Your currency is the credit rating of your country

Last week we published a discussion of the S&P's lowered outlook for the ability of the US to sustain a AAA credit rating. We noted that the silver lining to the debate over the creditworthiness of the US is the fact that at least we are having the debate. Perhaps the fact that this problem has become front-page news is a good sign. The dark cloud that goes along with that silver lining, however, is the fact that the government's balance sheet has probably never been worse (and a balance sheet, as any credit analyst knows, is a critical indicator of anyone's creditworthiness).

We don't need credit ratings agencies such as Standard & Poor's to tell us that the creditworthiness of the US government is at an all-time low. The late Dick Taylor used to have a saying that "Your currency is the credit rating of your country." As economist Scott Grannis explained yesterday, the value of the US dollar has hit a new all-time low, and he shows graphs illustrating the dollar's additional decline during Ben Bernanke's press conference.

Ironically, the budgetary woes of the US federal government coincide with a period of general financial strength and stability for many US corporations. Corporations that survived the government-induced financial shocks of 2007-2009 and 2000-2002 have learned to keep the debt side of their balance sheets under control and in recent years have held large amounts of cash on hand for emergencies.

Some pundits have claimed that those who say that US corporations are flush with cash are only looking at one side of the balance sheet. For instance, last fall financial journalist Brett Arends wrote that "American companies are not in robust financial shape. Federal Reserve data show that their debts have been rising, not falling. By some measures, they are now more leveraged than at any time since the Great Depression. "

Because of all this leverage, Arends said, "companies only have 'record amounts of cash' in the way that Subprime Suzy was flush with cash after that big refi back in 2005. So long as you don't look at the liabilities, the picture looks great. Hey, why not buy a Jacuzzi?"

But this claim is simply not true. He supports his assertions by looking at net debt versus assets for US nonfinancial companies, but excludes assets held overseas. Furthermore, data about net debt and net assets of every company in the aggregate tells us nothing about the strength of individual company balance sheets, which is what investors should be looking at in the first place.

If we look at some of the Taylor Frigon growth companies that we have highlighted over the years in our "Have you heard of this company?" series, we can see that their balance sheets typically contain more than sufficient assets on hand to cover any long-term debt (see table below). We would also note that these corporations are typically increasing their earnings at a very healthy rate each year, which makes comparing corporations to individuals who finance hot tubs with a "big refi back in 2005" a very misleading analogy.

EZCH cash and cash equivalents: $65 million. long-term debt: zero.

CHRW cash and cash equivalents: $399 million. long-term debt: zero.

IIVI cash and cash equivalents: $119 million. long-term debt: $4 million.

HITT cash and cash equivalents: $295 million. long-term debt: zero.

DLB cash and cash equivalents: $434 million. long-term debt: zero.

TSCO cash and cash equivalents: $257 million. long-term debt: $1 million.

RMD cash and cash equivalents: $540 million. long-term debt: zero.

Some may accuse us of "cherry-picking" only the best companies, but that's exactly what we do when we select businesses to include in an investment portfolio, and what we suggest that most investors should do as well. Besides, for this illustration we simply looked at those companies from our Core Growth Strategy that we have mentioned before in this blog.*

And let's not forget Apple, which recently released absolutely jaw-dropping earnings and whose long-term stock performance we compared to the long-term price increase in gold in an earlier post about the weakness of the dollar against gold. Their corporate balance sheet has about $16 billion in cash and cash equivalents, and long-term debt of zero.*

Rarely has the split between the financial soundness of the public sector and the financial soundness of the leading companies of the private sector been so great. Private companies are driving amazing innovation in many areas, at the same time that government spending has reached completely unsustainable levels.

Our recommendation for the government would be to enact government reforms that allow continued growth and innovation (including lower tax rates, less byzantine regulation, and a strong and stable dollar) while tackling the entitlements that are sinking the federal budget and the budgets of many states.

