May 2011

A society grows great when old men plant trees whose shade they know they shall never sit in. Greek Proverb

If you want to understand what is happening on Wall Street a good clue comes from watching ESPN and the Public Access Channel.

Stay with us as we explain.

It is common knowledge that management and labor are at loggerheads in the world of professional sports. NFL owners and union-represented players are battling in court. The NBA is bleeding money and small market franchises like the Sacramento Kings are in disarray. Even iconic franchises like the LA Dodgers are struggling.

Simultaneously, public employee unions and state and local governments are haggling (often times acrimoniously) over budget cuts, layoffs and benefit reductions.

So why should an investor care…and what does this have to do with IBM’s earnings anyway? More than you think.

We believe the above labor strife is illustrative of a bigger trend manifesting across the American economic landscape. We are seeing wage inflation and wage deflation simultaneously…and while this phenomenon is not necessarily new, the direction has changed.

You see, for years those employed by public employee unions or by powerful private sector unions (like the NFL Players Union) have seen their pay and benefits increase at a much higher rate than those people employed by the private/non-union sector.

In fact when the private sector was dealing with downsizing, restructuring, and absorbing benefit reductions, the public sector was passing out pay and benefit increases!

We are now coming full circle as union-heavy organizations (like government and professional sports) struggle with massive debt obligations, bleak revenue projections, and hefty labor costs they can no longer pass on to taxpayers or ticket holders.

It is becoming increasingly obvious that unions (both private and public) have overplayed their hand and are now hurting the very people they purport to support. It is very reminiscent of the outcome of labor “winning” too many labor negotiations with the big three auto companies in years past.

Meanwhile, non-union companies like Apple, Microsoft, Google, IBM, and Exxon Mobile are now posting record profits and are flush with cash. They are now able to and beginning to be competitively forced to raise wages.

Microsoft just announced 10% across the board pay raise to its employees. Google gave $10,000 per person holiday bonuses to keep its employees from fleeing to Facebook. Even freshly-minted college graduates with geology degrees are commanding solid six figure salaries from energy companies.

In short we are seeing “wage rotation” from the public sector to the private sector.

The affects will be widespread and--- as with any sea change---there will be winners and losers.

First you have to recognize that government statistics will not accurately tell the story. In the past, wage deflation numbers in the private sector were masked by public sector gains in wages and benefits.

That trend is now reversing as private sector gains mute public sector losses; so we continue to be told there is no wage inflation. And while, in total, that may appear true role reversal from wage inflation from public to private will affect the markets, consumers, and investors very differently than in the past.

First, we believe private sector wage inflation could adversely affect the earnings of companies as they report profits in future quarters. This did not happen when government hiked pay and benefits. Here is why.

When government employees got pay and benefit increases, either taxes or public debt went up…but price inflation did not appear on the grocery or retail shelves.

However, when private industry raises wages, price increases are passed on to consumers and price inflation ensues.

From the consumer perspective, those employees who can command higher wages will be fine. Those, however, who have been laid off, or see pay and benefits cuts, will suffer the double whammy of lower wages coupled with higher prices.

From an investor’s perspective, companies that can pass on the wage hikes to consumers via price increases will prosper. Those who can’t…won’t.

For example, companies that sell “must-have” products like oil, food, and toilet paper can pass on price increases. Also, “sin stocks” like tobacco or alcohol companies have historically demonstrated pricing power to their loyal customer bases. Finally, low price category killers can also drive price increases.

Next, firms with high sales-per-employee ratios will be winners. For example Apple boasts over $1,000,000 in sales per employee! General Motors can’t say the same. In short, Apple can give its employees a pay raise and not suffer significantly on its bottom line. GM can’t.

Of course rising wages aren’t the only component to rising prices.

Clearly rising commodity prices are affecting prices on the shelves. As energy and raw material prices have risen, companies initially adapted by shrinking sizes (or quantities) of their products. Some firms even reduced the quality of the ingredients/materials used to hold prices steady.

They knew from experience that consumers react more adversely to price hikes than diminished quantity or quality.

Some companies even tried to make lemonade out of lemons by marketing reductions as “eco-friendly” based on smaller boxes, less energy used, etc. But, these gimmicks can’t go on forever and eventually prices are raised.

Therefore, putting these two trends (rising wages and commodity prices) together brings us to the conclusion that we are now in the transition period between the “good effects” of inflation and the “bad effects” of inflation.

You see when inflation first starts there is benefit for almost everyone as costs haven’t caught up with the free flow of new money that is liberally injected into the economy….think TARP,TALF, and the QE’s.

But now, the bad part of all that easy money is coming back to haunt us in the form of higher prices…and once the inflation-horse is out of the barn so to speak, it is very hard to corral.

With this as backdrop, we will be investing carefully and thoughtfully.



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