The Taylor Frigon Advisor

Headline: Earnings don't collapse

2012-01-26T10:00:00.000-08:00

For the past few months, bears have been warning that investment prices are dangerously overvalued. In spite of the fact that the P/E ratio of the broad US stock market is near historic lows, doomsayers have argued that the market is still overvalued, because the bulls are too optimistic about future earnings and earnings are set to collapse.

We are now about one-fifth of the way through earnings season, and not only are earnings giving no indication of imminent collapse, but they are generally blowing past Wall Street estimates (the same estimates that the bears say are "too bullish").

Yesterday, machinery maker Caterpillar* reported income of $2.32 per share, well above analyst expectations of $1.73 per share and up 58% year-over-year. Revenues were up 35% from the year-ago quarter and beat analyst estimates by over a billion dollars.

A couple days ago, Apple* reported earnings of $13.87 per share for their most-recent quarter, demolishing the consensus estimate of $9.87 per share and representing 118% growth since the year-ago period. Revenue grew 73% to $46.3 billion, with quarterly iPhone sales more than doubling year-over-year to an incredible 37 million. iPad sales grew 111% year-over-year to 15.4 million sales during the quarter, well ahead of Wall Street estimates of 13.9 million.

We have been cautioning our readers to be wary of the constant barrage of negativity that has been coming out of many financial media outlets recently. Back in November, for instance, we said that:

the dire predictions of many media pundits and market commentators are overblown and overly pessimistic . Pessimism is in vogue right now, and optimism is out of fashion. However, we believe it is very important for investors to tune out the financial media and focus on actual business measurements. In fact, we have always said that trying to time economic ups and downs is folly anyway and that investors should focus on business fundamentals rather than economic predictions.

Going into this earnings season, you could still find plenty of bearish prognosticators saying things like, "As earnings season wears on, other executives might find it more difficult to put a smiley face on disappointing results" (from this article dated January 11), or arguing that the broad US stock market is between 20% and 40% overvalued (as this lengthy piece dated January 8 suggests).

We would advise our readers to try to tune out those who think they have a formula for detecting where in the "economic cycle" we are, and instead to focus on deploying their investment capital into well-run businesses with good prospects for future growth. As this earnings season has revealed so far, there are plenty of companies that meet this description, for those who care to look.

* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Apple, Inc. (AAPL) and did not own securities issued by Caterpillar (CAT).

Fifth Anniversary of the founding of Taylor Frigon Capital Management

2012-01-19T10:38:00.000-08:00

Today is the fifth anniversary of the founding of Taylor Frigon Capital Management, founded on January 19, 2007.

Since that inception date and through the end of 2011, the Taylor Frigon Core Growth Strategy has returned a cumulative 28.07% net of fees, versus a cumulative return of -2.18% for the S&P 500 for the same period of time (see full performance details and important GIPS disclosures here).

While we have often cautioned that short-term performance "horse-races" are not good ways to evaluate an investment philosophy, we believe that longer periods become more significant and that the five-year history tends to validate the investment convictions that we have employed since founding this firm and for many years prior to the founding of Taylor Frigon Capital Management.

These are the same investment principles that we share with you here on the "pages" of this blog as well.

We would like to thank all of our clients over the years (past, present, and even future) and look forward to continued success on their behalf.

Happy New Year!

2011-12-30T11:52:00.000-08:00

We wish all of our readers and clients a very happy and prosperous New Year!

2012 is sure to be a very interesting year for investors with much to look forward to and many opportunities for those who stay patient and disciplined and look to take advantage of owning great businesses at values not seen in decades!!

Seasons Greetings and Warm Wishes

2011-12-22T10:26:00.000-08:00

Seasons Greetings and warm holiday wishes from all of us here at Taylor Frigon Capital Management!

Above, a wreath at the General Grant tree in Sequoia and Kings Canyon National Park rests in the snow. The General Grant tree was designated "The Nation's Christmas Tree" by President Calvin Coolidge in 1926, after a little girl visiting the tree was overheard to remark, "What a lovely Christmas tree that would be!" at the sight of the massive sequoia. The story of how that came about is related on the home page of the Sanger, California Chamber of Commerce here.

The tree is also the only living, federally-designated monument to U.S. military men and women who have lost their lives in service to their country.

We wish all our readers a very safe and happy holiday season this year.

The fantasy world of modern portfolio theory

2011-12-15T12:08:00.000-08:00

The calendar year of 2011 will soon come to a close, and active managers will be watching to see how the performance for the year will turn out.

Many who hire active managers will also be watching closely, and will be judging whether or not they should continue to keep their investments with this or that manager based upon the outcome when the market closes on Friday, December 30.

Others, who disavow active management, will be watching in order to see how many managers failed to "beat the market" (or beat their benchmark) so that they can declare that "active management doesn't work" and that everyone should "just index."

While we believe that keeping score is important in investment management, we don't agree that the emphasis placed on a calendar year is the best way to determine whether any particular manager is doing a good job, nor is it the best way to determine the broader question of whether active management is better than (so-called) passive management or vice versa.

For starters, we have argued that investors often have far too short-term of an attention span when it comes to committing capital to businesses, much the way that the Ents in J.R.R. Tolkien's Lord of the Rings criticize hobbits for being too hasty. Would anyone select a money manager based upon whether or not his overall portfolio of investments went up or down on a single day? That would be ridiculous. How about based upon whether or not his portfolio outperformed "the market" or some other benchmark during a single day?

If you had a friend who told you that he moved his life's savings from one manager to another based upon which one did the best the day before, you might (like Treebeard) advise him, "Don't be so hasty."

The same could be said for jumping to conclusions about whether active management is better than passive management. It would be ridiculous for financial commentators to publish reports declaring "Several prominent active managers underperformed the market yesterday, leading to the conclusion that active management may not be the best way to invest."

We would argue that, while better than a single day, a single calendar year is not the most useful time period to select, but that investors should instead focus on longer periods, and should consider start and end points that are less arbitrary than the annual calendar but which correspond instead to major economic events (such as from one recession to another).

More importantly, the broader question of active versus passive management should not be decided based upon arbitrary and short periods of time. If active managers beat the market or their benchmark in one year or even in two or three consecutive years, some critics will always be waiting to pounce on them in a year that they do not, in order to declare that the mathematics are irrefutable and that nobody can beat the market in the long run. More precisely, these critics will often argue that anyone who does beat the market for a few years does so by taking "excessive risk" which could have been avoided by owning more securities. Since no one can really beat the market without undue risk, the passive advocates argue, then it is best to just buy the market -- that way, you will get the best possible return for the amount of risk that you take.

The mistaken idea that passive management is the best way to invest is one outgrowth of a much larger academic theory called "modern portfolio theory" which has slowly expanded its influence in the investment world, beginning in 1974. We have written about its problems numerous times in the past, such as in this previous post. The distinctive concept at the core of this theory is the idea that risk can be captured in mathematical formulas, and that because it asserts that risk is mathematically linked to potential returns, its advocates believe that mathematical analysis and diversification can point investors to the optimal level of risk and return for their investment profile (the so-called "efficient frontier" is an example of this concept).

This seemingly harmless idea manifests itself in many different ways in the investment industry, one of them being the idea that owning indexes with hundreds or even thousands of individual securities provides better "risk-adjusted return" than owning a smaller number of carefully-selected securities. If you think about it carefully, you will be able to see that this idea (which is at the heart of the "just index" or "passive investing" argument) was also behind the construction of the various structured investments and synthetic vehicles full of sub-prime mortgages which banks and other financial institutions bought under the illusion that enough diversification and the right mathematical models would make the analysis of the individual loans unnecessary. This fantasy led directly to the disastrous financial meltdown of 2008 and 2009.

In this regard, modern portfolio theory resembles the kung fu seen in certain martial arts movies like the one above -- it's a nice fantasy, but it is completely divorced from the real world. Thinking that its mystical precepts will keep you from ever getting cut in a real knife-fight could have disastrous consequences.

It is our conviction that in the real world of investing, there will be times when good investments are out of favor and therefore perform "worse than the market," whether for a day, a month, or even a year. The idea that owning a small number of good investments (even if they sometimes go in and out of favor) is "risky" but that owning a huge number of unexamined investments mitigates risk is actually a dangerous fantasy, and one that unfortunately is pumped out to viewers and readers daily by the financial media in video, magazines, and books. Investors who are tempted to buy into this fantasy should be cautioned that modern portfolio theory's vision of investing is as divorced from reality as mystical movie kung fu is from real fighting.

For investors who want to practice real investing, we would advise that finding quality businesses is not as difficult as they might think -- we have discussed criteria for doing this and provided several examples in previous posts (a list of some of them can be found here). They should then plan on owning those companies through the inevitable ups and downs of the market for long periods of years (this does not mean holding them forever -- we discuss sell discipline in other posts such as this one -- but rather owning them until the business signals that it is no longer the kind of business you want to own, instead of relying on the market signals that so many investors and pundits focus on).

Take a look at the kind of returns an investor could have experienced if he had purchased shares in Wal-Mart in 1982 and owned them through 1992*. Look closely at the chart and you will see that there were plenty of ups-and-downs along the way, including some sudden and rather severe drops: what would that investor have missed if he had been listening to what all the pundits were saying or if he had the mistaken idea that owning a tiny piece of a truly great company could be done without ever taking some hits and receiving some bruises?

Understanding this perspective is the first step towards building a strategy that is based on principles that investors should be focused on, instead of building one that is based on the fantasy of modern portfolio theory and its quest for "risk-adjusted return." It will also enable investors to see most of what appears in the financial media for what it really is -- entertainment that might offer an enjoyable escape into a fantasy world, but which should not be confused with reality, and actually isn't even as fun to watch as a good old-fashioned kung fu flick.

* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Wal-Mart Stores, Inc. (WMT).

Have you heard of this company? PNRA

2011-12-07T13:18:00.000-08:00

While most of the financial world focuses on Europe and waits with bated breath for every new development in Greek parliamentary voting, S&P sovereign-debt rating, or ECB bank-lending stimulus, we would like to point out that economic indicators in the US have been showing modest but real progress.

Without downplaying the importance of the issues that are at stake in Europe (which we believe are extremely important issues, and which we have discussed in this and this recent post), we would suggest that investors might want to pay attention to some of the companies in the US that we think are well-run and positioned in front of what we call "fertile fields for future growth."

One such company is Panera Bread*, which operates a chain of "fast casual" restaurants which they call "bakery-cafes" distinguished by fresh-baked artisan breads, hormone-free chicken, all natural ingredients, and a dining atmosphere that very different from a typical "fast food" establishment.

Panera Bread calls their concept "fast fresh," which points to one of the reasons that we believe the company is operating within a larger paradigm shift that may constitute a "fertile field of growth." The explosion of the fast-food restaurant concept during the 1950s through 1980s corresponded with a paradigm-shift in pace of life in the United States after World War II. The tradeoff consumers made, however, was in the healthiness of the meal -- you don't always feel very good (or very good about yourself) after consuming a fast-food meal.

Fast-fresh seeks to counteract the negative aspect of traditional fast food without sacrificing the main positive aspect of the fast-food concept (the "fast" part). Instead of plastic decor, bright and unnatural colors, and mass-produced bread, Panera features fresh-baked breads (fresh dough is delivered daily from strategically-located fresh-dough facilities that have an optimal distribution radius of 300 miles), a healthy menu, and a natural ambiance emphasizing earthy colors and free wi-fi.

The history of the company provides a clue to another paradigm we believe is important to the investment thesis. In 1976, a French oven manufacturing company created a showcase restaurant in Boston's newly-renovated Faneuil Hall Marketplace, dubbed Au Bon Pain (French for "with good bread"). In 1978, investor Louis Kane bought the restaurant and began expanding in the Boston area. In 1981, he was joined by political consultant and cookie chain regional manager Ronald Shaich, and together the two began pioineering a new concept in fast-food, the bakery-cafe.

At about the same time, in Kirwood, Missouri, a man named Ken Rosenthal was appropached by his brother about starting a business based on the sourdough bakeries popular in San Francisco. Ken and his wife traveled to SF, learned sourdough baking methods, and founded St. Louis Bread. The concept was successful, and they began expanding slowly over the next few years. By 1993, they had grown to twenty cafes. At that time, their business was acquired by Au Bon Pain, which had gone public in 1991. The concepts of the two companies were very similar, serving breakfast and lunch and featuring baked goods, made-to-order sandwiches, soups, salads, and locally-roasted coffee.

Eventually, the Au Bon Pain line was sold to a private equity firm and the remaining St. Louis Bread bakery-cafes were branded as Panera Bread bakery-cafes (except in St. Louis itself). The company has now grown to over 1,400 locations.

The interesting thing to note about this story is that Panera's success appears to be built in part upon the expansion of an urban phenomenon into suburban, "ex-urban," and even "sub-rural" markets. The concept of a "corner bakery" is an urban concept, and the convenience of having fresh-baked bread available in the neighborhood, and the cultural phenomenon of having neighborhood delicatessens and bagel-shops, are primarily an urban phenomenon in the United States. Panera has built a business model based on capturing the benefits of this primarily urban experience and exporting it to non-urban settings (suburban, collegiate, upscale rural, etc).

The company, of course, continues to have a significant presence in cities, but that is not surprising -- by making a successful urban concept repeatable, they can compete in cities as well, gaining economies of scale and using their superior resource base to their advantage.

Finally, the company faces an attractive potential field of growth in the large portions of the country where there are still few or no Panera Bread bakery-cafes. Our internal analysis suggests that, if the saturation level of Missouri can be projected to the rest of the US, the country is still under 50% penetrated in terms of the addressable market for the Panera Bread concept.

This is an example of the type of company that we look for as a potential destination for investment capital, and the kind of growth story which we seek to connect our investors with so that they can participate in the company's future earnings.

To read about other companies which we believe exemplify some of the same criteria, please visit this previous post, which contains a description of a different investment thesis and links to others we have published in the past.

* At the time of publication, the principals of Taylor Frigon Capital Management own securities issued by Panera Bread (PNRA).

The biggest lesson from Europe

2011-11-30T10:09:00.000-08:00

Six central banks -- the ECB, the US Fed, the Bank of England, the Bank of Japan, the Bank of Canada, and the Swiss National Bank -- rushed in to the European crisis today by taking steps to ensure liquidity for banks (essentially, lowering the cost of lending backstops that European banks can use as a source for short-term liquidity).

This was obviously a coordinated plan that had been prepared beforehand, probably for use in the event of real emergency (the collapse of a major European bank, for example, as Jim Cramer speculated this morning on CNBC). It is thus another example of "too big to fail" in all likelihood.

Before anyone explodes in anger at yet another example of those now-hated words (which have become so well-known that they are sometimes simply abbreviated TBTF without needing explanation), let's ask a few questions about why too big to fail has become the order of the day.

There is a line of argument which says that no bank should be "too big to fail," and that if banks make stupid loans, they should pay the price and go bankrupt if those loans don't pan out. After all, if those loans do work out, the banks get the profit, so why should they get the profit when their risky loans turn out well, but spread the cost of their failure to everyone who pays taxes, or to everyone who is forced to use a currency that is devalued over time?

However, there is a problem with this line of argument. For one thing, there is the moral problem that arises from the fact that the banks were often forced into making some of those risky loans in the first place (by governments, who have plenty of leverage over banks and can make life unbearable for them if they don't make loans to people or countries that the government wants the banks to loan to).

You can decide for yourself if it seems right for governments to coerce banks into making risky loans, and then to stand back when the loans go sour and shake their heads and say, "Well, I guess you never should have made those risky loans -- now you have to pay the price, by the laws of the free market!" We can look back in recent history and see plenty of examples that follow the same exact pattern.

Everyone in the US is angry that the government "bailed out" banks who held lots of subprime mortgage securities, but the citizens shouldn't be too angry, since they elected the government officials who passed laws forcing banks to loan to less-than-creditworthy borrowers (Congressman Barney Frank, who recently announced his retirement, was one of the primary culprits in pressuring the banks to loan to borrowers they would not otherwise loan to, and he will be replaced as the ranking member of the House Financial Services Committee by Representative Maxine Waters, who was just as aggressive).

Similarly, during the Latin American debt crisis of the 1980s, US banks had been told by the US government to lend at below-market rates to Latin American nations such as Mexico, Brazil and Argentina. When those countries found that their income (in the form of taxes, which come from the earning power of their businesses and the earning power of their citizens) was not enough to pay for the interest on the debt they had racked up, it would not have been right for the US government to simply let those banks swing as a penalty for lending to risky borrowers. They were forced to lend to those risky borrowers.

The same scenario is now playing out in Europe.

Further, while it does impress some people to talk tough and say, "I wouldn't lift a finger to help these banks -- they need to learn their lesson," the problem is that "teaching the banks a lesson" could entail collateral damage that goes far beyond the banks and causes severe harm to many innocent bystanders. Is "teaching the banks a lesson" worth the risk that ordinary citizens might be unable to access money that they have in money market funds for an unknown period of time, for example? If ordinary citizens can't access their money, it would cause all kinds of disastrous problems for families and small businesses. Is that a worthwhile price to pay in order to "teach those banks a lesson" about loaning to risky borrowers (especially when the government made those banks make a lot of those loans in the first place)?

To take this position is almost equivalent to saying, "If kids are playing with matches, you have to let them burn down the house sometimes -- it teaches them a lesson -- and that's just tough if they get burned to death in the process, along with a few of the neighbors."

The bottom line of all this is the fact that "you can't have just a little bit of socialism."

When governments interfere with banking, even if it's just a little bit, it eventually results in situations just like the one that is unfolding right now in Europe. First, the government meddling tends to result in expanded lending activity to borrowers who would not otherwise get loans (and at terms that those borrowers would never be able to get under a purely "free market" situation). This happens both because governments feel they can tell banks to whom they should loan and also because banks become more willing to lend to people or governments they would not otherwise lend to, as long as the government promises to pick up the tab if those loans don't work out (have a look at our previous post on the Solyndra debacle, for a recent example).

After the first result (expanded lending to people and/or governments who would otherwise not get loans, or who would otherwise have to pay a lot more for those loans), the second result is rather obvious. When all that artificially-expanded credit begins to go sour, the government sails in with other people's money in order to prevent the whole house from burning down. Once even a "little bit of socialism" gets added to banking, TBTF becomes an inevitable acronym of banking.

The sad fact of the matter is this: there is a market rate for borrowing that is based on creditworthiness, and if you want to subvert that rate, you will end up with inevitable losses. Loaning lots of money to people or nations with terrible credit histories will always mean that some of it is lost, and if you don't charge them high enough rates to cover those losses, you will have to get the money from someone else to cover those losses. The place that governments get that money is obviously from everybody else, either in the form of higher taxes or in the form of inflation and the slow loss of their purchasing power over time, or both. As Milton Friedman famously said numerous times, in economics there is no free lunch.

Yesterday we published a post about some other lessons from the current European crisis, but we believe the topic of this post is the biggest lesson out of the entire European situation. We have been talking about today's action which was probably taken to prevent a bank failure, but the question of government involvement in banking, lending, and bailing out is related to what we have called "the question of our time," because bloated spending by governments is directly connected to easy credit and borrowing, interference in banking, and ultimately the devaluation of currency. The pensions and other government entitlements that some Europeans have been enjoying on borrowed money are now going to be paid for by everyone else, but this should not come as a surprise.

Once people, through their elected leaders, decide to abandon the principles of free market capitalism, the socialization of losses and "too big to fail" become inevitable consequences. Everyone pays.

Another lesson from Europe

2011-11-29T11:51:00.000-08:00

Over the Thanksgiving weekend, data for shopping activity in the US blew away the forecasts of most economic prognosticators. Sales for the full weekend (from Thursday to Sunday) were up 16.4% over the previous year -- an astonishing increase and an all-time record in terms of dollar value spent during the period.

This data should indicate that the US is not in the middle of a Great Depression, in spite of the constant pessimism on display throughout the financial media and the confident predictions by numerous pundits over the past six months that a double-dip recession was on the way. We have been on record opposing the pessimistic conventional wisdom about the economy for some time now see here and here for example), so we were not at all surprised by the strength of the numbers.

We'd like to go out on a limb a bit and suggest that the conventional wisdom over the European debt crisis may be overlooking some positive angles there as well.

One of the most consistent themes among commentators on the European debt crisis is the refrain that Europe is a preview of America's future -- that the US is resembling Europe more and more, and that if we're not careful, we will end up like Greece or Italy (in some cases, the argument is made that the US will end up like Europe no matter what -- it's too late to avoid the fate of Greece, and the only question is how long it will take).

For example, here is an article published earlier this month by Dan Mitchell of the Cato Institute and the Center for Freedom and Prosperity, entitled "US should learn from Europe's Welfare State Mistakes."

We agree with Dan Mitchell on just about everything he says or writes (you can see previous posts stretching back for many years in which we have cited his work or embedded his videos, for example here or here). We even agree with the arguments he makes in this article, to the degree that entitlement programs in the US (particularly Medicare but including a host of others as well) are unsustainable, and that planned entitlement program expansions will bankrupt the country if they are not fixed.