Meanwhile, for individual investors, we would recommend looking for innovative growing companies with sound balance sheets as places to put their investment capital. After all, while the dollars that the federal government issues hit an all-time low, the creditworthiness of many companies could hardly be better. While they don't issue dollars that reflect the state of their balance sheets, they do issue securities which can enable investors to participate in the benefits of their prudential budgetary management.

* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by EZchip Semiconductor (EZCH), CH Robinson Worldwide (CHRW), II-VI Inc. (IIVI), Hittite Microwave (HITT), Dolby (DLB), Tractor Supply Co. (TSCO), Apple (AAPL) and ResMed (RMD).

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The silver lining to the S&P change in outlook

As most investors know already, the credit rating arm of Standard & Poor's yesterday lowered the outlook on the credit rating of the US to "negative" from "stable," saying:

Because the U.S. has, relative to its 'AAA' peers, what we consider to be very large budget deficits and rising government indebtedness and the path to addressing these is not clear to us, we have revised our outlook on the long-term rating to negative from stable.

By saying this, S&P is indicating that they see a "material risk" that the credit rating of the US will have to be downgraded if meaningful budget change does not take place by 2013 (by the budget for 2014).

The silver lining to this dark cloud is the fact that the question of the government's budget deficits and indebtedness is now very much on the table. The debate over the direction of government spending has taken center stage in a way that has not happened since the US embarked on the course of building an enormous welfare apparatus over seven decades ago.

Another sign that things have changed in a massive way is the interview this morning on ABC News with Senator Dick Durbin (D-Illinois) in which even he acknowledged that the current configuration of Social Security is unsustainable. Beginning at 2:40 in the above interview, Senator Durbin says:

Social Security, untouched, will make every promised payment for twenty-six years, but in 2037 -- as we know it -- Social Security falls off a cliff. There's a 22% reduction in payments, which is really not something we can tolerate. If we deal with it today, it's an easier solution than waiting. I think we ought to deal with it.

We have called this the Question of our Time, and we believe it is an absolutely critical threat to future prosperity. However, in this case, we agree with Senator Durbin: there is no reason that the problem cannot be fixed if it is dealt with in time.

Our preference is that the solution involve increased growth (see "Growth is the Answer") as opposed to European-style "austerity plans," but we absolutely agree that entitlement spending needs to be radically reduced, and for that to happen, the voting population needs to be ready for some changes in Social Security, Medicare, and Medicaid. Even though the public is waking up to the problem, recent polls show that the appetite among voters for these kinds of cuts is still low, and we don't think the politicians will have the courage to make them until the voters change their attitude towards reducing these "big-three" entitlements (see this recent post for more details).

The good news is that this debate is now getting the attention of people who never paid attention to it before, and we believe that is a cause for optimism.

As economist Scott Grannis has pointed out, we don't need ratings agencies such as Standard & Poor's to tell us that this deficit problem exists -- in fact, as he says, if the analysts at S&P were thinking about it the right way, the fact that this debate has reached this level should be a positive sign for the creditworthiness of the US! The budget problem was just as bad a year ago, but we weren't even having this debate at that time, so you could argue that the situation has really gotten better!

In any event, the fact that even the S&P analysts have added their voice to this debate shows how things have changed, and we take that as a potentially positive development.

Sad state of affairs in sell-side research

Hat tip to Steve Waite of Research 2.0 for bringing this story to our attention:

Integrity Research Associates recently commented on an unpublished study from the IBM Institute for Business Value which concluded that the asset management industry is "paid too much for the value it delivers." Among other factors, sell-side research and excessive trading are cited as contributing to the problem.*

A recent Financial Times article on the subject reports: "Liz Rae, senior adviser, investment and markets at the UK Investment Management Association, said fund houses were already bringing more research activities in-house, partly driven by a view that sell side was irredeemably conflicted."

We have written about this subject in the past, for example in "The benefits of in-house research," published in February of this year.

We also believe that the increased reliance of Wall Street on the mathematics of large sample sizes rather than fundamental analysis of the individual underlying investments may have contributed to the decline in sell-side research over the past decade and a half.

