September 2011

“Once you eliminate the impossible, whatever remains, no matter how improbable, must be the truth.” Sherlock Holmes

Discerning fact from fiction has never been easy for investors. Discerning relevant from irrelevant facts is even harder.
If you scan the daily headlines you would likely be convinced of the following:

  • The US consumer is tapped out.
  • A recession is imminent---if it not already here.
  • The financial system is irreparably broken

And, while there are legitimate metrics to support the above conclusions, there is clearly something else going on that belies the headlines.

For example, if things are so bad, how is it that the last quarter 80% of companies reporting beat their profit estimates? One explanation would be that companies did more with less and became more efficient. And while we believe that to be true, that can’t be the whole story.

You see, not only were bottom line numbers better, but so were top line revenues. That means sales were up. Revenues were up. Somebody had money to buy what US firms were selling.

Skeptical readers could now reasonably say, “It was foreigners who were buying. They have all the money and that is why multi-national companies did well, but that doesn’t mean the US is on the mend.”

That response makes sense especially for companies like Coca-Cola, McDonald’s, IBM, & Apple---they all have strong international sales. But it doesn’t explain how US-centric companies like Home Depot and Nordstrom’s can consistently beat top line and bottom line growth estimates.

Something is amiss. US consumers can’t be dead if they are still buying sweaters and light fixtures. US producers can’t be dead if sales and revenues continue to rise above expectations.

Yet the stock market is still down for the year…and for the decade for that matter. And while stocks move for a myriad of reasons, the correlation between earnings and stock prices has historically been the best long-term stock price predictor.

So what else can explain the obvious disconnects?

One explanation is that we are still working of the excesses of the 1990’s tech boom… and because we over-rewarded stocks during the dot com boom, we are destined to over-punish stocks to right the ship.

That explanation made sense five or six years ago, but 11 years later? Not likely.

Another explanation could be analysts are mistaking inflation for growth. For instance, if Home Depot is selling light bulbs for 15% more than last year, it is possible for light bulb revenues to be up, while actual light bulb sales are down.

If you then apply this example across the entire store, jaundiced analyst could day business is down while revenues are up. There may some merit to this argument, but how much?

That leads us back to Sherlock Holmes’ insight regarding “whatever remains, no matter how improbable, must be the truth.”

Yet, “whatever remains” isn’t always clear—or, as Pontius Pilate so dismally quipped, “What is truth?”

On the positive side, we believe the truth is many private enterprise firms are navigating tumultuous economic seas extremely well. There are remarkable corporate leaders, managers, and workers who see the changing landscape clearly and are adapting at a pace never seen before. They will survive and prosper.

On the negative side, it seems clear that the “gauges” of the economy that we all rely on (jobless claims, CPI, Consumer Confidence numbers, etc.) may not be accurate indicators of reality/truth.

For example, because Social Security, pensions, and other benefit programs are indexed to inflation, it is in government’s best interest to have a low inflation number. Thus, over the years, we have seen the statistical methodology used to calculate the CPI tortured lower via arcane devices such as “exclusion of food and energy,” “substitution,” “hedonics” and “owner’s equivalent rent.”

And while explanation of each of the above is beyond the scope of this missive, the end result is an inflation number that bears little resemblance to what the average American experiences at the store.

All of this brings us back to our core thesis of concentrating on core bottom-up analysis of individual stocks, real estate projects, and bonds…attempting to ferret out truth one investment at a time.

For instance, if we know a firm has little or no debt, a low P/E ratio, and a 3-year growth rate of 20%/year, we may feel confident predicting a positive up-coming quarterly report. That does not, however, necessarily mean we can predict a positive stock price to match…unfortunately, stock prices do not move in lock-step to either positive or negative news.

If, however, we go back 3 years, and apply the same analysis, correlations begin to appear, and reasoned thinking is normally validated.

By the way, the same holds true for shrinking, unsuccessful companies. The stock price will eventually match the underlying performance seen on the balance sheets.

For a real estate project, net operating income will drive the price over time.

August was a tough month. The S & P was down 6% and all the gains for the year have been erased. At Talbot Financial we used it as a buying opportunity for those companies with the earmarks of success outlined above.

One last point. Just because a stock goes down does not make it a bargain. We have therefore not changed our view on banks and most financial stocks. We still do not understand the balance sheets well enough to put our clients’ money into these supposed “bargain basement” stocks. That time may come, but not now.


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