However, we do not agree that the only important lesson of the European debt crisis is that the US needs to learn from Europe's woes. In fact, we would be so bold as to suggest that this crisis has been beneficial in revealing that Europe needs to learn from the US, and that some of the early indications appear to show that Europe is learning from the US model and may be moving in the right direction! How's that for an opinion you aren't hearing in any other financial commentaries or analyses?

For starters, Europe created a common currency (the euro) in order to try to have the same kind of commonality enjoyed within the US (a worthy goal -- can you imagine how difficult and expensive business would be if California, Virginia and Alabama were each able to print their own money and pursued different monetary strategy regarding the strength or weakness of their currencies?).

However, they created that common currency without any sort of fiscal unity, so that member states were left to their own devices on questions of how much they could spend on welfare programs and other budget items, as well as on questions of how to raise taxes to pay for that spending. Predictably, some member states were more responsible than others, and they have started to get upset about the fact that they are now having to bail out the irresponsible parties without any mechanism for changing the profligate behavior of their more irresponsible neighbors.

In the US, there is a governing body that is capable of imposing a unified tax-raising policy on all the member states -- it's called the federal government. The unified tax-raising policy may be inefficient and byzantine (as we have argued in other previous posts, such as this one and this one), but that is a very different problem than the one that the more financially responsible European states are currently facing as they prepare to bail out their less responsible neighbors.

Even more importantly, one of the most important lessons of the European crisis is the need to enable innovation and economic growth within an economy. The countries in Europe that are having the biggest problems paying their debts are those which make very little money, because they have built economic systems that stifle innovation and make business difficult. Those that are in better shape -- and Germany is in the best shape of all of them -- are the countries that have boosted production and economic growth by getting out of the way of businesses.

In other words, it is true that if you have too much credit card debt, one thing you should do is start spending less (and America certainly falls into this category). But the other solution is to start making more money, and the way to do that is to create an environment that allows for innovation and business growth.

In this regard, our assertion that Europe can learn from the US is perhaps most telling. Even Germany's economic growth is somewhat anemic by US standards. Even with the increased regulations and government intrusions that have blighted the US economic landscape over the past eleven years (starting with Sarbanes-Oxley and accelerating through Dodd-Frank), the US remains an easier place to start a business or pursue a new innovation than almost any one of the European nations. We may have compared California's self-inflicted economic woes to those of Greece in previous blog posts such as this one (and they are similar), but the difference is that Greece does not have a Silicon Valley that produces much of the world's most innovative technologies, nor does it have a Hollywood that produces much of the world's entertainment content, nor does it have a Great Central Valley that produces much of the world's food.

So, we would argue that the lessons of the current European crisis do include the warning that many have sounded, about the dangers of the US heading further in the European direction. But, we would also argue that an important lesson, and one that many appear to have overlooked, is that Europe really needs to move more in the direction of the US.

If Europe really wants to foster the kind of economic growth and innovation that it needs to get out from under the credit problems some of its member states have created, it should look at steps that will create a uniform business-friendly environment throughout the continent, with relatively lower levels of government spending, lower levels of regulation, lower barriers to the ability to start a company, and more fiscal unity providing methods to impose discipline on countries that don't play by the rules.

We realize that Europe is an incredibly complex region and that getting to such a state of affairs may be impossible, and would certainly be extremely difficult even if all the member states decided that it would be a good idea.

The good news is that some in Europe appear to have gotten this message, and are making some real steps in that direction.

This is a very big topic and cannot be completely addressed in a short blog post, so stay tuned for more discussion on the subject in future posts.

Happy Thanksgiving 2011

2011-11-23T12:01:00.000-08:00

We would like to take this time to wish all of our readers a very warm and happy Thanksgiving. This of course includes our readers around the world, who can also share in the special message of this most American of annual holidays, wherever they may be.

As always, Thanksgiving is an opportunity to reflect upon and be thankful for the blessings in our lives.

In the United States, we certainly have an abundance of things to be thankful for, chief among them being a system which preserves human freedom and thus allows individuals to try to improve their situation by starting businesses, changing jobs, gaining new skills, and otherwise working to make things better. The byproduct of the free choices of individual Americans over the centuries has been a host of innovative products and services, new companies and new industries, medical cures and bounteous farm produce, all of which have enormously improved the world and created more wealth and prosperity than has ever been seen in human history.

Thanksgiving reminds us of this fact, and the humble origins of the holiday itself remind us that none of this was automatic: the first Thanksgiving on these shores, in 1621, was celebrated by a band of Plymouth Bay pilgrims who were not guaranteed of anything, including continued survival, and who would probably not have survived had it not been for the techniques taught to them by the Wampanoag Indians who were also present, and who brought the main course.

All of this is doubly pertinent this year, coming on the heels of nationwide protests by many who appear to be either misinformed about the freedoms that create such economic progress (and we would argue that the ability to start companies with limited liability, and the right to pay employees including CEOs as much as you want with privately-owned money fall into the category of "freedom"), or who are openly hostile to systems that give individuals and businesses such freedoms and who would rather have a system in which government bureaucrats or other dictocrats tell people what they can and cannot do instead.

We recently saw a video from a commentator named Bill Whittle, who with cutting insight suggests that the very prosperity that our system of freedom has created may in large part have led to the entitlement mentality so visible among many of the recent protestors. He proposes that some real exposure to the elements for just a few days each year might lead to a real change of views, and his arguments make some pretty good points about the benefits we often take for granted.

It occurs to us that the message of Thanksgiving is nearly the exact opposite of the mentality of "entitlement." We hope that perhaps the annual observation of Thanksgiving will renew the wonder we should feel at the incredible bounty that the attempt (however imperfect) to institute a system based upon human freedom has unleashed since America was founded.

For readers who would like to revisit our previous four years of Thanksgiving messages on this blog, you can do so by following these links: 2010, 2009, 2008, 2007.

We wish you all a very wonderful Thanksgiving.

I'm glad I actually opened my account statement!

2011-11-16T09:42:00.000-08:00

Anecdotally, we have now had more than one private client call us to say something along these lines:

"I was afraid to open my statement, knowing that things must certainly be going off a cliff, and when I finally did look at it, I was surprised to discover that things were far better than I imagined!"

Why would clients be so afraid to look and so sure that everything is "going off a cliff"? No doubt this feeling is due to the constant barrage of negative news coverage served up by the financial media for the past three months. Of course, the vicious market sell-off that accompanied the initial crescendo of fear during the month of September and into the first few days of October didn't help either. However, clients are surprised to learn that major market indices such as the S&P 500 are actually positive for the year right now (see this page for S&P data, for instance).

The financial media has a tremendous bias towards accentuating a perceived crisis -- any crisis -- because they know that such reporting drives viewers to stop what they are doing and hang on every word out of the media talking heads. This trend has been going on for some time -- since the dot-com crash, in fact. Before that (back in the 1990s), the financial media took almost the opposite tack and attracted viewers by reporting with wild optimism. We believe this trend is extremely dangerous for investors, because it gives them a false view of reality. The anecdotal comments we are hearing from clients, described above, appears to support this conclusion.

The economic data, as well as corporate earnings at many businesses, tell a very different story. All sorts of measures indicate that the economy is not going off a cliff but is in fact growing modestly (some businesses, of course, are not growing, while others are growing quite rapidly, particularly if they are involved in certain industries that are undergoing major paradigm shifts).

We have been cautioning investors on the pages of this blog for some time now that the dire predictions of many media pundits and market commentators are overblown and overly pessimistic (see here and here for some examples). Pessimism is in vogue right now, and optimism is out of fashion. However, we believe it is very important for investors to tune out the financial media and focus on actual business measurements. In fact, we have always said that trying to time economic ups and downs is folly anyway and that investors should focus on business fundamentals rather than economic predictions.

Certainly economic growth could be much better than it has been in the almost three years since the 2008-2009 recession began to turn around, and growth has been hampered by a host of government intrusions and mis-steps that have hurt everyone. However, the constant flood of financial negativity that has been hitting citizens from virtually every angle lately has created a perception in most people's minds that is entirely different from reality.

This is a very important topic and deserves careful consideration.

Why you can't pay off your home loan with Monopoly money

2011-11-11T13:25:00.000-08:00

First Trust Chief Economist Brian Wesbury recently published an outstanding one-page explanation of some of the underlying issues surrounding the ongoing eurozone debt crisis.

Entitled "The Drachma is Dead, and so is the Welfare State," it is an excellent primer on the topic of strong currencies versus weak currencies.

For those who might be wondering why Europe doesn't just kick certain countries out of the eurozone and let them go back to their old currencies (such as the drachma for Greece), Mr. Wesbury abundantly illustrates why that is not an option. Those who suggest such a remedy are implying that if Greece had their own currency, they could inflate it to help pay off their debts -- the reason Greece is in such a jam is that they cannot use this common method sovereign governments (including the USA) use to escape debt. The problem is that lenders to whom Greece owes money would not accept drachmas as payment for loans that were made in euros.

It's the same reason your bank won't let you pay back your home loan with some unreliable currency, such as Monopoly money: they don't have any way to be sure you won't go print out a bunch more of it, leaving them stuck with worthless dollars in return for the real dollars that they loaned to you. (Lenders wouldn't mind accepting Monopoly money -- or Greek drachma -- for debts, as long as they were tied to something that you can't print out at will, such as gold).

Mr. Wesbury's piece also gets to the deeper issue behind this whole drama: the question of whether the unsustainable costs of excessive welfare and government giveaways should be borne by everyone, or by those who depended on the government for guarantees and promises that proved to be too optimistic. For it is when governments inflate their currencies that their money-creating ways drive the cost of everything higher, slowly taxing everyone using those currencies. This approach especially hits hard those who save money only to find it worth less when they want to use it.

He points out that the choice most governments take is pretty obvious -- in the second choice, governments would have to admit that they were wrong, and take the anger of those who trusted them, while in the choice of debasing the currency, governments can blame markets, bankers, and the financial institutions that seem to be raking in money while everyone else suffers.

This deeper question does not face those in Greece, Italy, or even Europe alone: the United States and just about every other western country is facing the same question in one form or another, as the costs of guaranteeing more and more payouts to more and more citizens are shown to be a weight that no government can bear.

Financial innovation is largely bunk

2011-11-09T09:27:00.000-08:00

Here's a conceptual diagram of all the companies listed on the NYSE from September 2006, grouped by sector and sized according to market capitalization (value of the companies).

It is roughly based upon the excellent "map of the market" tool that is available to look at on a daily basis in the "Market Data Center" section of the Wall Street Journal. You can go over right now and see what it is doing today by following this link.

The point of showing the sector weightings from September 2006 is to illustrate the size to which the financial sector had swelled at that point in history -- in fact, to the point that it was the largest sector in the entire economy, by a large margin. In other words, at that particular point in time, the financial sector was 22% of the entire economy by market capitalization, meaning that an awful lot of capital was flowing into that sector -- not only monetary capital which can be measured on a chart of the market capitalization of different companies but also "human capital" in the form of individuals choosing to pursue careers related to finance, and students choosing to pursue degrees related to finance, etc.

As you might imagine based on the world events which have taken place since September 2006, the size of the financial sector has deflated somewhat since the days when its size dominated the rest of the economy by a wide margin. A simple visual inspection of the map of the market using the above link will verify that.

A visit to the data available at Standard & Poor's about the capitalization of the S&P 500 by sector (a slightly different group of companies) reveals that companies categorized as financial now make up only 14% of the economy (as of November 08, 2011). Financials are no longer the largest sector (that honor now belongs to companies categorized as "information technology"), although they are still the second biggest sector, and their relative footprint is now much closer to the third-place sector -- energy -- which used to make up only 9% to financial's 22% and which is now roughly the same size as the financial sector at close to 13%.

We would argue that this is a very revealing exercise, because we believe that the amount of capital (both monetary capital and human capital) that was pouring into the financial sector prior to the collapse of 2008-2009 illustrated a disastrous "over-valuing" of what we might call "innovative" financial products and services (more on that term in a moment). Even with the reduction that has taken place, this sector is probably still too much of the economy, although at least the trend seems to be moving in the right direction.

Now, as professional money managers and therefore members of the financial industry, the above commentary might seem confusing, especially as we just finished explaining how important the ability to buy and sell shares in a public market is to the economy in general, and defending the financial sector's valuable role of enabling pools of capital to become available to entrepreneurs and businesses who need it. We wrote that defense in light of some of the misguided attacks of the Occupy Wall Street movement, which appears to have banks, the exchanges, and the concept of legal personhood for corporations as its prime targets -- all institutions which play a valuable role in the critical allocation of accumulated capital to business.

The argument we are making when we say the financial sector's footprint became way too large and absorbed way too much human capital is the argument that financial companies moved far beyond the connection of capital with business and into all kinds of "financial innovation" and "financial engineering" of dubious value.

Much of this "innovative finance" was not only of dubious value but was harmful and played a role in creating the conditions that led to the financial implosion that followed. We have made this argument in numerous previous posts, including "The ideology of modern finance" and "Professor Amar Bhide and his praise of more primitive finance."

In fact, we think investors might be well served by considering the possibility that finance itself is pretty simple and straightforward, and that its job is to connect capital with innovation rather than try to be innovative itself.

In many ways, the confusion between the two is evident in the turmoil dominating the news of late, including the European crisis, where investors are mainly focused on the woes of the financial sector and are largely missing the root problem, which is the lack of innovation and business growth in the other nine sectors of the economy.

This confusion manifests itself in the breathless worrying over whether Europe's banking woes will cause an economic collapse in the US. The storyline goes something like this: Europe's banks go into a state of shock because loans they made to countries such as Greece and Italy were unwise loans and the borrowers default; US banks which have dealings with European banks are unable to lend because of the crisis in Europe; therefore, US businesses and consumers cannot borrow, and US business and economic growth suffers or goes into another 2008-2009 panic and recession (or worse).

Our response is that, while it is true that finance touches every aspect of the economy because every business needs to use money and every business needs capital, the financial sector is not (or should not be) the dominant sector, and innovations in finance are not (or should not be) the innovations that drive an economy (see the discussion above). US businesses are generally flush with cash and many don't need to borrow a penny in order to grow and continue creating valuable goods and services for their customers. The 2008-2009 recession was not caused by businesses being unable to access capital, but rather by businesses picking up the phone and canceling all their purchasing orders for more inventory in the face of the implosion of Wall Street's financially-engineered innovations and in the face of a Rose-Garden speech from the President of the United States warning of a scenario that sounded like the end of the world (see this previous post for more on our view of the causes of 2008-2009).

There is actually quite a lot of real innovation going on in the US economy right now, innovation of the sort that adds real value and real economic growth, much as the computer innovation of the 80s and 90s added real value and real economic growth. We believe investors should understand the distinctions we are making in this post about the importance of connecting capital to real business innovation, and the dangers of pouring too much capital (monetary and human) into financial innovation.

We believe that over time, the problematic nature of much of what is called "financial innovation" will become more and more widely perceived, and capital will naturally flow towards real innovation and business growth. Investors who want to be there ahead of the crowd should be thinking about these things right now.

"Stop me before I ease again!"

2011-11-01T13:22:00.000-07:00

Halloween is over, but that didn't stop markets worldwide from reacting in terror to the news that Greek leaders have decided to put their bailout up for a popular referendum, which is a little bit like asking a sick child to vote on whether he would like to take a bitter-tasting medicine or not.

The latest consternation arrives just in time for this week's meeting of the Federal Open Market Committee, which will announce its latest monetary policy decisions tomorrow. We hope that it will not encourage those at the Fed who want to introduce "QE3" or some other new form of monetary easing.

We believe the Fed's serial easing has already caused enough damage, and that more easing is uncalled-for.

Proponents of further easing argue that the stubbornly high unemployment rates, coupled with fears of another recession triggered by Europe's woes, necessitate pumping more money into the system in order to bolster consumer borrowing and spending, on things like homes and autos.

However, we have already explained in numerous previous posts that "the consumer" does not really drive the economy. If he did, the unprecedented amount of monetary stimulus that has been in place over the past two years might have been expected to have a lot more positive effect than it did.

On the contrary, we believe that production and producers drive economies. When producers increase their production, that prompts the hiring of more employees, which then stimulates the consumer much more effectively than artificial government stimulants can ever do. The Fed's excessive monetary easing has made life much harder for producers, by creating price instability and price uncertainty, which continues today (incidentally, this also ends up harming consumers because fewer of them get hired, and they also face higher prices for the goods and services they need to buy).

Noted Stanford economist John B. Taylor wrote an editorial in the Wall Street Journal today explaining the ways that the Fed's excessively easy policy has caused damage around the world. Some of them may surprise you because they are rarely explained by the consumer-centric media coverage that dominates the financial television shows. He explains:

Economic policies in America affect the world in ways that are often subtle. In the case of monetary policy, for example, decisions on interest rates by foreign central banks are influenced by interest-rate decisions at the Federal Reserve because of the large size of the U.S. economy. If the Fed holds its interest rate too low for too long, then central banks in other countries will have to hold rates low too, creating inflation risks. If they resist, capital flows into their countries seeking higher yields, thereby suddenly jacking up the value of their currencies and the prices of their exports.

While some might mistakenly believe that tilting the playing field in order to help one's own exports or harm another country's imports could be a good idea, we have explained in previous posts that such unstable business conditions make it very hard for producers to predict the future, lowering their willingness to hire employees and having a host of other negative side effects as well.

Further, with US GDP growth coming in at 2.5% for the third quarter, the argument that we are slipping into recession simply does not hold water, even though we believe that growth could and should have been a lot stronger at this point, if it were not for the misguided government policies that have been creating obstacles to business growth.

In sum, now that Halloween is over, we hope the serial "easer" that has been stalking the halls of American monetary policy for the past two years will not strike again.

7 billion

2011-10-31T12:11:00.000-07:00

In light of the headlines about the arrival of the seven billionth human being somewhere in the world today, and the inevitable hand-wringing over whether we have enough resources to sustain such a population, we thought it was appropriate to revisit some things we have written previously on the subject.

Back in 2009, we published a post entitled "The dark side of zero-sum thinking," noting that the angst over "overpopulation" has its roots in a zero-sum view of the world which sees resources as limited, like a "fixed pie," and every additional person as having the potential to leave a smaller slice for everyone else.

While declaring the 7 billion milestone as a "victory for mankind," the UN population fund abounds with this type of thinking, and their webpage entitled "Linking Population, Poverty and Development" makes declarations such as "slower population growth" reduces poverty, perhaps because "smaller families share income among fewer people" and "families with fewer children are better able to invest in the health and education of each child."

On a national level, the same page suggests that decreasing the population creates a "one-time only demographic window" in which countries can "spur economic growth" with government spending before the population ages and "dependency increases once more."

This kind of thinking is completely backwards, but it is consistent with the idea that growth is created by government spending (which often goes along with these same zero-sum assumptions) and that, since there is a limited amount of such spending to go around, the best way to maximize it is to create a one-time only "population window" for the fewer citizens who can enjoy the increased funding per person for a limited time.

Similar zero-sum beliefs are reinforced by the stark questions appearing on National Geographic's web site on the 7 billion milestone, such as

"Can we feed 7 billion of us?"
"Are there too many people on the planet?"
"Is there enough for everyone?"

and

"What influences women to have fewer children?"

Another article appears to be serious when it asks whether, in light of the population reaching the 7 billion mark, "the world should adopt a one-child policy" because the increased "demand on resources and the environment" might be "too large a demand for Earth to support."

In contrast to those who see the world as a fixed pie and every additional person as a potential drain on those resources, a few voices recognize that every additional person is actually a potential contributor who can make the pie bigger.

Not surprisingly, these voices tend to coincide with a view that governments and government spending do not grow economies, but rather innovation and entrepreneurial activity grow economies and make countries (and those who live in them) wealthier.

Last week, for instance, the Wall Street Journal's editorial page had an article by chief editorial writer William McGurn entitled "And baby makes seven billion" points out that prosperity is not linked so much to abundance of resources as to the correct view of the human being -- the right view being that "so long as people are free to trade and use their talents, the more the merrier."

For evidence that abundance of "resources" is not the central issue, he offers places such as Hong Kong that have prospered with almost no natural resources, while many countries with abundant resources have not.

This fact shows that the most important "natural resources" are human beings themselves!

The corporation as a legal person, the stock market, and other things Occupy Wall Street protesters don't like

2011-10-26T17:00:00.000-07:00

While it is impossible to state exactly what everyone associated with the "Occupy" movement is for or against, some general themes are emerging, some of which are captured in the above video. Some of the things that emerge in that video include:

against: the concentration of wealth among "the 1%" of rich persons and corporations.

against: the concept that a corporation can be a legal "person."

for: the idea that "corporations" and "the rich" need to "pay forward" by giving "a hunk" of their profits to "the next kid," since "nobody gets rich on their own" but brings their goods to market on streets that "the rest of us paid for" and employs employees who were educated in schools that "the rest of us paid for" as well.