We wrote about this phenomenon in "The ideology of modern finance," and noted that authors Andrew Redleaf and Richard Vigilante convincingly argue that this problem was at the heart of the financial crisis of 2008-2009.

While the IBM report anticipates a major shift towards greater reliance on so-called "passive investing" and indexing, we would argue that if the problem is caused in part by lack of scrutiny of the business prospects of individual underlying investments, running to something that rejects scrutiny of the underlying business entirely is hardly the appropriate response. We have put forward several reasons why we don't believe in "passive investing," some of which can be found here, here, here, and here.

We believe investors should be aware of the major changes that have taken place in the investment research world in the past years, and that should realize the importance of close scrutiny of the individual securities to which they commit their investment capital.

* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by IBM (IBM).

The unstoppable wave prepares to hit your television

This strikes us as a noteworthy video from technology commentator and author Robert Scoble, who writes the well-known Scobleizer blog.

Video over the internet is bigger-than-huge, as we have been saying for some time (see for example "The Unstoppable Wave" series here, here, here, and here). It is already an extremely big deal and growing like crazy even without the widespread ability to watch it on your living room television.

As Mr. Scoble points out, the ability to easily put video from the web onto your television has been virtually nonexistent up to now. Yes, there are devices that enable people to do so, but even for those who own such devices, finding a video using such devices on their TV is much more difficult than finding the same video over the web.

Now, with the debut of a new protocol from Apple* called AirPlay, the barrier between the world-wide web's trove of video and that big screen in your living room is coming crashing down. Other major players are sure to follow.

All we can say is, this looks really good for the Unstoppable Wave.


* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Apple (AAPL).

In defense of the politicians

In the past year, budget crises have forced the issue of entitlement spending into the spotlight in Greece, Portugal, the United Kingdom, and the United States.

The general reaction to any suggestion of cutting government welfare programs has been howls of protest. Even in the face of the eventual collapse of such programs if they continue on their current track, the citizens who elect the politicians send their elected officials the clear signal that if entitlements are cut, the politicians will pay a price.

The situation is analogous to an addict who refuses to stop asking for injections, even if he knows those injections will eventually kill him. Once the welfare state was created, removing it became almost impossible. The fact that politicians have gone along with and even encouraged this addiction is not surprising, given ongoing studies which show that their constituents overwhelmingly oppose any suggestion of scaling back.

In a recent article entitled "This is going to hurt," author and senior Cato Institute fellow Michael Tanner points to statistics from the US showing that:

• "According to the most recent Gallup Poll, two-thirds of Americans oppose cutting Social Security benefits."
• "Even self-professed supporters of the Tea Party oppose cutting Social Security by 2–1."
• "Nearly as many voters, 61 percent, oppose cutting Medicare."

In the United States, Social Security accounts for about 20% of the annual federal budget. Medicare, Medicaid and CHIP account for another 21%. Another 14% goes to other aid (other than Social Security and health insurance) to individuals and families facing hardship. Recently-enacted legislation will greatly increase the outlay of federal government dollars for healthcare, without reducing the other welfare programs such as Social Security and other aid.

The idea that government should take care of everybody led to a grand social experiment around the world that has proven to be unsustainable. Unfortunately, the recipients (including majorities of voters from all political persuasions) like the idea so much that ending this experiment may be impossible.

We have called this issue "The Question of Our Time" (see previous posts here and here for further discussion).

Investors should be very concerned about this issue on many levels.

For one, it is intimately connected to the phenomenon of inflation, by which governments devalue their currency in order to monetize their excessive debts and liabilities (see discussions here and here).

For another, it tends to lead to higher taxes, which impacts the entire economy but especially impacts risk capital and the willingness of entrepreneurs to form new companies (see discussions here and here).

At the same time, it makes growth and innovation more important than ever. The growth and innovation in the United States over the past century has helped it so far to avoid the severity of the problems faced by European countries which do not enjoy the same levels of growth and innovation (where the welfare state plays a far larger role). We have argued that investment is primarily a process for connecting capital with innovation, and believe that in times of greater inflation, taxation, and government interference, the need to search for pockets of growth and innovation becomes more critical than ever.

