for the 500 largest companies are projected by Wall Street analysts at $81.34 for 2010 and a record $98.14 in 2011–and we are only in April!. This might be one of the reasons that the market continues to climb at a slow and steady upward path…it can smell record profits next year.

We will always have headwinds, but corporate profits eventually lead markets and stock prices higher and lower over a cycle. So, I return to my basic philosophy of investing, in good times and in bad. Buy companies that are good businesses with the following characteristics: good free cash flow, a good return on invested capital and a dividend payment. That last characteristic is critical: Since 1930, stock dividends have comprised approximately 50% of the stock market’s total return.

Garry K. Schaefer
Atlanta, Georgia
April 14, 2010