Economist and Professor Emeritus of Economics at Pepperdine University George Reisman recently wrote an extensive discussion which deals with all three of these (especially the first one), entitled "In Praise of the Capitalist 1 Percent." In it, he points out that even if you accept the existence of a 1% / 99% split in the US for the sake of argument, the protesters are failing to realize that "the wealth of the 1 percent provides the standard of living of the 99 percent" (his italics).

By way of explanation, he points out that "in the modern world in which we actually live, the wealth of the capitalists is simply not in the form of consumers' goods to any great extent" but rather the wealth of the capitalists is "overwhelmingly in the form of means of production" and that "those means of production are employed in the production of goods and services" that are sold to voluntary buyers in the market.

He points out that everyone in a capitalist economy benefits from the vast concentrations of wealth that are required to buy the enormous tanker ships that bring oil to those who need to put it into their cars (after it is refined in refineries that also require huge capital investments to build and maintain), or the vast concentrations of wealth that are required to build the massive plants that are required to build those cars, or the vast concentrations of wealth that are required to create the ever-smaller and ever-more-powerful microchips that power their ever-less-expensive mobile connected devices.

In fact, since everyone depends on food and clothing that is delivered by these same trucks powered by this same fuel, it is quite accurate to say, as Professor Reisman does, that "the protesters and all other haters of capitalism hate the foundations of their own existence." Even the corporations that make products that compete with the products that individuals actually buy are helping them, by driving down the prices of the goods that they do end up buying.

One of the biggest reasons for the legal status of corporations as they exist in the US today is to limit liability for entrepreneurs and innovators and others who would otherwise not risk the loss of all their personal property. It is essential to create a tool whereby the legal personal property of a person engaged in business can be separated from the legal property held by the corporation. Without the legal ability to separate that, few if any innovators would risk the losses that often occur when starting a new business.

Without the concept of the corporation, access to capital would be severely limited, and the ability to bring together the resources needed to turn inventions like iPhones or iPads into reality would be severely limited. Professor Reisman explains why the ability to sell shares of corporations in a stock market is critical to this ability in his book Capitalism (available in its entirety on-line). Anticipating by several years the anti-Wall Street tone of the current protesters, he writes:

A widespread misconception is that the stock market is divorced from genuine productive activity [. . .]. It should be realized that the ability to sell their shares provides a major inducement to the purchase of those shares in the first place. If it were not for the existence of the stock market and its continuous trading in already issued stock, any purchaser of newly issued stock would be faced with the prospect of not being able to sell his stock, or of being able to so only with great difficulty. Such a prospect would greatly discourage the initial purchase of stock from the issuing corporations and would greatly reduce the availability of capital to those corporations. 466.

The protesters are thus shown to be squarely against aspects of modern economic life that are extremely beneficial to their own lifestyle -- and in fact to their very survival. It can be argued that governments can also accumulate capital in sufficient quantities to build automotive plants or oil tankers, although after the dismal record of the twentieth century experiment with that alternative, few sane people would recommend it. However, the last bullet point listed above shows that the protesters are indeed "for" the idea of requiring those with wealth (wealthy individuals and wealthy corporations) to "give back" a chunk (after all, as Elizabeth Warren says starting at about 3:30 in the above video, they used the roads "the rest of us paid for" when they were making that money).

Setting aside the fact that if it is true that "the rest of us paid for" those roads and schools, it is also true that the corporations who used those roads also paid for them out of their fairly substantial corporate taxes, the whole idea that the government needs to get involved in forcing certain people or businesses to give up some additional "hunk" to "pay forward for the next kid who comes along" may sound nice in principle but actually leads to all kinds of tyranny in practice. Once widespread redistribution (beyond what is needed to take care of the neediest members of society who might otherwise die without food, clothing or shelter) becomes the accepted role of government, all kinds of evils ensue. Just look at those countries where such a situation prevails, and you will find that people and companies spend their energy figuring out how to get those government (or UN) handouts rather than in coming up with the innovations and production that create growth and new wealth.

While it is not possible to make a blanket statement about the largely amorphous "Occupy" protests as they have developed so far, it is safe to say that the general tenor of many of the positions they are against as well as some of the things that they are for, reveal that many of their ideas would be extremely harmful to everyone if implemented, including to themselves.

Although we are not members of "Wall Street," we feel it is important that investors understand the benefits of the legal concept of the corporation, and the stock market and bond market and other institutions that enable those corporations to assemble the capital they use to bring those goods and services to market on which everyone in society relies.

There are certainly areas where the system in the US could be improved -- most notably in those areas where the government's willingness to benefit one group over another, whether on Wall Street or on Main Street, has created obstacles to innovation, entrepreneurship, and the ability of individuals to improve their situation through the very structures of capitalism that the protesters are mistakenly attacking -- but the institutions that are being attacked in the video above are institutions that actually protect and benefit the 100%, not just the 1%.

Quick comments from Gerry Frigon, October 24

2011-10-24T11:57:00.000-07:00

Here's a little commentary from Gerry Frigon from this morning, discussing the current state of the European situation, earnings season, and this week's GDP report (the advance report for Q3 GDP is due to be released on Thursday).

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

Another inspired presentation by Mary Meeker

2011-10-19T13:39:00.000-07:00

Mary Meeker's presentation at the Web 2.0 Summit on "Internet Trends" given yesterday, October 18, provided a wealth of data and some insightful analysis regarding the direction and speed with which the networked world is moving.

We have linked to previous presentations by Mary Meeker on the same subject before (2009 and 2010) and explained that the data she is discussing provides powerful and graphic confirmation of an extremely important paradigm shift taking place at a rapid pace, even in the midst of widespread economic angst and unmistakable government ineptitude.

We have also explained previously that paradigm shifts of this magnitude are so powerful that it is difficult for even government blundering to derail them completely (not completely impossible, but very difficult and in fact nearly impossible). In yesterday's presentation, Ms Meeker actually presents one slide which reinforces that theme, in which she shows the adoption by percentage of population of previous communications technologies going back to the AM radio, and includes bars on the graph showing recessions and the Great Depression, to illustrate that even the worst economic environments could not hold back change of this nature.

Finally, Ms Meeker closed her talk with a short but pointed quotation from the justly famous poem If, by Rudyard Kipling (1865 - 1936). She cites the first words of the poem's opening line:

If you can keep your head when all about you
Are losing theirs [. . .]

Her message is that the changes and innovations taking place in certain parts of the economy present a tremendous opportunity, but only if you keep your head about you (especially because there are plenty of talking heads who appear, in our opinion, to be "losing theirs").

Mr. Kipling's poem certainly applies to many other aspects of life, but we agree with Mary Meeker that it applies very well to investing, and particularly to investing at this particular junction of history. Bravo to her for another extremely worthwhile talk, and for sharing her insights so generously with anyone who cares to listen. We believe that every investor should do so.

More data says "no recession." So why is everyone so uneasy?

2011-10-14T11:32:00.000-07:00

The Census Bureau released their data for estimated monthly sales for retail and food services for the month of September this morning, and the numbers came in much stronger than most economists expected.

For the past month or so, many economists and pundits have been growing more and more pessimistic, with many of them declaring that a recession is all-but inevitable.

We have been on record several times saying that all the pessimism is overdone, and that those calling for additional government stimulus (they are often the same as the ones declaring an imminent recession) are mistaken. See for example this post from the end of August, in which we said:

Finally, we would like to point out the fact that economic growth of 1%, while anemic, does not indicate an impending crisis. The commentators in the NPR clip above imply that 1% growth is "just above stall speed," as if an economy that does not grow fast enough will automatically stall, in the same way that an airplane that does not go fast enough will stall. But that is a false analogy. Airplane engines require a certain amount of speed in order to force air into the engine, but there is no law of physics or of economics that says that a country must grow at a certain speed or else it will simply "stall" and go into a recession.

This view comes from the idea that economies are fragile things that will naturally break down unless they are constantly tinkered with and stimulated by governments. In fact, economic activity is the natural state of human affairs. Left to themselves, people will grow crops, start businesses, invent solutions to problems, look for cures to diseases, and generally "do economic activity" that will enable them to make money for their families in greater and greater amounts. It is government tinkering and interference that disrupts this natural pattern. Thus, the cure for the sluggish 1% growth is not more stimulus but rather removal of some of the "persistent drags" that we talked about above.

Today's data, and other economic measurements that have come out since we wrote that, have confirmed our analysis. The economy does not seem to be heading into a double dip, and today's strong retail-sales data makes it virtually impossible to continue to maintain that it is. However, growth could be much stronger, being held back by a host of damaging government policies.

So why is there such a pervasive feeling of economic angst out there? Well, for one thing, because the media continues to serve up pundit after pundit predicting disaster. For another thing, unemployment remains dreadfully high, because businesses understandably are reluctant to hire when government regulations make it more expensive to do so, and when the Fed and the Congress make it hard to predict the future stability of the dollar and of tax rates.

Even more importantly, we believe that these misguided policies are creating an environment very similar to that in the 1970s, when some innovative businesses in innovative industries were able to grow as they paved the way for the major changes that would take place in the next two decades, but when most businesses had a very hard time achieving real growth. We have been discussing this theme for quite some time -- see for instance this previous post and this previous post.

Forbes publisher Rich Karlgaard recently made this point again in an interview on MoneyShow.com, and we agree with many of the points he raised in his analysis of the economic similarities with the 1970s and the implications for technology (click the video in that story to listen to Mr. Karlgaard's interview).

What this means for investors is that you cannot simply "own the market" or "just index" -- an approach that became popular in the more economically friendly environment of the 1990s, when there was not the same kind of performance gap between more innovative companies and everybody else, the way there was in the 1970s.

We have always argued that the kind of businesses you choose as destinations for your investment capital matters a great deal. We believe that message is even more important in times like this, and that the combination of widespread economic unease even when economic data show signs of growth, indicates that we are probably in a period that is more like the 1970s than the 1990s.

Have you heard of this company? IDXX

2011-10-10T16:21:00.000-07:00

In order to explain what kinds of businesses we look for as potential destinations for investment capital, we have published many previous posts describing some of the important criteria. Readers may wish to go back to the series on "Beautiful Growth Companies" (part one, part two, and part three) for some discussion of those criteria, and they may wish to look at individual companies that we have highlighted in previous discussions (many of those discussions of individual businesses are linked in this previous post).

One of the companies we own in the portfolios we manage is IDEXX Laboratories, an innovative provider of diagnostic solutions primarily for use in the animal health industry (serving both companion animals or pets and production animals or livestock).* Their solutions are also being applied in the water and food safety diagnosis field.

IDEXX Labs develops, manufactures, and distributes products that allow animal healthcare providers to test for an impressive array of diseases, from canine heartworm to feline leukemia, from avian leukosis to chicken anemia, from bovine spongiform encephalitis (mad cow) to swine influenza and swine pseudo-rabies. The company has created a wide variety of "assay kits" which can be used right in the field to test animals -- for instance, they market simple tests that dairy owners can use to test milk for antibiotic contamination before shipping it in bulk to a milk plant (where, if it is discovered that their load has contaminated other loads, they may be liable for the losses of the owners of dairies whose milk had to be dumped due to the contact).

Other IDEXX assay kits enable vets to test pets for Lyme disease or parvo or pancreatitis, or allow cattle ranchers to test potential new additions to the herd for bovine viral diarrhea virus (BVDV) through a simple ear-notch test so that they can catch sick animals before they contaminate the rest of their cattle. Many of these assay tests return results in a matter of minutes.

IDEXX also manufactures and sells diagnostic equipment to veterinary offices and diagnostic labs, and they run their own lab business so that vets can send samples to IDEXX for testing with rapid turnaround times.

Additionally, the company develops and markets a range of products used for testing water safety for human consumption and for recreational use (lakes and pools and rivers, for example), including tests that can detect the presence of all coliform bacteria (including E. coli), enterococci, cryptosporidium (which is potentially fatal if ingested), and giardia.

While there are formidable competitors in the vet diagnostic field, we believe that IDEXX has demonstrated that they are extremely innovative and have a reputation for quality, and we also judge that the market that they serve consists of a very fragmented field of veterinary healthcare service providers which may be in the process of undergoing some consolidation, and that some of the companies that are doing the consolidating are IDEXX customers.

We provide these highlights of IDEXX not only because we believe it is an interesting and well-run business and one with which many readers may not be familiar, but even more because we are trying to give our readers an idea of the kind of characteristics that we believe they should be looking for as destinations for their investment capital.

We believe that when it comes to investing money for success over many years and even over many decades, it is vitally important to have a clear idea of what traits in a company investors should look for, so that they can participate in the future success of those companies. While the names of the companies that we own will necessarily change over the years, the characteristics we are looking for generally do not.

* At the time of publication, the principals of Taylor Frigon Capital Management own securities issued by IDEXX Laboratories (IDXX).

Rest in Peace, Steve Jobs

2011-10-06T09:57:00.000-07:00

It is no exaggeration to say that Steve Jobs changed the world and that he was directly responsible for shaping the way we all interact with technology and the way that technology will interact with our lives for years to come -- probably for generations to come.

There are many heartfelt and well-written tributes to him on the web today, and they all deserve to be read thoughtfully. A few we believe deserve special attention include:

Comments from Apple co-founder Steve Wozniak.

From technology writer Walt Mossberg.

From Steven Levy of Wired magazine.

From venture capitalist Fred Wilson.

From economist Scott Grannis.

From economist Brian Wesbury.

Not long ago, we were struck by a video interview of Steve Jobs by the late Louis Rukeyser, apparently from the period between his two turns at the helm of Apple, during a time when both Pixar and Apple were struggling*.

Around 6:01 in the clip, Steve says "I still think Apple has a future."

This in itself is a stunning statement, and reveals the entrepreneur's ability to see things with laser clarity before anyone else around him could. But even more memorable is what he said immediately after that:

"I think the way out is not to slash-and-burn. It's to innovate. That's how Apple got to its glory, and I think that's how Apple could return to it."

These words are so accurate and apply so far beyond one company that they should be memorized.

Vaya con Dios, Steve Jobs. You've made the world a better place.

* At the time of publication, the principals of Taylor Frigon Capital Management own shares of Apple (AAPL).

Excellent analysis of the recent Fed decision

2011-09-23T15:44:00.000-07:00

Economist Brian Wesbury explains in the above video why the markets threw a tantrum after the Fed announced Operation Twist last week. To see the video, follow the link in the previous sentence (or just click on the photo) and then press the "play" button on the video entitled "The Fed squashes gold bugs."

Mr. Wesbury's analysis is very insightful and we largely agree with his conclusions. In fact, in our previous post on "Operation Twist" we described the reasons why Wall Street and Washington need to be weaned from the baby bottle of Federal Reserve reactions to every economic worry. After that post was published, the markets threw a tantrum on the following day, and we remarked that the markets had screamed for the bottle (more easing) and the Fed had handed them a pacifier instead (Operation Twist), which the markets promptly spit out and then threw a hissy fit.

Mr. Wesbury argues that the realization that the Fed was not giving more easing was the primary cause for the sharp 20% drop in the price of gold, and that gold may have topped after this action from the Fed. We have written many times before about the dangers of trying to time the gold market (and other commodity-based speculation), and why we believe that investors would be better served focusing on the fundamentals of businesses. For those previous posts we recommend revisiting this one, this one, and this one.

We advise all our readers to watch the above video for themselves.

Operation Twist

2011-09-21T12:45:00.000-07:00

Today, the Federal Reserve announced that it will begin increasing its purchases of longer-dated Treasurys in an attempt to lower longer-term interest rates across the board, thus potentially spurring more borrowing. This plan, nicknamed "Operation Twist" because by doing so the Fed is attempting to bend or "twist" the yield curve to their liking, is yet another attempt to "boost an economy flirting with recession" (in the words of this Wall Street Journal article describing the move).

Our first reaction to this decision is something we've stated many times before: we do not believe the Fed should be trying to steer the economy, especially since Fed attempts to grab the steering wheel in the past have not ended well (see this previous post and this previous post, among others).

We believe that Wall Street and Washington need to be weaned from their habit of looking to the Fed to provide comfort every time they believe the economy is "flirting with recession". And we would add that we are not convinced that the recent signs of panic necessarily mean that an economic recession is inevitable, as we explained in this recent post. It is certainly possible that "taking the baby bottle away" would cause a few market tantrums, but in the end we believe it would be a good thing if markets would stop looking to the Fed to comfort them with some new stimulus every time they feel uneasy.

On the other hand, it's hard to blame the Fed, because it has been given a "dual mandate." That mandate is to provide a stable currency, and minimize unemployment. This dual mandate is the real problem. As we wrote some three years ago, an economist we respect compares the Fed's dual mandate to telling a football coach that he has been hired to win games and to make sure his players keep their uniforms clean during the game, and that he will be fired if he doesn't accomplish both missions!

We believe the better solution would be for the Fed to have one task: to maintain a stable monetary policy. In reality, the Fed can't do much more to improve the economy anyway. Think about it this way: the Fed has already lowered rates to effectively zero for going on three years, promised they would keep it that way until mid-2013, and initiated and concluded QE1 and QE2. How effective have these extreme and unprecedented measures by the Fed been at improving economic growth and lowering unemployment?

Operation Twist is supposed to spur borrowing by lowering long-term interest rates. But long-term rates have been extremely low for quite some time, as current mortgage rates indicate. Perhaps there are other factors affecting the level of borrowing and lending taking place in this country -- namely the massive new regulations regime that has been enacted which makes bankers scared to lend.

Politicians may be urging bankers to get out and lend, but regulators are sending bankers the opposite message, and it's the regulators who have the power to shut banks down. We've referred before to the titanic size of the new regulation included in the Dodd-Frank Wall Street Reform and Consumer Protection Act, passed last year.

This huge new landmark in the history of regulatory expansion gets to an even bigger problem than the Fed's dual mandate. In our view, federal lawmakers have largely abdicated their Constitutionally-given responsibility of making law to bureaucratic agencies such as those created by the Dodd-Frank Act, and for that matter to agencies such as the IRS and many others. These bureaucracies generate volumes of regulations that spend thousands of pages defining and regulating aspects of business which would be ridiculous if they weren't so damaging to economic growth and jobs creation (see for evidence the famous 1992 letter to the Wall Street Journal written by former Senator George McGovern after his experience trying to run a hotel in New England).

The two threads of discussion in this blog post are tied together: if politicians realized that the way to foster economic growth is to get rid of the nonsensical regulations and lower and flatten the tax rates, then the Federal Reserve could concentrate on keeping a stable money supply, and wean Wall Street and Washington from the baby bottle of "Fed stimulus."

Want a fair tax system? Get the steamroller!

2011-09-20T11:01:00.000-07:00

In all the recent uproar about taxes and people paying a "fair share," nobody is talking about Alvin Rabushka, and we think that is a tremendous oversight.

Dr. Rabushka is a political scientist and the David and Joan Traitel Senior Fellow at the Hoover Institute at Stanford University. Along with economist Robert Hall, he is the author of numerous books about the flat tax, which he has championed since the early 1980s.

We would challenge all the politicians arguing about the tax code, on both sides of the aisle, to read through the book The Flat Tax by Hall and Rabushka. We would advise all investors to do the same.

Right now in the US, we have one faction saying "millionaires need to pay their fair share" and another faction saying raising tax rates on the upper brackets and on capital gains is not a good idea "in a fragile economy" (as if it is a good idea at other times). We believe that to really get everyone to pay their fair share, and to do it in a way that actually helps the economy, policymakers should enact a flat tax that taxes everything and does so at a low flat rate, and that in doing so they should entirely do away with all of the deductions that special interest groups and social engineers have introduced over the years.

The benefits of such a flat tax policy are enormous. As Hall and Rabushka write:

Our flat tax solves many tax problems that have challenged academics and politicians for years: it eliminates double taxation; it improves capital formation; it correctly defines the tax base; it provides true simplification; it dramatically improves incentives; it removes millions of low-income households from the tax net; it lowers the costs of compliance; it puts a serious dent in tax cheating; it even reduces the adversarial stance of the Internal Revenue Service toward tax payers. 4.

The argument for the simplicity of the flat tax is incontrovertible. For example, if lawmakers decided that 18% of income was going to be collected, they could get to that number by a simple 18% flat tax or by a complicated system of brackets and deductions which charged higher than 18% on some earners but gave back deductions and credits to various groups for various activities, which ended up netting the government about 18%, although by a much more circuitous route. As a taxpayer, if you earned $100,000 of income in a year and were going to end up paying about $18,000 in taxes, would you rather do that with a postcard-sized tax return under the flat tax, or would you rather do it through a 40-page tax return that took hours of your time or hours of work by your accountant (charged to you)?

While nobody disputes the simplicity of the flat tax versus the current system, Hall and Rabushka note that many reject the flat tax on the basis of "fairness." However, they present extensive evidence that the flat tax is eminently fair, despite the criticisms often leveled against it. In fact, as argued in this chapter from their book exploring the concept of "fairness," the authors explain why the flat tax is far more "fair" than the current system (or any other practicable taxation system).