We are not trying to excuse the politicians who have continued to enable the addiction to suicidal social welfare policies in the US and other nations. As elected leaders, they need to be able to step up and explain why a policy may be unpopular but necessary, and get people to understand that cuts in other areas will simply not solve the problem if entitlement spending is not reduced (and especially not if they are increased!).

We are simply pointing out that, based on the poll numbers cited by Mr. Tanner above, the problem does not only lie with the politicians.

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For later discussions on this same subject, see also:

• "The silver lining to the S&P change in outlook" 04/19/2011.

A new-found bonanza of natural gas

Mississippi-based investment manager Ashby Foote has an excellent article entitled "US has gas bonanza" in which he notes that the US Energy Information Agency (part of the Department of Energy) continues to increase their estimates of the natural gas reserves present in the US.

"America, like Jed Clampett of old, finds itself sitting on a new-found bonanza of natural gas and oil reserves," he writes.

Mr. Foote explains that domestic oil and gas production has traditionally come from the sandstone layers that make up about 13% of the sedimentary rock in the US, but new techniques such as hydraulic fracturing (or "fracking") are unlocking the natural gas found in the vast shale beds that make up 79% of the rock beneath the surface of the US.

As the slide above from the Energy Information Agency proclaims, this means that US shale gas production has increased 14-fold over the past ten years alone, and estimates of reserves have tripled since the middle of 2007.

As usual, there are plenty of voices lining up already to try to make these massive new energy resources off limits (see our previous post, "Let's make it even harder to obtain oil in the US").

This morning, NPR ran a story about ozone levels in Sublette County, Wyoming. The culprit? As NPR explains, Sublette "is also home to one of the largest natural gas fields in the US." The NPR reporter ends by predicting "little chance for this remote spot of western Wyoming to ever be the pristine place it once was."

Previously, NPR has run stories about hydraulic fracturing implying that it might harm the water supply.

While we are not in favor of harming the water supply in order to extract natural gas, it occurs to us that preemptively poisoning public opinion regarding the ability to extract America's gas reserves safely carries its own potential side effects.

As we and others have observed before, the decades-long policies in the US which inhibit production of energy from domestic sources such as natural gas, coal, nuclear power, and domestic oil have artificially enriched despots in places such as the Middle East and given them a level of economic power that they otherwise would not have.

We believe investors should be aware of the new ability to tap the enormous energy resources in this country such as the natural gas reserves in shale deposits, and that they should also be alert to the often one-sided reporting generated by those who seek to discredit such efforts.

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Noteworthy interview: Dr. Joyce Appleby

Reason TV's Ted Balaker recently conducted a noteworthy interview with historian and UCLA Professor Emerita Dr. Joyce Appleby.

In it, she discusses the fact that capitalism cannot help but create economic progress, which is an observation first made by the Austrian economist Joseph Schumpeter (see here and here).

She also contrasts this forward-moving dynamism of capitalism with the incorrect and damaging zero-sum mentality. This is a very important distinction and one we have written about previously, for example here and here.

We would take exception to one sentiment expressed in the interview, in which Professor Appleby states that "income inequality" is terrible but that it can be fixed with "political will."

We have argued previously that being upset about someone else's income is linked to the zero-sum error (see for example our previous post entitled "Complaining about hedge fund managers and their paychecks"). The existence of people making a lot more money does not decrease my opportunity to improve my own paycheck, and can actually increase my opportunity to do so.

We certainly do not believe that political interference is necessary to regulate "income inequality," any more than we believe that political interference is necessary to ensure that nobody gives their children birthday presents that are more expensive than what other parents are giving their children.

Setting that one sentence aside, however, we heartily recommend investors watch the interview with Joyce Appleby and take to heart her insightful observations about the positive aspects of capitalism. We wish her continued success with her efforts to communicate that message through her writing and her work.

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