They point out that by almost any traditional definition of fairness, the flat tax is fair, except for a relatively new understanding of "fairness" that developed during the twentieth century among "politicians and intellectuals" who redefined it to mean "redistributing income" to "attain their egalitarian goals" (42-43). Aside from the philosophical and ethical problems with this new definition, Hall and Rabushka point out that attempts to redistribute wealth via higher tax rates on higher earners don't work very well in practice either: "Despite attempts to equalize after-tax incomes through steeply graduated tax rates, one Congress after another has riddled the tax code with hundreds of loopholes that permit some millionaires to pay no income taxes whatsoever and some high earners to pay low taxes" (43).

We would also add that philosophically, we disagree with Robert Hall and Alvin Rabushka over the idea in the quotation above that the flat tax should remove "millions of low-income households from the tax net." Their flat tax plan calls for no tax on those earning up to a certain minimum amount, after which the flat tax would kick in. We believe that there is moral hazard involved with excluding any group of voters from the tax system entirely, and believe that the tax rate should truly be low, flat, and the same for everyone.

Not only do all the complexities of the tax code waste time, money and energy for filers every year, and not only are they "not fair" in that they end up allowing some people to get away with paying less than others in similar circumstances and with similar incomes, but they have another huge problem that's not always well understood, which is that they encourage massive misallocation of capital, also known as malinvestment. By privileging various types of investment through the tax code, lawmakers encourage capital investment to go where it otherwise may not.

For example, real estate enjoys tremendous tax benefits in the US: many kinds of mortgage interest expenses are tax deductible, and sales of real estate property can be rolled into other "like kind" real estate investments without being taxed in between. In contrast, proceeds from selling shares in one company cannot typically be rolled into shares of another "like kind" corporation without being taxed in between. Similarly, insurance products and annuities enjoy different tax benefits. All of these tax loopholes and deductions encourage investors to commit more capital to those types of instruments than they would otherwise do, and this can lead to gross misallocations of capital, such as the real estate bubble that imploded with great collateral damage from 2007 to 2009.

(As an aside, we might ask Warren Buffett why -- if he is so keen on increasing "fairness" in the tax code -- he doesn't agitate to remove the inequitable tax loopholes that have been afforded to the insurance industry over the years in the United States).

A simple, low flat tax -- accompanied by the elimination of all the deductions and loopholes that politicians of both parties have enacted on behalf of lobbyists and favored industries over the decades -- would have a tremendous positive benefit on the US economy.

We are under no illusions as to the likelihood of such a commonsense solution ever being enacted. However, we believe it is important to go on record as supporting the flat tax as the most pro-growth policy that lawmakers could possibly introduce. With awareness growing of the problems inherent in the current abominable tax system, we can only hope that at some point more people will start listening to Alvin Rabushka.

We don't need to stimulate consumption

2011-09-12T09:24:00.000-07:00

Last week, President Obama rolled out the framework for his long-anticipated economic recovery and employment-improvement plan. Details of the plan are being sent to Congress today for their inspection. Mr. Obama says that the only reason anyone could be against this plan would be "political games," but from what we have seen of the plan so far, the economic approach of the plan is almost completely "demand-side" or "consumption" oriented, which is a reason to remain very skeptical.

We have written before about the difference between seeing our economic problem as one of boosting production versus boosting consumption. We would recommend all our readers understand this crucial distinction, and perhaps go back and review previous posts on the subject, including this one and this one, and this external article by the professor emeritus of economics at Pepperdine University, George Reisman, first published back in 1964.

The demand-side or "consumptionist" view of economics teaches that demand for goods and services is always in danger of growing too weak to consume what is being produced, leading to recessions and unemployment. Those who follow this view naturally believe that the way to improve the economy is to stimulate this demand in various ways.

The supply-side or "productionist" view of economics teaches that demand is a given -- it does not need to be stimulated. People will consume things -- in fact, if we do not consume food every day, we will soon die. Furthermore, left to themselves, people do not simply consume the minimum, but will naturally desire more and better goods and services. The desire to consume does not need to be stimulated, because it is built-in.

Each of the above approaches believes that the basic economic problem is very different. The consumptionist school takes supply for granted, believing that goods and services will naturally be produced, and that the problem is getting consumers to buy them. The productionist school takes demand for granted, believing that consumers always want to consume, but that producing enough for them is the problem.

We believe the productionist or supply-side school is much closer to the real situation experienced in the economy, and that this view of the world has demonstrated its worth over the demand-side/consumptionist theories that dominated the twentieth century (championed most famously by John Maynard Keynes and his followers and intellectual descendants).

The president's policies from the beginning have focused on stimulating demand and consumption, and last week's speech was no different. While the plan is ostensibly about creating jobs, the details it did contain centered around government spending on infrastructure (which will create temporary work for those involved, who will then spend and increase demand and consumption), lowering the interest rates on mortgages for homeowners (enabling them to spend more money, thereby increasing demand and consumption), and paying small businesses that have contracts with the federal government more quickly (enabling them to start spending sooner and thus boosting consumption and demand). These are all demand-side or consumptionist approaches.

We believe that the best way to increase economic growth and hiring is to remove obstacles to production, and the plan appears to do very little in that department. To be fair, there were some points about lowering payroll taxes for certain workers (such as those who have been unemployed for six months). However, these payroll tax reductions are always "targeted" (for certain employees only) and temporary -- which does not fool potential employers.

The speech also promised a review of government regulations in order to "cut away the red tape that prevents too many rapidly-growing start-up companies from raising capital and going public." We applaud any proposals that actually reduce obstacles to production, including reduction of government red tape, but must confess to being skeptical in light of the fact that this administration recently pushed for and signed into law a massive increase in red tape in the form of the Dodd-Frank bill, which dwarfs even the Sarbanes-Oxley Act in terms of red tape -- see the amazing graph posted by economics professor Mark Perry in his Carpe Diem blog here.

We also applaud the line in the speech about signing free-trade agreements, including the trade agreement with Colombia that has languished for years since being signed in 2006, and like the reduction of red tape will be more inclined to believe it when we see it.

However, the demand-side bias in the plan is revealed by the suggestion that any tax cuts in the plan be paid for by raising tax rates "on those who are most fortunate and can best afford it." This kind of statement ignores the simple truth that we have discussed in previous posts, that tax rates in the wealthiest brackets have a disproportionate impact on production because most of the capital used for business investment and backing for start-ups and new innovation comes from these brackets. Penalizing gains from such investments reduces the incentive for investors to risk that capital. If investors lose their capital, nobody pays them back, and if the government takes more of their gains when they invest in a winner, the risk-reward equation changes dramatically.

Finally, the plan does not reduce corporate tax rates in the US, which are among the highest in the developed world, a point that has been discussed by legislators from both political persuasions as a necessary ingredient to give US companies equal footing in the global markets. All he did was promise to eliminate loopholes and deductions that some companies receive. This reveals the fundamental demand-side bias of the plan, which was on display in this segment:

Should we keep tax loopholes for oil companies? Or should we use that money to give small business owners a tax credit when they hire new workers? Because we can’t afford to do both. Should we keep tax breaks for millionaires and billionaires? Or should we put teachers back to work so our kids can graduate ready for college and good jobs? Right now, we can’t afford to do both.

None of this is to suggest that consumption is not important -- it is obviously necessary to create demand for goods and services. However, it does not need to be stimulated. And when government reduces the obstacles to production, those producing companies end up expanding, hiring more workers, and creating more demand.

This fundamental distinction should be understood by all investors.

The lessons of Switzerland

2011-09-07T13:26:00.000-07:00

Earlier this week, the central bank of Switzerland (the Swiss National Bank) announced that it will enact a policy of buying euros in order to ensure that the Swiss franc does not continue to strengthen against the foundering euro. They set a target of requiring that the euro retain a value equal to at least F1.20 per euro.

Without this intervention, fewer and fewer Swiss francs would be required to obtain one euro (or, seen from the other direction, more and more euros would be required to obtain a set number of Swiss francs from one day to the next, as demand for Swiss francs drove the price of a franc higher and higher versus the declining currency of the economically troubled European Union).

This is a momentous occasion and a sad but probably necessary move from Switzerland, which abstained from joining the EU and which has been a true model of stable currency over the years.

As the European debt crisis intensifies, Switzerland has found itself in a difficult position, surrounded by eurozone countries filled with investors who have been trying to get their capital out of euros and into something more solid. Switzerland has been a rock in the midst of the recent stormy European sea (see diagram below), and as demand for their francs soared, their economy was put at risk by the rapid and increasing relative overvaluation that resulted.

Here is a link to an editorial in today's Wall Street Journal opinion page which explains that this move by the Swiss National Bank should not necessarily be seen as a sop to Swiss exporters whose goods were becoming too expensive for the rest of the world (or Swiss tourism, which would suffer as eurozone visitors found that their euros were not buying them much traction when turned into Swiss francs), nor as a nod to inflating their currency, but rather as a move to keep their foreign exchange rates more stable (having your currency appreciating rapidly can be as destabilizing as can having it depreciate rapidly).

The Wall Street Journal editors explain that the Swiss concern for stability is all too rare in recent decades, saying:

It's not fashionable these days for central bankers to worry too much about the external value of their currencies. Since the collapse of the Bretton Woods exchange-rate system in the 1970s, policy makers have grown fond of saying that markets should set exchange rates. But markets can't set the value of a commodity whose sole supplier is the central bank, and this pseudo-laissez-faire is an abdication of central banks' duty to control the supply of their currency, both internally and externally. Full marks to the Swiss for breaking with this mistaken central-bank orthodoxy.

This echoes arguments we have put forward in previous posts regarding the US dollar, saying that we are not among the camp that argues for a weaker dollar, but neither are we among the camp that argues for a constantly strengthening dollar. We are among the tiny camp of those who argue for a stable dollar.

On a related note, we also believe it is worth pointing out that the current turbulence in Europe is revealing once again that in a crisis, investors from around the world do not just flee to Swiss francs, but also to US dollars. There has been a lot of doomsday talk in the US in recent months that the US dollar cannot last much longer as the world's reserve currency.

We believe that such fearmongering is irresponsible: the US may be making egregious monetary and fiscal mistakes, but the fact remains that the US is by far the largest economy in the world and the only one with a system large enough to handle the job of acting as the reserve currency. We take our hats off to the bankers and policymakers in Australia and Canada (and Switzerland) who have done a far better job than those here in the US in managing their fiscal and monetary affairs than has the US, but the fact remains that those economies are nowhere near as diversified as the American economy in terms of goods and services produced, nor are they anywhere near as large. This should be well understood by investors who are being bombarded on all sides by politically-motivated messages threatening the end of the US dollar's reserve currency status.

The real thing that investors should take out of all this currency turbulence of late is the core lesson that we have tried to make central to everything we say here on this blog: that investors should be focusing on the businesses to which they commit capital, and avoid being sucked in to the siren song of chasing currency-based speculations (or any other primarily market-driven trading activity, all of which are the opposite of making business-based investments).

The real question for investors at any time and in any economic situation is, "What kind of businesses do you own (or to what kind of businesses do you lend investment capital)?" This is the question investors should ask themselves, rather than the seductive but dangerous questions of "How are you playing the (weakening/strengthening) US dollar?" or "What kinds of international plays are best to take advantage of the current situation in (insert latest headline-grabbing country or region of the world)?"

These are some of the important lessons investors should take out of the current situation in Switzerland and Europe.

The Solyndra bankruptcy

2011-09-02T17:32:00.000-07:00

A couple days ago, on August 31, tubular solar-cell company Solyndra filed for Chapter 11 bankruptcy. This fact is notable for a few reasons, most prominent among them being the fact that the company received a $535 million loan guaranteed by the US government, which guaranteed the loan in order to promote the solar industry.

Because of the government involvement, and the "green energy" connection, this bankruptcy is turning into something of a political football, with predictable battle lines forming almost immediately. This blog post on the Forbes website describes the two sides of the argument, and then makes the argument that "Solyndra’s failure, while unfortunate, is hardly an indictment of federal energy technology policy. Failure is to be expected with emerging, innovative companies, whether they are financed by the government or the private sector."

A similar argument is made in this blog post from the Huffington Post website, in which the authors make the case that "it would be a serious mistake to over-interpret regarding the Solyndra crack-up, whether to generalize about the solar industry and cleantech or to broadly indict particular technology and development policies" and that "the blow-up of one particular loan guarantee to one particular company with one particular technology should not be spun into any broad new chilling of U.S. efforts to compete more aggressively in cleantech and other advanced manufacturing industries."

As professional investors who also back private companies with venture investments, our perspective on this matter is that the environmental angle is a gigantic red herring (or in this case a "green herring") and the bigger problem is the idea that tax dollars should be used for venture investment at all.

As investors, we are not particularly fond of the "cleantech" craze that has seized Silicon Valley and many private venture investors (many of whom were backers of Solyndra as well), but if private investors want to throw their money at businesses that they judge to be worthwhile investments, that is their concern and we don't begrudge them their right to do so. However, when the government ventures taxpayer money, an entirely different dynamic comes into play. As Milt Friedman said on many occasions, "very few people spend other people's money as carefully as they spend their own" (see for instance this video).

While the bloggers in the two articles cited above argue that government dollars are necessary to foster innovation, the fact is that if a company is innovative and is judged to have a high likelihood for future success, there will be investors who will be willing to fund that innovation for an opportunity to participate in that success. The technology companies which made Silicon Valley what it is today (and which provided much of the wealth of the founders of Solyndra and of their private investors) were built on private investment, not public investment.

No matter how much the authors of those blogs promise that greater government focus on "developing rigorous, market-informed finance strategies" will enable wise investment in the future, the fact that government investors are committing taxpayer dollars rather than private investors committing private dollars completely changes the equation. We believe this is true regardless of whether the government is committing those taxpayer dollars to solar technology companies or to any other business.

With taxpayer dollars, the market forces which penalize imprudent investment are absent: the providers of those dollars cannot in any way hold the person(s) who invested them accountable for their imprudence.

Those readers who are familiar with venture capital investment and the dollar amounts involved will appreciate the fact that $535 million is an enormous venture investment in a company. They will also appreciate the fact that getting a venture capitalist to give your company $535 million is an inordinately difficult thing to do, and would entail extremely rigorous examination with many blunt questions and no beating around the bush with small talk.

On the other hand, getting a loan from a bank which has the prospect of collecting interest on the loan if things go well, and of receiving their money back from the government if things do not go so well, is an entirely different proposition.

The operative point in all this is that it doesn't really matter whether the company in question is a solar-cell company or some completely different business -- the government should not be in the business of trying to determine which companies will be winners and receive taxpayer-backed loans or venture investments.

Critics of this position will of course argue that there are some very long-term projects which are appropriate for the use of taxpayer dollars, such as putting a man on the moon or building freeways, and we would agree. But those projects are owned by the government. Giving taxpayer dollars to someone's business as an "investment" is different and it should fall within the sphere of private investing, where those who make those investments bear the risks, have a vested interest in making sure the money is not wasted, and then can profit from the success if they invested wisely.

We believe investors should be aware of the Solyndra case and the issues involved, and should see through the distracting "green" debate to the deeper issues that this case reveals.

Here is a recent video in which Taylor Frigon President and Chief Investment Officer Gerry Frigon discusses the recent Solyndra news.

Kick the habit of begging for new stimulus

2011-08-30T11:59:00.000-07:00

The Fed minutes from their most recent meeting have just been released, and talking heads in the media are debating whether the Fed needs to "do more" to stimulate the economy. Many pundits are calling for a third round of asset-buying by the Fed in order to increase Fed balance sheets -- a process known as "quantitative easing" which we explained in detail in this previous post -- the possibility of which is colloquially referred to as "QE3."

We believe the markets need to kick their long-time "Fed addiction," in which many on Wall Street and in the financial media look to the Fed to steer the economy and to take "bold action" at every bump in the road.

Granted, an unemployment rate at 9% is no mere bump in the road -- it is a disgrace -- but as we have frequently explained, stimulating consumption through various forms of easy monetary policy does not truly create the need to hire among business owners. To do that, the government should remove roadblocks to growth, lower corporate income tax rates, and get rid of regulations which make hiring more costly than beneficial to business owners.

The Fed is not the savior of the economy, and Fed stimulus can be like a drug to which the markets have been addicted for far too long. In fact, we would argue that this addiction to the Fed goes back at least to the tenure of the previous Fed Chairman, Alan Greenspan, who became known as "The Maestro" on Wall Street among those who felt that he always knew what to do in order to direct the "unruly" economy like a master conductor in control of a symphony orchestra.

While it would no doubt cause pain and outrage on the Street, we would like nothing better than to hear the current Fed Chairman declare, "I am going to give you a stable dollar and nothing more -- QE1 and QE2 were probably more harmful than beneficial, and you are not going to get a QE3. The economy knows how to grow itself, if we just give businesses a stable dollar." It's not his job to lower tax rates or repeal burdensome regulations, but if Congress wanted to follow such a declaration with legislative actions along those lines, we would welcome those moves as well.

Of course, the markets might well react with a temporary plunge upon learning that the Fed Chairman was no longer in the business of providing them with their regular stimulus "fix" whenever they started to crave it. The reaction might become quite ugly, but we truly believe that such a detox would be beneficial, and that after the rage and the withdrawal symptoms wore off, everyone would be a whole lot better for it.

Unfortunately, such a scenario is not very likely to ever take place, based on what we have observed during the tenure of the current Fed Chairman. But we believe investors should thoroughly understand the position we have outlined above, and should remember that the Fed does not grow the economy, the next time they hear someone on the financial news basing their arguments on the assumptions that it does.

Does NPR speak for "investors"?

2011-08-26T11:00:00.001-07:00

This morning, Fed Chairman Ben Bernanke said something we agree with for a change: that it's really up to elected officials to initiate policy changes if they want to "do something" for the economy.

In their spin on the Fed Chairman's remarks, NPR presumed to speak for "investors" whom they described as "waiting breathlessly" in hopes that the Fed was going to ride to the rescue with more "solutions" to the present state of the economy.

While NPR announcers may be very good at their job, we question their ability to speak for investors. As professional investors with decades of daily experience analyzing the economic situation and businesses in the economy, we would like to point out that these announcers certainly do not speak for us.

The NPR commentary this morning began:

Nervous investors -- and these days that's most investors -- were all ears this morning as Federal Reserve Chairman Ben Bernanke delivered a speech in Wyoming. The investors were listening for any clues about additional steps the Fed might take to shore up the sagging economy. Bernanke did not outline any big rescue plans, but he did say the Fed has tools it can use if necessary.

Later, the back-and-forth between two commentators included this exchange:

David: So, investors were waiting for this breathlessly. Why all the buildup?
Scott: Well, precisely it's because the economy has been in such a slump, David. You know growth in jobs has slowed dramatically since the beginning of the year, we've seen signs that factories are losing steam. Just this morning the Commerce Department came out with a revision of it's economic growth numbers for the second quarter, showing that the economy grew at just one percent, barely above stall speed, and so there's a lot of interest in what the Fed, or anybody, can do to try to come to the rescue.
David: And I gather Bernanke did not have as much to say as some investors would have liked. Tell us what he included in the speech.
Scott: Well, there was very little specific, in terms of what the Fed is prepared to do, there was no grand new silver bullet unveiled, nothing for investors to really grab onto as a strong dose of economic medicine. But as you say, Bernanke did again reiterate that the Fed has tools in its tool kit that it is prepared to employ as appropriate to support a stronger economic recovery. He also acknowledged that the weakness of the recovery is not just a result of some of the temporary factors that we were talking about this spring, the Japanese tsunami and the disruption in supply chains that caused, or the higher oil prices that resulted from the Arab spring. Bernanke said there are more persistent drags at work on the economy, so I guess if you want to look for a silver lining, that negative assessment of the problem could indicate some willingness in the future for the Fed to take some action. Bernanke said Fed leaders will be looking more closely at this when they meet again next month.
David: But Scott, a year ago -- I believe in the very spot, in Jackson Hole -- the Fed seemed ready and took some bolder action. If we're talking about "persistent drags" on the economy now, as you put it, what's changed? Why not take bold action today?

We've already published a series of posts which explain that "bold action" from the Fed is not what investors -- or anyone else who cares about economic growth -- should be pining for. To suggest that the Fed's negative assessment of the economic conditions could be a "silver lining" that will lead to "some bolder action" (such as QE3) in the near future is quite troubling, and demonstrates a clear bias towards Keynesian economic views by those running taxpayer-supported NPR.

Contrary to what the NPR commentators say when they presume to speak for investors, we are not looking for a "silver bullet" from the Fed, or a "strong dose of economic medicine" for investors to "really grab onto." Indeed, we think that those who can read between the lines of the above commentary will perceive that there are some other "persistent drags" holding the economy back, and we would include the effects of QE2, and all the other so-called forms of "government stimulus" among the drags!

We believe the Fed Chairman is right to have said that the real problem and solution lies with the elected officials. However, while some will interpret that as a call for some kind of short-term stimulus to the consumer, we would argue that government attempts to throw money at the consumer do not create a sustainable economic recovery. Companies do not hire more workers just because of temporary consumer stimulus -- they hire more workers based on their outlook for long-term business conditions, which can be improved primarily by removing obstacles to growth, including obstacles that make hiring workers or increasing profits more expensive.

If elected officials really want to take "bold action" to get the economy growing faster, they should consider actions such as replacing our byzantine tax code with a flat tax, lowering or eliminating the corporate tax rate in the US, repealing regulations that make healthcare more expensive for employers, replacing welfare payments with a negative income tax, signing free trade agreements (some of which, such as the agreement with Columbia, have been stalled for years), and repealing unnecessary regulations such as Sarbanes-Oxley, and even the recently passed Dodd-Frank financial reform bill.

We do not make these suggestions as representative of one political party or another -- we are speaking on behalf of investors, and for policies that we believe are good for overall economic growth, innovation, and the investors whose capital fuels that growth and innovation. After all, we actually are investors and professionally represent investors.

Finally, we would like to point out the fact that economic growth of 1%, while anemic, does not indicate an impending crisis. The commentators in the NPR clip above imply that 1% growth is "just above stall speed," as if an economy that does not grow fast enough will automatically stall, in the same way that an airplane that does not go fast enough will stall. But that is a false analogy. Airplane engines require a certain amount of speed in order to force air into the engine, but there is no law of physics or of economics that says that a country must grow at a certain speed or else it will simply "stall" and go into a recession.

This view comes from the idea that economies are fragile things that will naturally break down unless they are constantly tinkered with and stimulated by governments. In fact, economic activity is the natural state of human affairs. Left to themselves, people will grow crops, start businesses, invent solutions to problems, look for cures to diseases, and generally "do economic activity" that will enable them to make money for their families in greater and greater amounts. It is government tinkering and interference that disrupts this natural pattern. Thus, the cure for the sluggish 1% growth is not more stimulus but rather removal of some of the "persistent drags" that we talked about above.

In summary, the NPR story above is full of very poisonous ideas, all pleasantly masked by congenial banter between likable reporters with sophisticated diction. Investors should be wary when listening to such stories, which imply that the writers are accurately reporting the sentiments of investors at large. In fact, nothing could be further from the truth.

Tax rates and employment in Illinois

2011-08-24T13:34:00.000-07:00

Above is a chart from the Illinois Policy Institute, based on US Department of Labor Statistics, showing employment in Illinois since January 2010. In the article accompanying the graph, the Institute authors note that Illinois lawmakers approved a tax rate increase in January, and point out that the employment gains in Illinois turned around the same month.

The tax rate hike raised individual income tax rates by 66% (from 3% to 5%, still well behind California) and corporate tax rates by 45% (from 4.8% to 7%). The rate hikes were retroactive to the beginning of 2011 and were designed to last for five years, in order to help pay off budget deficits, after which they expire at the end of 2015.

While some may argue that other factors may have caused employment to turn around, and that the graph above does not necessarily prove cause-and-effect, we believe that people do indeed modify their behavior in response to changes in tax law and tax rates. In particular, venture investors become less likely to risk capital to fund new companies, because the risk-reward equation changes (the potential reward is reduced), companies become less likely to expand (leading to fewer employment opportunities than would otherwise take place), and individuals who have the option of working or not working weigh the costs and benefits differently (because the costs have increased and the benefits decreased).

This whole discussion goes back to a very important post we published back in 2010 entitled "Growth is the answer: the primacy of human creativity." Ironically, that article featured a quotation from a professor of finance from the University of Chicago (in Illinois) who said, "Countries only pay off debts by growing out of them." We would add that the same thing applies for states.

In the same post, we cited sage words from George Gilder, who argued that the two most important ingredients for innovation and growth are low taxes and sound money. Creating conditions that do not impede growth will ultimately lead to greater tax revenues and the ability to pay off debts.

We hope that other leaders around the world are paying attention to the evidence from Illinois.

Excellent article from Marc Andreessen

2011-08-22T13:01:00.001-07:00

All investors should carefully consider an article published in the Opinion section of today's Wall Street Journal from entrepreneur and venture investor Marc Andreessen, entitled "Why Software is Eating the World."

It explains the paradigm-shifting impact that technology is having on businesses that at first glance might appear to have nothing to do with software. In fact, in the article, Mr. Andreessen declares that "Companies in every industry need to assume that a software revolution is coming." He also believes that "this is a profoundly positive story for the American economy, in particular."

This is a subject which we believe is profoundly important for investors to understand, and one which we have written about many times in the past. For previous discussions of the important concept of a business paradigm shift, see this previous post (or search for posts containing those words). For previous discussions of the transformative impact that technological advancements are having and will increasingly have on all areas of business, see this previous post (or search for posts containing the words "unstoppable wave").

In the past, we have advised readers to learn from the way venture capitalists look for companies in which to commit investment capital. We believe that this new article from Marc Andreessen provides an excellent opportunity for exactly that kind of thinking and learning.

A notable study on imports

2011-08-22T12:09:00.000-07:00

Hat tip to our friend Steve Waite of Research 2.0 for alerting us to this research from two senior members of the Federal Reserve Board of San Francisco entitled "The US Content of 'Made in China.'"

In their analysis, senior economist Galina Hale and senior research advisor Bart Hobijn determined the percentage of US consumer spending which goes to imported goods made overseas. Further, they determine the percentage of the cost of imported goods which actually ends up going to the value added by US transportation, wholesale and retail activities. Their findings are very interesting.

For starters, they find that 88.5% of US consumer spending actually goes towards goods and services produced in the US. Of course, they note that a large percentage (about 66%) of this number is spent on "services," which are largely produced in the US. Durable goods, on the other hand, contain a higher percentage of goods made overseas (about 33%).

In total, the study found that only about 11.5% of the total personal consumption expenditure went to foreign goods. About 2.7% of the total went to goods that were made in China. Of the amount spent on goods made in China, the authors found that about 55 cents of every dollar went to services that were provided by people in the US who were involved in getting those goods to the end consumer.

We believe that the numbers in this study are important for investors to understand, especially in light of the fact that politicians and pundits of all political persuasions are fond of declaring that the US economy is dead or dying because "we don't make anything here anymore" (a complaint we have debunked many times in the past, such as in this previous post). The most recent politician we have heard floating this complaint is Republican presidential candidate Jon Huntsman in the recent Iowa debates, in which he said, "We don't make things anymore in this country."

Besides proving this sentiment to be wrong, the analysis also reveals something that should be obvious: Americans and American jobs are involved in importing, distributing, marketing and selling those goods which are imported. We pointed this out before in a post entitled "The ugly tomatoes of protectionism," in which we showed how a Supreme Court case back in 1893 which ruled to protect domestic tomato growers from foreign competition ended up hurting the family business run by John Nix and his three sons, who initiated the court case. The modern data shows that imports are just as important to the livelihood of many Americans as they were back then.

The entire article is worth reading and understanding, as an antidote to the anti free-trade sentiments which still surface frequently in political discussions from both members of both major US parties.

Some investors worry that government IV bags will run out

2011-08-18T11:35:00.000-07:00

US markets are reeling again on increased concerns over European debt defaults and this morning's latest jobless-claims-number ticking back upwards across the 400,000 mark to 409,000.

Investors are voicing concerns that governments (especially the US government) don't have much ability to "help" out due to their deficits. For example, in this Wall Street Journal article from this morning, a professional investor declared, "I don't see much help from Washington."

What surprises us is the fact that anyone still believes the fallacy that "help" in the form of increased government spending has a positive effect on the economy. The evidence that increased government spending has a damaging effect on economic growth and on employment is overwhelming, as we will see below.

Nevertheless, NPR this morning ran an interview with University of Texas economist James Galbraith advancing the exact same argument, that government spending is good for the economy, especially in a sick economy. Professor Galbraith argued that government spending is like an "IV bag" that keeps a sick patient alive, saying:

Well, the IV bag in an emergency room provides fluid -- saline solution -- that keeps a patient who's very sick alive. What the federal deficit does -- the federal government spending in excess of what it takes out of the economy in taxes -- is to put money into the pockets of private individuals, businesses, and it keeps them able to continue their consumption, so it buffers the effect of the severe economic shock we had three years ago and makes it less difficult for ordinary citizens to get through tough times when their incomes are low and they may be experiencing bouts of joblessness.

The sheer wrong-headedness of this argument is shocking. As Dan Mitchell of the Cato Institute explains in the video below, the argument that the government can "put money into the pockets of private individuals" completely ignores the fact that in order to do so, the government must first take that money out of the pockets of private individuals!

Mr. Mitchell goes onto demonstrate that arguments like the one articulated by Professor Galbraith on NPR are not only illogical and theoretically unsound, but that these theories have been an utter failure every time and everywhere they have been attempted.

For example, he points out that Herbert Hoover boosted government spending by 47% during his term, during which time economic growth dropped and unemployment increased. Under Franklin D. Roosevelt from 1933 - 1940, government spending went up 106%, during which time the economy tanked and unemployment averaged 17.2%*. Gerald Ford in the 1970s and Japan in the 1990s had similar unsatisfactory results from their attempts to "stimulate" the economy.

There is a rising chorus of voices saying that further government stimulus cannot be attempted right now because "we can't afford it" from a budgetary perspective, but we wonder why there aren't more who instead argue against further government stimulus because it doesn't work!

In fact, we ran the above video about the bankruptcy of the argument for government "stimulus" over two years ago. Since then, government stimulus has resulted in slower economic growth and continued stubborn unemployment.

At the end of his NPR interview, James Galbraith says that cutting government spending "willy nilly" would be "like running through the emergency room pulling IV needles out of people's arms." We would suggest that his metaphor might be in need of a little modification. Government IV bags, instead of carrying helpful Ringer's solution, contain a mix of depressants that keep an economy weak, sluggish and dependent.

It's amazing to us that academia and the media continue to flog this tired old theory, and that people continue to buy into it.

* Henry Morgenthau, Jr. (1891 - 1967), FDR's Treasury Secretary, declared in 1939 in a quotation that is now famous (and should be more famous):

Now, gentlemen, we have tried spending money. We have spent more than we have ever spent before and it does not work. And I have just one interest, and if I am wrong, as far as I'm concerned, somebody else can have my job. I want to see this country prosperous. I want to see people get a job. I want to see people get enough to eat. We have never made good on our promises. [. . .] But why not let's come to grips? And as I say, all I am really interested in is to really see this country prosperous and this form of Government continue, because after eight years if we can't make a success somebody else is going to claim the right to make it and he's got the right to make the trial. I say after eight years of this Administration we have just as much unemployment as when we started.

Mr. Doughton: And an enormous debt to boot!

Mr. Morgenthau: And an enormous debt to boot!

Source: microfilm roll #50, Henry Morgenthau Diary, May 9, 1939. FDR Library, Hyde Park, NY. Pages 3 and 4 of the pdf scan of the microfilm; pages 42 - 43 of the original document. Hat tip to Burt Folsom, author of New Deal or Raw Deal, who linked to this microfilm source on his website in response to questions about the authenticity of the Morgenthau quotations. We note that we do not agree with Mr. Morgenthau's belief that "taxing the rich" would be the best solution to address the deficit FDR created (for reasons see here and here), but note that his frustration at the ineffectiveness of government spending to create jobs should be powerful evidence to anyone who still believes the myth of the "IV bags" perpetuated by NPR and James Galbraith.

What to do during a financial panic

2011-08-15T15:31:00.000-07:00

The recent market gyrations have largely resulted from fears that the economy (either the global economy in general or the US economy in particular) is poised to drop into another recession similar to the most recent recession of 2008-2009. The memory of the market plunge that accompanied that recession is still fresh in investors' minds, and many are fearful of returns to the lows of early 2009.

There have been many articles written and video interviews broadcast about the differences between today's situation and 2008. We believe that an important distinction that should help investors understand why 2011 is not 2008 is the distinction between what we might call a "financial panic" and what we might call an "economic panic."

We explained the distinction at least as far back as December, 2008, when in this blog post we explained that the recession of 2008 was very different from typical recessions. In a typical recession, "companies have been over-optimistic, built up their inventories, hired too many people, and then were caught flat-footed when the economy suddenly slowed." In contrast, the recession of 2008 was not caused by anything that companies had done: it was caused by a panic in the financial sector caused by the implosion on Wall Street, which then caused companies to slam on their own brakes. Companies hastily canceled orders for more goods to sell, trimming their inventories and going into a sort of "state of shock" in which all expansionary activity was shut down until the panic subsided. In other words, a financial panic led to an economic panic.

Here in 2011, we are again not faced with the sort of behavior that typically precedes a recession: companies have not been over-optimistic, they have not built up excessive inventories, and they most certainly have not been hiring too many people in anticipation of massive increased demand.

However, in the past week we have experienced something of a mini-panic, in which markets around the world plunged in response to the S&P downgrade of the US credit rating and in response to fears of the loss of stable value in funds invested in European banks. The plunge was steep and violent and certainly characterized by panic selling, with severe volatility -- wild swings from one minute to the next -- and heavy volume. It reminded some observers less of 2008 than of 1987.

The question of the hour is whether this financial panic will result in another economic panic, as companies slam on the brakes and gape in slack-jawed amazement at the chaos in the markets. So far, we believe there are some encouraging signs that the economy may avoid catching the financial sector's panic this time around.

For one thing, the damaging mark-to-market accounting rule that was so critical to the previous implosion on Wall Street, by creating a vicious cycle or "feedback loop" which we described in numerous previous posts in 2008 and 2009 such as this one, this one or this one, has been put to rest. In fact, the end of that terrible accounting regulation during the first half of March 2009 initiated the beginning of the market and economic recovery.

For another thing, economic data, including real-time or very close to real-time data, shows that the economy continues to expand slowly, as explained in this video by respected economist Brian Wesbury, entitled "This is not 2008."

Finally, we believe that those parts of the economy where the government is less intrusive, real growth and innovation are still taking place -- especially in the area of networking communications, what we call "the Unstoppable Wave" (see for example this previous post). Evidence of the importance of this area of innovation and technology was reaffirmed today by Google's dramatic deal to acquire Motorola Mobility Holdings for $12.5 billion in cash.*

All of this, we believe, translates for investors into advice that we have reiterated before. First, don't panic. It has often been said that investors tend to damage their long-term returns in anticipation of economic calamity than in actual economic calamities themselves.

Second, swear off the advice of those who pretend they can predict what the economy or the market is going to do next -- we have explained before that this is a "persistent delusion" that has led many investors to ruin.

And finally, we believe that the best course of action for long-term investors is to commit their investment capital not to "the market" but to well-run businesses positioned in front of fertile fields for future growth. We believe that this is always good advice -- in fact, our entire investment discipline has always been based upon this conviction, and it has served us well through not just the 2008-2009 panics but previous recessions, going back in fact to the one-day panic of 1987. We believe it is just as applicable -- in fact, maybe even more applicable -- today as it has ever been.

* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Google (GOOG) or Motorola (MOT).

Commentary on the S&P downgrade and the current situation

2011-08-08T11:06:00.001-07:00

We still recommend that readers go back and read the previous two posts discussing the latest market volatility and widespread fear of impending recession that has been rising over the past couple weeks and escalated sharply at the end of last week.

Those two posts were published before the S&P downgrade of the US Treasury's credit rating on Friday afternoon. For some perspective on this latest development and how it fits into the larger picture, check out the video above of Gerry Frigon speaking on KCOY television this morning.

We would also recommend the perspective of economists Scott Grannis (see his post from yesterday here) and Brian Wesbury (see his essay from this morning here).

It is also noteworthy that the US Treasury prices are actually going up rather than down in the first day of trading after the S&P downgrade. This fact may be evidence that the downgrade has more political significance than economic significance. However, it is also important to note that this downgrade forces large institutional investors to sell other forms of debt that they own for their investors and to purchase more Treasurys. This perverse consequence is the result of the "law of unintended consequences" explained two weeks ago in a different post by economist Scott Grannis.

We have previously highlighted other instances of consequences that well-meaning politicians often create when they write legislation that attempts to restrict the free decisions of rational actors and tells them what they are allowed to do with their own money (how much they should be allowed to pay employees, for instance, or what kinds of bonds they should be allowed to buy). For discussions of that subject, see here and here.

Also highly recommended is the editorial from the opinion-page editors of the Wall Street Journal this morning. They point out that the rating agencies only care about balance, and have no opinion over how to make it happen. The debate about how to reduce the imbalance has been raging for some time now and intensified over the weekend.

Increasing revenues and lowering spending are obviously the two components of a solution, but some politicians continue to believe that increasing revenues is best done by raising tax rates. We believe that such an idea couldn't be further from the truth: the best way to raise revenues, as the WSJ piece points out and as we have argued many times in this blog, is to unleash innovation and growth. Increased tax rates squash innovation and growth. For a few previous posts with evidence to support this fact, see here, here, and here.

We believe that the most important thing for investors to do in times like these is to remain disciplined, and to focus on the fundamentals of the individual companies to which they are providing investment capital.

Lions and Wildebeests: Excellent commentary from Jeb Terry

2011-08-05T15:28:00.000-07:00

Our friend Jeb Terry of Aberdeen Investment Management has just published an excellent examination of the current fear-ravaged market entitled "The Wildebeests are running . . . Be a Lion!" It should be required weekend reading for all investors to provide some perspective on the current situation.

His arguments, backed up with extensive data, provide further support for some of the things that we wrote yesterday in the post entitled "Don't Panic (August 2011 edition)." We believe investors should consider all these arguments very carefully.

Don't Panic (August 2011 edition)

2011-08-04T12:51:00.000-07:00

The equity markets have been reeling for the past weeks, and today they were particularly savaged as additional fears of impending economic doom took over. The Dow Jones Industrial Average plummeted 512 points, and the S&P 500 index dropped a whopping 60 points (an even greater drop in terms of percentage than that of the Dow). The drop sent the markets into "correction" territory (defined as a pullback of 10% from most-recent highs). Both indexes are now in negative territory for the year, and the Dow closed at its lowest point in six months.

Markets began sliding as the artificial crisis over the debt ceiling intensified -- we call it an "artificial crisis" because politicians on both sides of the aisle explicitly threatened that the US would "default" on its debt obligations if a resolution was not reached by the arbitrarily-selected August 2nd deadline, a possibility that we showed was utterly ridiculous (see this previous post).

Now that a debt-ceiling deal has been reached, markets have shifted their angst to the ongoing weak economic reports, including a weak GDP number (the first estimate of US 2nd quarter GDP came out this past Friday at a meager 1.3% annual rate of growth), weak numbers for ISM manufacturing and non-manufacturing for the month of July (50.9 for ISM manufacturing and 52.7 for non-manufacturing), and another disappointing jobs number (400,000 unemployment insurance claims for the week ending July 30, as reported today). The ongoing fears about sovereign debt in Europe are adding to fears that a major economic catastrophe is just around the corner.

However, we believe that fears of impending Armageddon are ill-founded and overblown. For starters, we would argue that ham-handed government interference with the economy in the US, including "stimulus" spending and sharp increases in regulation, have hampered the economic growth that would otherwise have been stronger. However, we believe the recent debt-ceiling debates reveal that the American people and their elected representatives are now sharply focused on the question of spending in a way not previously seen in this country. For some insightful commentary on the debt-ceiling deal from an economist we respect, we would advise investors to check out the video entitled "We have a deal" by Brian Wesbury.

Further, while the government's inept intrusions have hampered growth, the economy is still growing (albeit slower than anyone would like, and certainly slower than it otherwise could). While 1.3% expansion is nothing to write home about, it is expansion. Similarly, both of the ISM numbers noted above indicate expansion as well, just at a slower pace than expected.

We would also point out that the red line above, which indicates GDP growth, continues a fairly steep increase, while the stock markets continue to trade as though we were no better off today than we were in 1997. If you look at the blue line, representing the S&P 500 index as of close of markets yesterday, and trace its current level back in time to the first time it crossed that level, you will see that the underlying US economy was well below $10 trillion in size back then. Today, even with the recession of 2008-2009 and even with the obstacles that the government keeps throwing in its path, the economy is well over $14 trillion and very close to $15 trillion in size. This is an astonishing fact for investors to keep in mind.

However, these sorts of data do not make much impact on investors who believe that another huge recession is yawning ahead of them. To put those fears into perspective, we recommend they avail themselves of some of the historical and economic data discussed by Larry Kudlow in his most recent posting, "No Recession." We would also recommend our own posting from less than two months ago (when similar fears began to push their way to the forefront) entitled, "Do we have a dead economy walking?"

Finally, we would point investors to the most important point, which is our deeply-held conviction that trying to call economic ups and downs -- and trying to time one's equity ownership of promising companies to those economic forecasts -- is a loser's game, and a very dangerous one at that. We recommend that investors commit their financial market capital to well-run, growing businesses, and hold those investments through economic cycles. This ties their potential success to the quality of the business, rather than to their ability to make correct economic predictions (predictions that even professional economists botch quite frequently).

We would also point to previous posts we have written to try to pass along our convictions on these matters during previous times of panic, such as a post entitled "Don't Panic!" in 2010 here, and a series of posts entitled "Don't Get Off the Train" here and here.

Finally, we would note that corrections like this can be a good opportunity to contribute to investments which have long time horizons, if done as part of a plan of regular, disciplined contributions. For more on that subject, we recommend investors read "Paying yourself first," published on this blog on March 26, 2009. Those who followed its advice at that time had an opportunity to do very well indeed.

Growth company highlight: Coach Inc (COH)

2011-07-20T16:06:00.000-07:00

Readers of our client letters and our Taylor Frigon blog know that in the past, we have highlighted some examples of businesses which we believe fit the definition of a Taylor Frigon growth company. These short vignettes outline the business model of the company and give a brief overview of our investment thesis for the business. They typically feature a company which we own for the Core Growth Strategy at the time of publication, and enable our clients to gain some insight into the reason we own a particular company and the characteristics of the companies which we believe can be described as “well-run companies positioned in front of fertile fields for future growth.”

Previous companies we have highlighted include EZchip and CH Robinson Worldwide, and while we do invest in many companies that are involved in what we believe are high-growth aspects of the high-tech industry, we often feature companies that are not primarily tech companies in order to demonstrate that Taylor Frigon growth companies can be found in many different industries.*

That is certainly the case for the classic Taylor Frigon growth company Coach Inc (ticker symbol COH).* Founded in 1941 in a loft in Manhattan New York, and inspired by looking at old baseball gloves and seeing the way they burnish with age (see the burnishing in the image above of the iconic glove of Willie Mays), Coach has since grown to become one of the most-recognizable luxury brands in the world. Their high-quality premium lifestyle accessories now include handbags, accessories, apparel, travel goods, business accessories, footwear, and fragrances, but it all started with quality leather handbags that sought to emulate the classic burnished baseball mitt!

Coach sells their merchandise through upscale Coach stores in the US and other countries (especially the Asia Pacific region), as well as through wholesale distribution to department stores, specialty stores, and duty-free stores located in over twenty countries. The company is taking advantage of the spread of economic freedom to other countries in the world (such as China, where economic freedom was horribly absent for decades), which enables more people to start businesses, contribute to others by providing desired goods or services, earn more money, and then improve their standard of living, some of which they often choose to spend on quality luxury goods such as those provided by Coach.

With the majority of their items priced between $125 and $400, Coach is more accessible and reaches a larger demographic than the typical European fashion house selling bags in excess of $700 or even in excess of $1,000 to $3,000. Coach’s competitive advantages also include the company’s carefully-maintained and distinctive brand, the quality of their materials, the store experience, a very high customer service level, and the existence of factory stores (typically located more than fifty miles from the nearest major market) to address a more value-oriented shopper.

Coach is the number one luxury bag brand in the US and the number two luxury bag brand in Japan. Future growth fields include new target markets within the US (such as the teen demographic successfully targeted with the introduction of the Poppy collection in 2010), further expansion into the men’s bag and small leather goods market, and its ongoing expansion into international markets.

* At the time of publication, the principals of Taylor Frigon Capital Management owned shares of securities issued by Coach Inc (COH), EZchip (EZCH), and CH Robinson Worldwide (CHRW).

Debt doom-and-gloomsayers

2011-07-18T15:03:00.000-07:00

The headlines these days are thick with fearmongering over impending debt crises.

In the US, politicians from both sides of the aisle declare in stentorian tones that a failure to raise the debt ceiling (or, in some cases, a decision to raise the debt ceiling) will put the US Treasury in danger of default. Credit agencies are threatening to downgrade the US government's credit rating, due to the country's impending inability to service an ever-growing debt burden.

Elsewhere in the world, fear of a Greek debt crisis has pundits in the financial media declaring that conditions are right back to the summer of 2008. Greece's inability to service their own outsized debt, it is predicted, will set off a domino effect which will cause European banks to implode, sending the economy back into a panic crisis like that of 2008-2009, or worse.

While recognizing that bloated spending by governments is a serious problem (a problem so serious, in fact, that we have called it "The Question of Our Time" in previous discussions on this blog), we nevertheless disagree with the doom-and-gloomsayers predicting certain catastrophe from seemingly every street corner of late.

As the graph above created from data provided by the Federal Reserve Bank of St. Louis illustrates, the US is in no real danger of defaulting on its debts. The graph shows Federal receipts (the money that the US government takes in, primarily in the form of taxes) versus Federal outlays on interest (the money the US government must pay to service its debt). The top line in blue represents the receipts, and the bottom line in red represents the outlays, and it is clear that there are more than enough receipts to service the debt.

If we were to create an analogy for ease of understanding, the top line would represent a household's income (taxes being the "income" of a government), and the bottom line would represent that household's periodic mortgage payment. In the case of the US, this is a household that has a bigger mortgage than any other household in the world, and a bigger mortgage than at any time in the nation's history. However, it is also true that if the US were a household, it would have a higher income than any household on the block, and that its income was higher than at just about any time in its history as well.

To suggest that this household might seriously have problems paying its mortgage is ridiculous. The data shows that Federal receipts total almost $2.2 trillion, while the interest on the nation's debt is closer to $250 billion. This situation is analogous to a household with an annual income of around $2.2 million and an annual mortgage of around $250,000. If such a household was complaining that it needed an additional home equity line of credit in order to be able to pay all of its bills, one might reasonably ask what on earth it is spending all of its money on. It might need to cut back on some of its other discretionary spending, but most families would not stop paying their mortgage first -- if anything, that is the one bill that absolutely needs to be paid. If the US Treasury doesn't pay the service on the debt, it won't be because of lack of income.

Thus, all of the talk about a US default is really a gigantic red herring. The real problem is outsized government spending. In our analogy, the household with the $2.2 million annual income appears to have joined so many charitable organizations, signed up for so many expensive club memberships, and purchased so many subscriptions to worthwhile but expensive products and services that it is wondering if it can pay them all and still pay the mortgage. It is these extras (which in the case of the federal government are government programs on which it spends the tax receipts) that need to be cut and which are causing the budget pressure.

Similarly, the European debt problem also stems from over-zealous spending on programs that might have seemed like a good idea at the time, but which have completely overwhelmed the ability to pay the mortgage. In countries such as Greece, which doesn't have a very large income to begin with, there is a very real possibility that it will be unable to service its debt. However, as we have written before, the answer for every country that finds itself in this unfortunate circumstance is to increase its income through policies that promote economic growth and innovation -- not to raise taxes, the death-knell of economic growth!

In spite of the very real problems in Greece (and the likelihood that the Europeans will try to fix them in many of the wrong ways, stifling growth instead of encouraging it), we don't think the debt situation there is about to cause an economic Armageddon either. As economist Scott Grannis wrote over the weekend, the recent fears of "Carmageddon" in Los Angeles over the closing of Interstate 405 turned out to be unfounded -- as so often happens, it's usually not the crisis that you're expecting that turns out to be the real problem.

While the rest of the US and the world frets over impending debt-driven doom, we would advise investors to simply continue looking to invest their capital with well-run, growing companies, positioned in front of fertile fields for future expansion.

Tax loopholes and corporate jets

2011-07-12T12:08:00.001-07:00

It seems like everyone is talking about "tax loopholes" these days, on both sides of the aisle, with President Obama making accelerated depreciation of corporate jets into a symbol of everything that he believes is wrong with such "loopholes."

In the CNBC clip above, Dan Hubbard of the National Business Aviation Association notes that in a recent speech the president singled out corporate jets eight times in twenty minutes. The CNBC reporter points out that the "loophole" in question (accelerated depreciation for equipment purchased by corporations, equipment which includes private jets) was signed into law by the president himself in his own stimulus plan of 2009, although the idea was first enacted by Congress after 9/11 almost ten years ago and was enacted again in 2003.

While the jet industry spokesman gives plenty of coherent arguments why his industry's "tax loophole" should be spared from scorn and criticism, we would argue that there is a bigger issue here, and that is the principle of why we as Americans ever enacted a tax system that invites so much "engineering" in the first place. In fact, we would argue that the current debate exposes everything that is wrong with a progressive tax system that awards deductions for those industries and causes which can convince lawmakers that they are more worthy of special tax incentives than others.

We have written many times before about the fact that there are always consequences (often unintended consequences) whenever the government decides to tilt the playing field for the benefit of one player or another -- see for instance "Christina Romer and the strong versus weak dollar debate" or "The ugly tomatoes of protectionism" or "Government interference, Wall Street bonuses, and unintended consequences."

We would like to see a flat tax which eliminates all the arbitrary tax breaks awarded by politicians to producers of ethanol, or producers of biodiesel, or drivers of hybrid cars, or those who own homes rather than renting them, or those who loan money to municipalities by buying tax-free bonds, or any of the entire host of "loopholes" that have been enshrined in the tax code over the decades. However, we fear that politicians on both sides of the aisle are generally unwilling to remove the "loopholes" in the tax code that benefit one constituency or another.

While we believe it is hypocritical of the president to attack loopholes that benefit owners of corporate jets when he signed those loopholes into law in the first place, we believe that such loopholes are no more distasteful when they benefit private jets than when they benefit any other industry. This is an aspect of our convoluted tax code that more citizens should understand.

Steve Forbes asks, "Why is Greece such a basket case?"

2011-07-08T09:18:00.000-07:00

American businessman and champion of economic freedom Steve Forbes has written an important article entitled "For Whom the Greek Bell Tolls." It should be required reading for all investors.

Mr. Forbes brings up many excellent points, some of which we have emphasized previously in this blog, such as the importance of pro-growth policies rather than "austerity plans," as well as the problems with lavish pay for an ever-expanding force of government employees (some of the details he adds to this discussion are breathtaking).

He also provides some details about the primitive state of property rights in Greece, and the lack of effective procedures for registering property. This is an extremely important point, and one we have discussed before. We recommend all our readers take the time to visit this previous post and watch the excellent video embedded therein, in which Peruvian economist and advocate for property rights, Hernando De Soto, explains how the ability to formally register private property is at the heart of the rule of law and the ability to advance economically.

For those who wish to understand why Greece is such an economic basket-case (in spite of the fact that people of Greek descent are as innovative and successful in other countries as the members of any other group of human beings), Steve Forbes' article is highly recommended.

A perspective on the overvalued / undervalued debate

2011-07-05T12:26:00.000-07:00

Here is a link to an article from economist Scott Grannis, who writes the very insightful Calafia Beach Pundit blog.

In it, he adds to his ongoing argument that equities are not currently overvalued, using evidence including the forward earnings ratio of the S&P 500, which has been higher than corporate bond yields for the past year.

The earnings yield is the inverse of the PE ratio, and represents the percentage of earnings each dollar invested in a stock represents. Earnings yields are typically lower than bond yields, because investors are compensated by the potential for earnings growth in a stock (a potential which a comparable bond does not possess). The fact that earnings yields for stocks are now generally higher than the yields of comparable bonds indicates that investors have a very pessimistic view of the potential for future earnings growth.

Other market observers, such as Morgan Stanley equity strategist Adam Parker, have recently argued the opposite position from Mr. Grannis, saying that the market may be overvalued. This Wall Street Journal article explains Mr. Parker's position, which says that while large-cap stocks in the S&P may be cheap, the rest of the index is slightly overvalued. Mr. Parker also believes that estimates of future earnings are too high and "seem likely to fall back to earth," according to the Journal report.

Our position is that trying to predict the next price move -- or the next earnings trend -- of an entire index is a fool's game, and that such exercises fall into the same trap of failing to focus on individual businesses that is the hallmark of Modern Portfolio Theory (which we recently discussed in this post).

While it is useful to look at overall earnings yields and it is also useful to know that large-cap companies have not participated in the positive price move of the past two years to the same extent that smaller cap companies have, we do not advise that investors take that information and try to time the market with it, either by shifting from stocks to bonds based on such statistics, or by shifting from small-cap to large-cap names either. All of these are common techniques of investment processes that focus on large categories, sectors, or indices rather than on individual businesses themselves.

We agree with Mr. Grannis that stocks in general are not overvalued at this time, and we would use that information to encourage investors to continue regular, systematic investment into the securities of well-run, carefully selected businesses. With such regular and systematic investments, investors will be able to buy more of an investment when securities are undervalued, and will buy less when markets are overvalued.

Happy 4th of July!

2011-07-01T14:02:00.001-07:00

We at Taylor Frigon Capital Management would like to wish all our readers a very happy Independence Day this 4th of July.

We extend these wishes to readers who are not in the US as well, since we believe that the truths articulated in the Declaration of Independence on July 4, 1776 are universal human truths belonging to everyone by virtue of being an individual human being -- they are not granted by one government or another but are "self-evident," "unalienable," and "endowed by their Creator."

We also feel it is appropriate to sound a note of optimism this July 4th, as so many in the United States and the world at large are beset by fears of a new debt crisis triggered by Greece which will engulf the world, 1970s-style hyperinflation, or some other form of "global train wreck" on its way.

While there are certainly significant economic problems -- almost all of them induced by harmful if well-intentioned forms of government intrusion or downright socialism (even if "European-style" socialism) -- we would point out that investors can acknowledge these problems while still acknowledging the fact that in the long run, the system of freedom, rule of law, limitation of government, and right to private property established by the Founders has led to the greatest advances in human productivity and prosperity that the world has ever known.

On the other hand, systems in which the government levies excessive taxes in order to support pension and benefit systems such as those enjoyed by certain government employees in Greece (and in California!) inevitably self-destruct. We have argued that the attention this fact is now getting is at least a silver lining to the clouds over Europe.

However, those who are predicting that America is already worse off than Greece (including many voices in the United States from both sides of the political spectrum) are overlooking the fact that the United States is producing more than it ever has in its history, and continues to be the home of innovation and entrepreneurship (yes, even in California!).

We believe that amidst all the current negativity, this weekend would be a good time to relax, consider the benefits of the liberty and rule of law envisioned by the signers of the Declaration of Independence, and be thankful for the society that their vision made possible.

New investment idea: invest in good businesses

2011-06-30T14:56:00.001-07:00

Here's a recent article from the New York Times entitled "New Investment Strategy: Preparing for End Times."

It describes a host of "investment" vehicles designed to protect against "tail risk" or "black swan" events -- terms derived from the academic fields of probability modeling, which took over the financial world during the course of the past four decades, where the marriage of mathematics and financial engineering became known as "modern portfolio theory."

For our part, we never subscribed to modern portfolio theory in the first place, and we have written that MPT is about as "modern" as a 1974 Ford. In fact, it should be perfectly clear by now that the tendency to trust that a bunch of financial engineers who create complicated structured products designed to whisk away various forms of risk led directly to the Wall Street implosion of 2008-2009. Nevertheless, as we noticed all the way back in April 2009, instead of learning this fairly obvious lesson, advisors and investors were already clamoring for still more products based on the false premises of Modern Portfolio Theory.

The hallmark of Modern Portfolio Theory -- and all the latest manifestations of MPT described in the recent story from the New York Times -- is the belief that analysis of individual businesses or individual securities is a waste of time. Individual securities don't fit into the standard distribution curves with "tails" at which the high priests of modern finance worship. Because they don't fit their models, the devotees of MPT believe individual securities are less predictable and more dangerous than huge numbers of securities, or statistics, or indexes such as the "fear gauge" cited in the article.

As we mentioned in the previous post entitled "The ideology of modern finance," this is exactly the sort of belief that led to the idea that structured investments composed of thousands of securitized mortgages were more predictable than careful analysis of individual mortgages or borrowers. Those who are currently investing tens of billions of dollars into "tools engineered to bulletproof investors" (in the words of the NY Times article) might want to consider that fact of history.

Instead of rushing into "Armageddon funds" which are tied to everything but the fundamental analysis of individual securities, we would recommend that investors consider a novel investment idea: going back to the analysis of individual companies that prevailed before the Modern Portfolio Theory craze began to take hold in 1974.

A good place to learn about that time-tested approach would be the pages of this blog, where we have written many times about the fundamentals of the investment strategy that we have followed for twenty-five years, and which we in turn inherited from Richard C. Taylor, who inherited it from Thomas Rowe Price. We would also recommend some of the collected wisdom of the investment professionals who achieved decades of success before the advent of the ideology that took over modern finance, some of which is described in this previous post.

We believe that the concept of analyzing individual businesses for the investment of one's capital is the only method with a long-term record of success, and that the kinds of novelty vehicles described in the Times story have a long track record of being invented by Wall Street one month, only to be discarded a few months later when something new comes along.

This is something that anyone who lives through times such as these should understand.

Some thoughts on inflation and the economy

2011-06-28T15:34:00.000-07:00

Here is an insightful commentary from one of our favorite economists, Brian Wesbury, entitled "Inflation Now and Later."

In it, Mr. Wesbury explains how the Fed's mistaken belief that inflation is caused by high employment and strong economic growth is leading them to stay too easy for too long and introducing inflationary pressures into the economy. He notes that the Consumer Price Index (or CPI, a measure of inflation that looks at the price of a hypothetical "basket of goods and services" and compares it to previous prices for the same hypothetical basket) for the first six months of 2011 is up at an annual rate of 5.1%.

We discussed the CPI and inflation in this previous post from 2008 and in a series of other posts listed at the bottom of that one, pointing out the damage inflation does to purchasing power. A good or service whose price rises at an annual rate of 5% will double in price in about fourteen years.

We have also discussed the erroneous thinking that leads the Fed (and many other economists from a similar school of thought) to believe that inflation is influenced by strong or weak economic growth and employment, which is sometimes known as "Phillips Curve thinking." The counter to Phillips Curve thinking is the belief that inflation is caused by monetary policy, rather than by slower or faster economic growth, and it is typified by the work of economist Milton Friedman and Professor Friedman's quotation, cited by Mr. Wesbury, that "inflation is always and everywhere a monetary phenomenon."

On the other hand, note that while Mr. Wesbury believes that the Fed is too loose and allowing inflationary pressures, this is a far cry from saying that 1970s-style hyperinflation is right around the corner. He does not predict hyperinflation, and gives cogent reasons why not.

We believe that, while the Fed and the government have hurt the recovery by some of the policies they adopted in their attempts to help the economy, nevertheless businesses in general are in better shape than almost any time in economic history, with strong balance sheets and with productivity and efficiency at all-time highs.

Inflation has remained a threat to investors' purchasing power for several decades now, a scenario that is unlikely to change in the future. We believe the antidote, however, is the same as it has been in the past: participation through the investment of capital in well-run businesses positioned in front of fertile fields for future growth. There are many businesses out there today that meet that description, if investors know where to look.

Do we have a "dead economy walking"?

2011-06-13T06:04:00.000-07:00

Recent weaker-than-expected economic data sent the stock market into a six-day decline, particularly weak employment and manufacturing data. This is bringing back talk of a "double dip" recession, which has never been far from the headlines since the economic recovery began back in 2009 (see here and here for previous posts discussing the "double dip" fears).

Much of the recent economic discussion features this familiar argument: the government has been artificially propping up a broken economy, and now that the artificial stimulants are wearing off or losing their effectiveness, we are heading back down to the dark days of March 2009 and the bottom of the market, the depths of the recession, or even to a worse place than that.

This argument can be heard both from pundits who believe that government spending is good for the economy (generally, a Keynesian view, which we have discussed in previous posts such as this one and this one), as well as from pundits who believe that government spending is bad. The latter tend to think the economy was not ready to recover without those stimulants and such artificial "propping up" only served to delay a necessary "purging".

An example of the first group would be the author of this recent article from the Economist. In it, the author operates under the assumption that the government "swinging into action" is what saved the economy before, and that it is inexplicable that the Fed and the Congress are reluctant to stimulate it again since it appears to have crashed (the article features a graphic cartoon of an 18-wheeler truck -- labeled "Economy" -- crashing nose-first into the ground).

An example of the second group is Peter Schiff, CEO of brokerage firm EuroPacific Capital. He also thinks the "recovery" has been dependent on the government, but he thinks that intervention has been bad, because it has prevented the collapse of the institutions that led to the crisis in the first place. In this recent interview, he declares that:

The data that we’ve been getting for the last several weeks -- and of course today’s data merely solidifies that with the weak jobs numbers -- is that the effects of trillions in govt stimulus is wearing off, and the mother of all hangovers is now setting in. (Beginning around 2:20 in the video clip).

He then goes on to say:

This is a phony economic recovery – it’s basically a giant hallucination caused by the government stimulus, which is like a hallucinogen [. . .]. That’s why we’re seeing the economic data imploding like it has been – because it wasn’t real. (Beginning around 11:20 in the video clip).

While agreeing with Mr. Schiff that government stimulus is actually harmful rather than helpful (a position we have argued many times over the past years and which we explain here and here), we disagree with both points of view represented above.

Both of the above camps basically agree that the entire recovery has been the product of government engineering -- a sort of Frankentsein's monster re-animated by the government (playing the role of Gene Wilder). One side thinks that Dr. Frankenstein is a genius and that his constant supervision of the economy is a must, while the other side thinks he is a madman who is going to destroy the entire village.

We are in a completely different camp, in that we don't think the economy is a Frankenstein's monster at all.

In fact, we think that most of the time the economy resembles a pretty healthy individual, who should absolutely avoid the dubious prescriptions of the Keynesian doctors. We have written extensively about evidence that supports the view that the panic of 2008-2009 was the result of various forms of mad-scientist tinkering. This tinkering included:

Direct government pressure to make questionable real estate loans.
Tinkering by financial PhD's on Wall Street who subscribe to modern portfolio theory's false premise that risk can be eliminated with the right mathematical formulas and who used that theory to create billions of dollars of synthetic investment vehicles.
And, last but not least, a well-meaning but disastrous accounting rule known as mark-to-market accounting, which caused the holders of those structured investments to panic like it was 1907.

Because we hold this view, we do not believe that the recovery has been a "giant hallucination," although we do believe the recovery would have been stronger without all the additional government "stimulus" that acted more like a narcotic than a stimulant. During the past few years, we continued to advise investors to look for investments in companies that are adding real value, and there are plenty of them if you look in the right places (we have highlighted several on these pages in recent months, such as here and here).

There are numerous voices out there dispensing advice to investors based upon the premise that the US economy is just a reanimated corpse and that the end is approaching. Some of these recommendations include:

Investing in gold and commodities (we address some of the issues surrounding that advice here and here).
Investing in variable annuities (which we believe is almost always a very bad choice, as we discuss here).
Investing in foreign stocks and bonds (which often boils down to a bet against the US dollar, a game that is more difficult than it looks and which has burned some of the biggest investors in recent years, including George Soros and Warren Buffett).
And, last but not least, investing in one of the 31 flavors of "alternative investments" (the ramifications of which we discuss in this and this previous post).

We are not saying that all is well with the US economy -- in fact, we agree with most of the arguments made by economist Martin Feldstein in his recent Wall Street Journal opinion entitled "Why the economy is worse than you think." But we don't agree with those who say that the profits of real innovative companies (such as those fueling the "unstoppable wave" of broadband and mobile technology applications) over the past two years have been nothing but a figment of the Fed's monetary stimulus (as we explain in this recent post about the end of QE2).

The bigger picture to this question is the idea that investors should be trying to time economic ups and downs, and to figure out whether the latest round of economic data reflects a "soft patch" or (as Peter Schiff says) "quicksand," and that they should be timing the markets based on their own economic gut feelings or those of someone else.

This is a form of "stock market guessing" and it is one of the main reasons that relatively few people make significant money from investing. In fact, such guessing is usually very, very harmful. We point out how harmful in our posts entitled "Don't get off the train."

We don't believe the pundits who are saying the current economy is a dead economy walking, whether those pundits are calling for more of Dr. Frankenstein's medicine or less of it. However, even if some rocky economic roads lie ahead, we do not believe that the answer is trying to time the market.

Instead, we believe investors are best served by sticking to a disciplined investment strategy founded upon commitment of capital to well-run companies positioned in front of strong growth opportunities.

Debunking "we don't make anything here anymore"

2011-06-03T14:32:00.000-07:00

By now, everyone is familiar with the argument that America's economic future is threatened because "we don't make anything here anymore."

We have highlighted this argument -- and our disagreement with it -- in previous posts, such as this one in which we took exception with arguments that America is left with nothing but a "phony service sector economy" now that we have thrown away all our manufacturing production. Examples of this line of argument abound, such as this article which bemoans the fact that there are fewer manufacturing jobs in the US today than there were in 1979, and this article which strikes a similar tone.

While there may be fewer workers actually employed in manufacturing today than there were in the 1970s, the undeniable fact is that American manufacturing output is enormously higher today than it was in the 1970s -- or at any time in the past for that matter -- as the chart above illustrates. Much of this increased productivity is the result of improved technology.

More goods being produced with fewer people is the very definition of increased productivity. Occasionally, someone will argue that producing more with fewer people is bad (because it reduces the number of available jobs), but that is a fallacious argument. If it used to take ten or twenty workers to produce one washing machine or Corvette or other manufactured good, and today it only takes two or three workers (plus some machines and robots that weren't available in the past), then it stands to reason that there will be relatively more Corvettes or washing machines available per person than there were before, and that such goods will actually become more affordable to a larger number of people. And in fact, this is exactly what has happened -- any examination of the statistics from the 1970s versus today will show that American households now have more cars, washing machines, televisions, and just about everything else than they had forty years ago. It is absolutely wrong-headed to argue that we should want to go the other way and use more people to produce the same amount of stuff, thereby making everything less affordable.

While many people do not come across examples of American manufacturing in their day-to-day lives, this does not mean they do not exist. There are a great many little companies all across America contributing to the tremendous manufacturing chart shown above. We come across them every day in the research that we do as managers of investment portfolios. Remember that the amazing rescue of the trapped miners in Chile last October was facilitated by a special drill bit that was invented and manufactured in Pennsylvania. Other American manufacturing success stories include the following companies* that you have probably never heard of:

John Bean Technologies Corporation, a designer and manufacturer of equipment for the freezing and chilling of foods, the cooling of aircraft, and other airport and food-service equipment. Based in Chicago, Illinois.

Kaman Corporation, a designer and manufacturer of complex power transmission components, motion control systems, aircraft bearings, and metallic and composite aerostructures used in the aviation and defense industries. Based in Bloomfield, Connecticut.

Middeby Corporation, the inventor of the conveyor oven and a designer and manufacturer of industrial-strength ranges, broilers, steamers, fryers, charbroilers, and other cooking and food dispensing equipment. Based in Elgin, Illinois.

Kemet Corporation, a designer and manufacturer of dielectric capacitor solutions using high-tech materials such as tantalum, multilayer ceramics, electrolytic aluminum, and other materials. Based in Simpsonville, South Carolina.

MKS Instruments, a designer and manufacturer of instruments, components, and subsystems for vacuum and gas-based processes for a variety of industries, including the semiconductor, pharmaceutical, chemical, electronics, and energy industries. Based in Andover, Massachusetts.

Kronos Worldwide, a producer of titanium dioxide pigments used in coatings, plastics, papers, fibers, foods, ceramics, paints and cosmetics. Based in Dallas, Texas.

These are just a few representative examples from a field of manufacturing companies all across America that are producing and manufacturing the things that we supposedly "don't make here anymore." The next time you hear that trope used to support an argument about America's "phony economy" and predictions of inevitable economic doom, remember that the facts tell a completely different story, for those who are willing to look at them.

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* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by John Bean Technologies (JBT), Kaman Corporation (KAMN), Middleby Corporation (MIDD), Kemet Corporation (KEM), MKS Instruments (MKSI), or Kronos Worldwide (KRO).

The US corporate tax rate

2011-05-31T14:10:00.000-07:00

We have long argued that lower tax rates are crucially important for economic growth, and that lower rates can actually result in increased tax revenues. Moreover, because those who control most of the capital that is used for production (rather than consumption) will respond very quickly to changes in tax rates, cranking up tax rates on the profits that result from productive activity is even more counterproductive and damaging to growth.

If this is true for individual tax rates, it is just as true for corporate tax rates. In fact, it is especially true for corporate tax rates because earnings that corporations retain are typically invested back into productive activities that employ more individuals or result in purchases of plant equipment, IT equipment, and so on.

On this front, the United States has the second-highest corporate tax rate in the industrialized world, at 35% second only to Japan (see map showing world corporate tax rates, above).

Many politicians in the United States like to bash American corporations that do not bring home cash from their overseas operations, but when that cash will be more severely taxed in the US than abroad, can anyone really blame them?

If every road in your town was a toll road, but some toll roads charged $10 per day and others charged $35 per day, with all kinds of dollar figures in between, would you rearrange your daily driving based on the different prices, or just buffalo right through without paying any attention to the costs?

Capital behaves the same way -- it flows like a river, and it will flow around places that are unfriendly to it and towards places that are friendlier. The US corporate tax rate of 35% is equal to the 35% charged in Argentina and Angola. Canada charges 16.5% and Mexico 28%. Much of Europe is at or below 30% (except France), with Bulgaria at 10%, Ireland at 12.5%, and Latvia at 15%. To argue that corporations ignore such corporate tax rate discrepancies is really naive.

In order to stimulate economic growth, raise employment, and ultimately raise more tax revenues, the United States should lower its corporate tax rate.

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Christina Romer and the strong versus weak dollar debate

2011-05-26T10:47:00.000-07:00

Here's a recent piece in the New York Times from Christina Romer, former Chair of the Council of Economic Advisors to the Obama administration and since 1988 an economics professor at the University of California at Berkeley (faculty profile here).

Entitled "Needed: Plain Talk About the Dollar," the essay decries the longstanding talking points that declare that "The exchange rate is the purview of the Treasury" and "The United States is in favor of a strong dollar."

Romer counters both these assertions, explaining that the dollar responds to a lot more factors than simply the actions of the US Treasury (she outlines them clearly and articulately) and chastising those she calls "strong-dollar ideologues" who reflexively prefer a strong dollar, without realizing what she sees as the occasional benefits of weak-dollar policies.

She says:

A weaker dollar means that our goods are cheaper relative to foreign goods. That stimulates our exports and reduces our imports. Higher net exports raise domestic production and employment. Foreign goods are more expensive, but more Americans are working. Given the desperate need for jobs, on net we are almost surely better off with a weaker dollar for a while.

We would respond to this argument by asking why we want the government to be engineering swings in the dollar's value in the first place! It strikes us that Professor Romer's argument assumes the premise that a small cadre of elite government officials are best able to decide when a strong dollar and when a weak dollar will create a situation in which "on net we are almost surely better off." Even if they could accurately make this determination (which is dubious), we are not sure that would argue that they should then act on it.

We would much prefer that the government get out of the business of engineering a stronger then weaker then stronger dollar and simply concentrate on creating a stable dollar. While proponents of government steering of the dollar might counter that such an idea is naive, we would argue that the government has no business steering the economy, and that their efforts to do so consistently result in disaster. For extensive evidence from recent history, see here, here, and here.

As for the idea that a weak dollar is good for Americans because it "stimulates our exports and reduces our imports," it strikes us that Americans who make their living importing goods (which other Americans want) might not be so quick to agree that taking away their livelihood in order to protect the livelihood of someone else is justified on the basis of the platitude that "on net we are better off."

This kind of privileging of one group at the expense of another was highlighted in our post entitled "The ugly tomatoes of protectionism," in which we saw how the family business of John Nix and his sons, who lived in New York and imported tomatoes from the Caribbean, was penalized by a law designed to protect domestic tomato growers from foreign competition. Where does the government get off in deciding that the interests of the tomato growers are more worthy than the interests of other citizens such as the Nix family? What formulas do economists use to decide that "on net" the oppression of the Nixes is more than compensated by the reduced competition experienced by the Smiths or the Joneses?

We completely disagree with those who argue that deliberately weakening the dollar is a good idea, and for reasons that go beyond the rather considerable problem we just discussed. In addition, artificially weakening a currency creates capital misallocations just like the ones discussed in the Fed oversteering posts linked above, feeding speculation and asset bubbles while starving worthy businesses of capital that would normally flow to them.

By the same token, we do not argue that the dollar should be artificially strengthened either -- the government simply does not have a good track record whenever they tilt the playing field to cause capital to flow one way or another. We believe that those decisions should be made by private parties, not by government officials. In order to allow private parties to make those decisions most effectively, the government should try to create a stable dollar and disavow any illusion that its public officials know better which way capital should flow.

This is not a position we are taking simply in response to Professor Romer's piece: we made this same argument almost two years ago in a post entitled "The 97-pound weakling," about the problems being caused by the weak dollar back then.

People of Europe, Rise Up!

2011-05-23T10:47:00.000-07:00

The markets are down sharply today over a downgrade to the outlook for Italy's credit rating, as well as over the rout of the socialists in elections in Spain over the weekend.

Investors might wonder, Why would socialists getting voted out worry the bond market? Spanish voters apparently revolted against "austerity measures" that the socialist government was implementing, but investors might scratch their heads because it doesn't seem that voting in a center-right government would spell less austerity than a socialist government.

Let's try to untangle some of the strings between austerity plans, protests, and the market reaction.

Europe is increasingly being forced to deal with the issue that we have called "The Question of our Time," namely the realization that seemingly endless government benefits have to be paid for by someone, and that in many countries (and a few US states) these benefits have become so generous that they will break the budget completely unless they are reduced.

The erstwhile socialist administration in Spain initially passed laws giving out even greater levels of benefits than before: everyone could get a government-paid scholarship to college, universal health coverage was extended to everyone for procedures including sex-change operations, childcare was paid for by the government, young adults received government rent money so that they could afford to be "emancipated" from their parents even without a job, and the minimum wage was raised even higher.

However, the bond market has a habit of imposing a reality check on countries whose spending threatens their ability to pay the interest on their debts, and in order to prevent credit rating cuts and higher borrowing rates, Spain's government executed a dramatic about-face and instituted an "austerity plan" to preserve its ability to borrow.

In Europe, the phrase "austerity plan" signifies reducing government spending and raising taxes. In Spain, for example, the government spending reductions included lowering pay for government workers by five percent and pushing back the age for retirement benefits from 65 to 67, while the country simultaneously increased the tax rate on the highest bracket from 43% to 45% and created a new bracket below the highest bracket that would pay 44%. The government also increased the tax on cigarettes by 24% in 2011.

We believe that European-style "austerity plans" are terribly damaging, not because they reduce government spending (which we applaud) but because they raise taxes, which further cripples the economy by reducing the ability and incentive for business creation, innovation and growth. As we've written before, growth is really the best answer in the long run.

Cranking up tax rates simply crushes growth. We have also written about the fact that the tax rate on the highest brackets matters an awful lot to everyone in the economy, even though many people don't understand why (see here and here for an explanation).

The bulk of the protests against austerity plans in Europe, however, does not seem to come from a recognition that taxing the highest brackets even more excessively will crush growth, but rather from anger at the reduction of the lavish benefits that are apparently viewed as a right.

In Spain, the Puerta del Sol in Madrid is now filled with thousands of young adults who are indignant at the high rate of unemployment, and the new austerity measures that they see as passing on the pain to the people in order to spare the pain to "the bankers."

This NPR story on the indignados (as the young protesters are called) notes that the young people are angry at the austerity measures and notes that one young man who lost his job two years ago and has a heavy mortgage "blames the banks" (presumably for giving him the mortgage, not for the loss of his marketing job). He declares, "The bankers from Lehman Brothers, Barclays Bank, Spanish bankers — all must be in jail." The story describes middle-aged women and restaurant owners who sympathize with the protesters bringing them food -- "vegetables and fruit, because many people are vegetarian."

This story from South Africa's Sunday Independent notes that demonstrators are particularly angry with the austerity measures because they came from the socialist party that is supposed to support government spending. "It is a socialist government but they are implementing the same policies as Sarkozy in France, Merkel in Germany and Cameron in Britain," one spokesman complained. "This directly affects the welfare state." The idea!

But why would the voting out of the socialists worry the international markets? We believe it has to do with the mistaken Keynesian ideas that still dominate the thinking of many economists, even on Wall Street and in big international financial institutions. Many do not accept the argument that lower taxes and less government spending is good for growth. While the center-right governments of Europe are not exactly libertarian when it comes to taxes and the role of government, it is probable that many observers believe they will be less likely to raise taxes than the socialists would be.

The perception that government spending grows the economy and that cutting government spending means less stimulus and less growth is wrong, in our view, and yet it still operates as an underlying assumption for many modern intellectual descendants of John Maynard Keynes. There is plenty of hard evidence that government spending not only does nothing positive for economic growth, but in fact has a negative impact -- see this previous post which discusses evidence from history.

Keynesians in general believe that consumption drives the economy (which is why they think government spending helps the economy by stimulating more consumption). However, production is what really drives an economy and what Spain and other European countries such as Greece and Portugal need to stimulate.

It may seem like it's too late for some of these European nations to figure out how to become productive members of the economy again, but to this negative assessment we would reply: "It's never too late." There are plenty of examples of countries with moribund economies getting rid of bad economic policy and experiencing dramatic turnarounds. Israel and New Zealand are two that come to mind.

We would argue that human beings everywhere possess the potential for incredible and unexpected innovation and creativity. To unleash it, governments need to remove the shackles of high tax rates, and stop paying people not to work.

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Bulls always win

2011-05-12T10:33:00.000-07:00

With the ongoing high unemployment and signs of building inflationary pressures, the bears are starting to come out with predictions of economic catastrophe.

There is a school of thought which argues that the entire recovery from the recession of 2008-2009 was a fabrication of the easy Fed policy and subsequent injection of additional easing through QE2, and that now that those drugs have run their course, the hangover is going to be horrendous.

Such a view is on display in a recent Barron's article by Randall Forsyth, "Anticipating the Removal of the Punchbowl," in which the author cites a quotation from Cantor Fitzgerald's chief economist who asks, "So, what happens when they take the addict off the dope?" The "dope" in this case is quantitative easing, or as the article puts it: "the Federal Reserve's $600 billion Treasury securities purchase scheme to pump liquidity into the financial system." He implies throughout the article that the rise in prices of stocks and other "risk assets" are the product of continual "spiking the punch bowl" by the Fed, and cites frequent bear Jeremy Grantham who advises, "Sell in May and go away for 41 months." Forsyth notes that while Grantham "freely admits to being early many times with his calls since the early 1970s, he notes they have eventually worked out."

Another bear recently pointing out how his pessimistic market predictions have worked out is Doug Kass, who recently wrote an article entitled "False Sense of Security," taking the bulls to task for their optimism in 2008 and saying they are making the same mistake again. He declares that the problems of today are worse than the predecessors, and says that "At best subpar growth looms on the domestic economy's horizon; at worst, a double-dip is still possible."

While bears such as Grantham and Kass can point to previous recessions as evidence that they were right, we would argue that in the long run, the bears are always wrong. Anyone who looks back over the past hundred years would have to admit that being a long-term bear would have been a huge loss.

Therefore, the bears are of necessity short-term focused: they try to predict a short-term downturn in order to avoid it, and then correctly predict the moment to get back in. We would argue that this is a fool's errand, and that saying "I've been early a lot but I'm always rewarded by a recession in the end" is a recipe for missing the real opportunity to participate in the growth that takes place while you are waiting for a disaster.

Contrary to the straw man argument that many pessimists will use in response to such criticism of their view, our long-term optimism does not mean being a blind pollyanna and investing in just any company (or even all companies via an index fund) forever. We believe in researching investments very carefully and looking for well-run companies positioned in front of exceptional fields of growth. Even in periods of "sub-par economic growth" for the economy as a whole, there will be innovative companies that are creating or profiting from major paradigm changes, and we believe in owning these companies through economic cycles and selling them when business conditions change, not when the unpredictable stock market conditions change.

We have pointed out that Thomas Rowe Price, from whom our investment process is descended, did not believe in trying to time cycles, and his long-term record speaks for itself. We would also point out that our process has led to significant outperformance versus the broader market over the past four years, even through one of the most punishing bear markets in American history.

In short, we are bullish on capitalism over the long term, and believe that as long as free enterprise is still allowed, bearishness is short-sighted. This does not mean that investors should not change their strategy based on the prevailing regulatory, monetary, and fiscal environment that they see developing -- that would be foolish, and we have written about the indicators investors should look for and changes they should make in a series of articles, such as this one, this one and this one.

We would caution investors to fight the urge to run under a rock every time the bears begin predicting disaster. This is not a game in which the bulls win some and the bears win some. Over the long run, the bulls always win.

The ugly tomatoes of protectionism

2011-05-10T15:46:00.000-07:00

Today's Writer's Almanac with Garrison Keillor calls attention to a US Supreme Court decision rendered this day, May 10, 1893 in which tomatoes were upheld as a vegetable.

What exactly this topic has to do with writers is a bit of a mystery, although the narration treated it as a quaint issue of semantics over whether something with seeds should be considered a fruit or a vegetable. In fact, however, the case illustrates the ugly power of tariffs and an all-too-familiar example of the heavy-handed government interference with free trade, privileging one business over another to the detriment of consumers in general.

In the 1893 case of Nix v. Hedden, a family business run by John Nix and his three sons was engaged in importing tomatoes from the Caribbean into the US, and the case involved their protest over being charged a tariff of 10% levied against all imported vegetables.

Such tariffs are enacted to protect domestic growers who want to charge higher prices and don't want to have to compete in a free market, and who use the government to pass laws harming their potential competitors. As this case shows, those competitors are not always citizens of other countries but also US citizens who are trying to make a living, such as the Nix family who had the bright idea of importing tomatoes that would be less expensive than domestic tomatoes. We point this out not because we think it is ok to harm businessmen from other countries, but rather because the supporters of such tariffs usually bill them as a measure against "foreign competition," implying that they think using the law to prevent competition is just fine as long as it only hurts "foreigners."

The Nix family paid the 10% tariff on their shipments, under protest, and then appealed the case on the grounds that tomatoes were actually a fruit (which is true). The Supreme Court unanimously ruled that although tomatoes actually are a fruit under the botanical definition, "As an article of food on our tables, whether baked or boiled, or forming the basis of soup, they are used as a vegetable" and, it was added, "not, like fruits generally, as dessert." Case closed, the tariff stands, and the Nix family has to pay extra money in order to make it impossible for them to sell foreign-grown tomatoes at a lower price.

The NPR narration of this ugly case completely glosses over the fact that one group is using the law to squash the livelihood of another group, and that consumers in general are the ones who end up suffering as well, since they have to pay the higher prices that result when competition is artificially blocked and less expensive sources are arbitrarily charged more because a product was more commonly used in a soup than in a dessert.

In fact, the narrator displays the common ignorance of free market principles often found on NPR* when he declares during his narrative that in this case "tomato growers had an interest in a tomato being declared a fruit" (at about 2:00 into the narrative). By saying this, Mr. Keillor has missed the point entirely! The tomato growers in the US had an interest in the tomato being declared a vegetable, so that they could be protected from outside competition from other growers: the tariff was enacted only on vegetables, and the Nixes wanted to prove the tomato a fruit so that they could import tomatoes from the Caribbean into the US to compete on price.

This may seem like a funny little sidelight of history with an amusing angle on vocabulary, but it is actually yet another example of the damaging effect of government barriers on free trade (which are almost always erected in order to artificially protect one group from competition).

We have written about the damaging impact of such intervention before, including the ongoing tariffs on imported sugar, which keep sugar prices in the US artificially high and have led to the proliferation of high fructose corn sweetener in items that used to be sweetened with sugar, as well as the protectionist policies that kept foreign ships from helping in the cleanup after the Gulf oil spill last year.

We'd like to suggest that such policies deserve the proverbial shower of tomatoes that were thrown at awful stage performances during the 1890s, when Nix v. Hedden was taking place.

* For other examples supporting the allegation of general ignorance of economic principles on NPR, see also:
"There are some things that are just too important to be left to the free market?"

"Air Vulgaria"

"What Rube Goldberg could teach us about economics"

"Banker calls for a 'New Capitalism'"

and

"Government interference, unintended consequences, and Wall Street bonuses"

Sector sloshing

2011-05-03T14:07:00.000-07:00

As active professional investment managers (see track record and GIPS disclosures for Taylor Frigon Capital Management located here), we are sometimes asked why good managers ever experience any periods of relative underperformance?

To put it another way, why do managers who outperform over longer periods frequently experience shorter periods in which they lag the market -- as research has shown that well over 90% of long-term outperforming managers actually do for periods of as long as three years? For data supporting this assertion, see this previous blog post and this study entitled "Investor's Paradox -- All High-Performing Managers Underperform."

We believe that the reason for this paradox lies in the fact that in order to perform better than the overall market, an investor must own companies that are better than the overall market (see here and here for our views on the topic). However, while an investor is owning those companies and waiting for them to realize their business potential, short-term market players are often stampeding from one part of the market to another, and back again. In the process the prices of companies in the "popular" sector will go up faster when the herd is focused on them, only to drop again later when the herd stampedes somewhere else.

We have written about this phenomenon as well, such as in this post explaining why we do not follow the typical Wall Street practice of "sector rotation." Big investment firms will often rush from one sector to another in response to various signals that they perceive as favoring one sector over another. Whatever the "flavor of the month" happens to be, where the herd is rushing at that particular moment, those stocks will go up for a short period, and often more swiftly, than the sectors that the herd is currently rushing out of.

To illustrate this point, have a look at the data collected from an extensive survey of investment managers shown in the table above. The data is from the period between August 2005 and August 2006, but it illustrates behavior that is very typical for almost any one-year period on Wall Street. The first column shows the months, and the next column over shows the percentage overweight or underweight that the US portfolio managers surveyed were at that period in time with regards to one sector, technology.

For the month of December 2005, the managers were net 38% overweight in the technology sector. By February 2006, they had reduced their exposure to a net 32% overweight, then by April 2006 had reduced their exposure to a net 27% overweight. Then, very suddenly, they went to 0% net overweight in tech during the month of May 2006, followed by net underweight 5% in June 2006 and then underweight 15% in July and underweight 22% in August.

In other words, in six months, the managers surveyed swung from being 32% overweight in technology to being 22% underweight in the same sector! That's an enormous amount of investment dollars sloshing out of one sector in a very short period of time. Portfolio managers who tend to hold companies for longer periods of time (such as ourselves) would have seen their technology companies suffer as prices dropped in the vacuum of all those other investors stampeding somewhere else.

A logical question that might come to mind at this point is, "Why would you stay in a tech company if you realized that all the money on Wall Street was moving out of technology stocks that month? Why wouldn't you chase the herd, so that your technology names didn't underperform during those months?"

The answer to that very practical-sounding question is, "because nobody can do that effectively." It turns out that trying to chase the erratic stampeding of the market herd is a surefire recipe for long-term underperformance. The fact is that the herd will inevitably come thundering right back in some future time period, and that nobody is good enough to predict its endless motion year-in and year-out for very long periods of time (such as the thirty-year, forty-year, or even longer periods of time that an actual investor typically should be thinking about for his investing lifetime).

In fact, we would go even further and make an even more shocking argument. We believe that because trying to chase one sector or another on a month-to-month basis is such a losing proposition, that disciplined investors who own better-than-average companies over long periods of time will very possibly do better than the herd! That's right: it may turn out in the long run that not only is it possible to beat the market using active management (and we certainly believe that it is possible, as we argue here and here) but that over the long run it would be difficult not to!

We don't have empirical evidence that this is so, but we may think of a way to prove it in the future. In the meantime, we would advise investors to think about this information very carefully, and to avoid the common practice of sector rotation -- or as we might call it based on the data above, "sector sloshing."

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Your currency is the credit rating of your country

2011-04-28T08:48:00.000-07:00

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

2011-04-19T11:44:00.000-07:00

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

2011-04-18T10:21:00.000-07:00

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

2011-04-13T10:11:00.001-07:00

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

2011-04-07T10:12:00.000-07:00

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

2011-04-05T11:33:00.000-07:00

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

2011-04-04T09:56:00.000-07:00

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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The end of QE2

2011-03-29T09:23:00.000-07:00

Recently, more and more Federal Reserve officials have been going on record to say that they believe there is no need to extend the second round of quantitative easing (or QE2) beyond its planned June deadline.

Some of them, such as St. Louis Fed President James Bullard, have even publicly stated that the Fed should stop short of buying the entire amount of securities ($600 billion) anticipated when QE2 was first announced. In a statement this morning, Mr. Bullard said: "We have to get started on the process of getting back to normal on the balance sheet. We are fueling the fire right now, and it needs to be turned around."

"Quantitative easing" describes a Fed method of increasing bank reserves by purchasing securities, which enables banks to lend more money, in effect creating more money in the system without lowering interest rates (hence, "easing" the monetary policy through the "quantity" of assets on the Fed balance sheet). We described the mechanics of this process in this recent blog post.

Chicago Fed President Charles Evans said it would be a "high hurdle" to end QE2 early, but that he did not anticipate needing to go beyond the June end-date or the $600 billion target, as he had previously thought they would. Atlanta Fed President Dennis Lockhart also said there would be a "high bar" to clear to go beyond the target, and Minneapolis Fed President Narayana Kocherlakota said the economy would have to worsen "materially" in order for the Fed to go beyond the target.

Philadelphia Fed President Charles Plosser stated that the Fed would need to normalize its balance sheet and even begin raising rates in the "not-too-distant future."

We have been on record for a long time saying that the Fed is "oversteering" by staying this easy for this long (see here and here), and agree with both Mr. Plosser and Mr. Bullard that the Fed should begin to unwind QE2 and begin to tighten Fed funds rates, which have been at 0% for over two years.

At the same time, we realize that unwinding QE2 and later raising rates will both inevitably rattle the markets. There are a huge number of investors and pundits who believe that the Fed's easy rates and quantitative easing are the primary reason that the stock market recovered, and that "removing the punch bowl" will remove the only thing that has supported asset prices since the bear market bottom of 2009.

Harvard economist Martin Feldstein published a widely-read article in February entitled "Quantitative Easing and America's Economic Rebound" in which he argued that the Fed's bond purchases induced bondholders to shift their wealth into equities, propping up the stock market and increasing consumer confidence and consumer spending. When this "artificial support for the bond market and equities" comes to an end, he wonders if "we are looking at asset-price bubbles that may come to an end before the year is over."

We disagree that the stock market recovery has been driven primarily by the Fed's "punchbowl." We believe the 2008-2009 recession was induced by a financial panic and that once the accounting rule (mark to market accounting) that helped fuel the panic was removed, the real economy began to recover almost immediately (see "How your view of the crisis of 2008-2009 impacts your understanding of today's big issues"). As the chart above shows, corporate profits have been on a steady rise since then, and have now reached new highs, but not ridiculous new highs. In fact, they are roughly in line with the growth that was rudely interrupted by the crisis on Wall Street.

We have also demonstrated that, although QE2 massively expanded the Fed's balance sheet, the new money available to the banks did not go anywhere, but rather appears to have stayed on the balance sheets of banks as excess reserves held at the Federal Reserve itself (see "Understanding where the banking system is right now").

Therefore, while the stock market may be rattled by the end of QE2 and the eventual tightening of the excessively-easy rates, we believe any negative reaction will be short-lived and that most businesses will be just fine when it happens. These are issues that investors should consider carefully, and which may create opportunities for those who understand the big picture.

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Information and meaning

2011-03-25T11:17:00.000-07:00

Hat-tip to Bret Swanson, who recently linked to three thought-provoking book reviews of the new book by James Gleick entitled "The Information: A History, A Theory, A Flood."

The three articles -- by Nicholas Carr, John Horgan, and Freeman Dyson -- hint at the deep issues explored by Gleick concerning information and meaning, centered around the seminal life and work of Claude Shannon, founding father of information theory, and inventer of the concept of the "bit" (or "binary digit" -- the theoretical smallest unit of information, encoded as a choice between two opposites, such as "yes" vs. "no," or "up" vs. "down," or "0" vs. "1").

Shannon noted the distinction between signal and noise -- information is best transmitted by disrupting a regular background, such as a blank sheet of paper rather than a page full of other scribbles, or a regular sine wave within the electromagnetic spectrum in which the disruptions to the regular pattern or the wave constitute information.

He also authored the radical proposition, as Dyson's article discusses, that "meaning is irrelevant" -- that information can be transmitted, stored and manipulated more efficiently when divorced from meaning, turned into a mathematical formula.

This concept has ushered in the incredible flood of information -- an "Information Age" -- an "Exaflood" as Bret Swanson calls it, with reference to the sheer volume of information being shared, a reference to "exabytes," each of them equal to 50,000 "Libraries of Congress" of information or about a trillion 400-page books (each byte is equal to eight bits, and an "exabyte" is equal to one times ten to the eighteenth bytes). As the book reviews above indicate, it has also led to new ways of understanding the universe itself, as an expression of coded information (think, for instance, of DNA).

The epistemological questions raised by this topic are endless, but for investors there are some clear and important areas to consider. We have already written extensively about the important investment opportunities related to the new ability to transmit more information more rapidly and cheaply than ever before, in our series of posts on the concept of "the unstoppable wave" (see here and here).

A different angle on this same issue for investors to consider carefully is the distinction between information and meaning. At the end of Nicholas Carr's review of The Information is the warning that: "The danger in taking a mathematical view of information, with its stress on maximizing the speed of communication, is that it encourages us to value efficiency over expressiveness, quantity over quality." This subject is extremely pertinent to the management of investment portfolios, where the sorting through of massive amounts of information is a daily necessity, and the ability to find the meaning in the information is critical.

We have written before about those who wish to reduce investing to mathematical formulas or capture "risk" in a series of graphs and reduce it away with esoteric vehicles of structured finance (see here, here and here). It strikes us that those who fall for this error have fallen into what Carr calls "the danger in taking a mathematical view of information."

Nicholas Carr warns in his final sentence that what can be lost in such a reduction is "the stuff of poetry." It might not seem like "poetry" has much to do with portfolio investing, unless you understand that poetry is actually about seeing connections, and that great poets can see and articulate connections that nobody has seen before.

The challenge in negotiating the flood of information that we are faced with in the modern world and in investing today is to find the right connections between the bits. We would argue that this requires more than a computer model can deliver. This is not to say that the incredible growth of information available is a bad thing -- far from it. However, it is certainly true that this exponential increase creates challenges, and that it makes the ability to analyze critically and see connections all the more necessary for the modern investor.

We are looking forward to reading Mr. Gleick's book, and believe that all investors should think carefully about its implications.

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Understanding where the banking system is right now

2011-03-22T13:21:00.000-07:00

Economist Scott Grannis has a noteworthy discussion of the current state of the monetary policy in the US over at his Calafia Beach Pundit blog.

In it, he observes that "the Fed has dumped a ton of reserves into the banking system, but banks have been either unwilling to make new loans, or the economy has no desire to take on more debt, or both." He draws this conclusion based on his examination of the Fed's balance sheet, which has ballooned to unprecedented proportions, versus the M2 measure of the monetary supply, which has not expanded at any unusual rate.

To understand this discussion, it is important to understand how balance sheets work throughout the banking system, which is illustrated in the diagram above (click on diagram to see larger image). The primary concept being illustrated is that deposits made into a bank are an asset for the depositor (in this illustration, the couple at the lower right) and a liability for the bank (in the center of the diagram). The couple has earned some income, which they deposit in their bank account, creating an asset on their balance sheet and a liability on the bank's balance sheet. The couple's savings or checking account is a liability to the bank, because the couple can demand those funds back at any time from the bank.

The bank, of course, also receives an asset to correspond to the liability on their balance sheet. They can hold the cash from the couple in their vault, they can purchase some securities with it (most likely US government bonds), they can turn around and loan it out to someone else, or they can put it in a bank account themselves.

If the bank selects this last option, the balance sheet activity will be very similar to the balance sheet activity we discussed when the couple took their deposit to the bank: the bank will send its deposit to a Federal Reserve Bank (the Federal Reserve acts as the "banker's bank") and will have an account there, which will be a liability to the Federal Reserve Bank (known as "bank deposits") and an asset to the bank (known as "reserves"). This is illustrated in the diagram below:

In the illustration above, the bank is shown doing two things: banking some deposits at the Federal Reserve (green arrow and green circled lines on the balance sheets, which creates the corresponding asset on the bank's balance sheet under their "reserves," and also creates a liability for the Fed under "bank deposits") and making a loan to some other members of the public (in this case, some businessmen who are starting some kind of business). The loan (red arrow and red circled lines on the balance sheets) creates a liability for the businessmen on their balance sheet, but it is an asset for the bank and it is the primary way that the bank makes money, because it is going to pay them interest.

The reason the diagram above shows the bank putting some of the deposits into reserves (green arrow) and lending some of it out (red arrow) is that this is the typical activity of a bank. It is required to hold some percentage of deposits in reserves, and it will usually lend some or all of the rest out (since lending is the way that banks make money).

As an aside, this lending activity by banks creates more money in circulation. When the two businessmen receive their loan in the diagram above, they may put it into their bank (which can then put some into reserves and then loan the rest out again) or they may use it to buy capital goods or other items for their business (in which case the vendors of those goods will put the money into their own bank accounts, and their banks will then save some in reserves and loan the rest out). The measure of money M2 mentioned in the Calafia Beach Pundit article looks at the sum of all currency, checking deposits, savings deposits, time deposits (such as CDs) and money market funds.

As Scott Grannis explains, QE2 has "dumped a ton of reserves into the banking system." The way this has taken place is that the Federal Reserve has decided to purchase massive amounts of US Treasury bills and bonds. Where does the Federal Reserve go to purchase these US government securities? The answer is: banks and other depository institutions (such as savings banks and credit unions). Banks have US government securities on their balance sheets, as we discussed above when we noted that banks can hold deposits as cash, send them as deposits to the Fed to become reserves, loan them out, or invest them in securities -- if they invest them in securities, those are usually US government debt instruments.

When the Fed decides to purchase US Treasury securities, the balance sheet repercussions are shown in the diagram below:

In the diagram, the Fed has decided to buy some US government bonds from the bank. These will leave the asset side of the bank's balance sheet and show up on the asset side of the Fed's balance sheet. The Fed will pay for these by increasing that bank's reserves, which increases the asset side of the bank's balance sheet by the value of the bonds that it sold to the Fed.

On the Fed's balance sheet, the newly-purchased government bonds will increase the asset side of its balance sheet. To counter-balance this entry, the Fed will gain a corresponding liability in the "bank deposits" line on the liability side of its balance sheet. This liability also corresponds to the "reserves" asset on the bank's balance sheet, as discussed previously. This explains why the purchase of US Treasury securities by the Fed increases the bank reserves available to banks.

Because banks are required to have a certain amount of reserves to support a certain amount of lending (the reserve requirement), an increase in their reserves creates the potential for banks to increase their lending as well.

Scott Grannis is observing that although bank reserves have grown tremendously due to the Fed's purchase of treasury securities, the M2 measure of the money supply has not grown any faster than its rate for the past fifteen years, which indicates that banks are not lending out what their larger reserves enable them to lend out.

Thus, he concludes that the Fed's actions have so far not been extremely inflationary. Had banks been lending to the degree that their larger reserves would allow them to lend, inflation could have become a huge problem already (remember that bank lending actually creates more money in the money supply, and boosts the size of M2, as discussed above; inflation is a function of "too much money chasing too few goods").

The reason bank lending has been lower than it could have been (or, seen from the other side, borrowing demand has been lower than it could have been) primarily has to do with fear and uncertainty, some of it on the part of lenders and some of it on the part of borrowers. Some of it also has to do with the fact that the private sector is awash in cash, with businesses holding huge reserves of cash on their balance sheets, and households generally paying down debts and shoring up their own balance sheets during the past four years.

There are indications, however, that business profits are picking up in many parts of the economy, which will tend to increase the appetite for borrowing to pursue business opportunities. And, as Scott Grannis points out, there are plenty of inflationary indicators that have been ticking up strongly over the past several months. Both of these observations indicate that both lending activity and inflation may be on the verge of increasing very sharply very soon.

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Creative destruction continues

2011-03-18T14:06:00.000-07:00

Kris Tuttle at Research 2.0 has an excellent article today entitled "Who Pays?" which discusses the latest New York Times attempts to get people to pay for their content*. He examines the many issues surrounding free versus paid content, and the problems that arise from "existing companies trying to apply old models to the new online medium."

Kris notes the connections to other forms of content, such as music. On that subject, we would also recommend Steve Waite's Research 2.0 article from earlier this month covering the Digital Music Forum in New York City. Here again, the discussion highlights the plight of businesses hoping somehow to apply old models in a world that has dramatically changed.

One of the positive aspects of capitalism, according to economist Joseph Schumpeter, was that it not only allows innovation and radical new advances, but it actually makes them inevitable when free enterprise and competition are not blocked by the government. Using examples from one industry after another, he wrote that free-market capitalism "incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism."

Ironically, the published content of the New York Times typically takes positions that belittle the positive effects of free-market capitalism: we have highlighted several examples in the past, such as this one, this one, and this one.

It's not surprising that those who reject the economic insights of pro-free-enterprise economists such as Schumpeter also have a difficult time perceiving the revolutionary aspect of certain technological advances, such as the ones that now pose a lethal threat to the Times' entire business model. Over three years ago, we criticized the shortsighted thinking in a New York Times article that declared that not enough Americans had high-speed internet connections to make web-delivered movies a good business, and contrasting that with the insights of George Gilder, who published a book all the way back in 1990 entitled The Death of Television predicting exactly the sort of revolutionary changes that the web is now wreaking on the delivery of content.

There are plenty of companies -- perhaps even the New York Times -- that will continue to have a business in providing content of value to those who are willing to purchase such content, as Kris Tuttle and Steve Waite discuss in their articles. But it will certainly help their own cause if those companies avoid trying to apply old business models in a radically different landscape, and if they accept the truths about business available from far-sighted authors such as Joseph Schumpeter and George Gilder.

* At the time of publication, the principals of Taylor Frigon Capital Management do not own securities issued by the New York Times Company (NYT).

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Be centered, be still -- 2011

2011-03-16T14:36:00.000-07:00

We, along with the rest of the civilized world, are of course horrified at the awful developments in Japan as a result of the massive earthquake and tsunami.

From an investment perspective, in times of great catastrophe or calamity, our professional experience suggests that the best response for investors is to pursue a philosophy which we describe in the phrase, "be centered, be still."

We have written about this concept before, most notably here and here, and we explained that our definition of being "centered" (in terms of investment) can best be defined as "remaining within a consistent discipline; not making rash changes that represent a departure from the discipline."

Similarly, we argued that being "still" does not mean "doing nothing" but that it means "continuing to act in line with the principles of an investment process." We have observed that during times of great turbulence, many are tempted to either abandon their process (if they ever had one) or alter it in the face of events that cannot help but arouse strong emotional responses.

The most recent catastrophe has inspired a host of irresponsible predictions, some of which we believe are causing investors to overreact. Misinformation spurred by dubious claims of "imminent" catastrophe almost always prove to be hyperbole and can cause investors to make poor decisions regarding their long term investment and finances.

Yesterday, for example, an official from the European Union Energy Commission, Guenther Oettinger, stated that the Japanese nuclear accident was effectively "out of control". This comment came a day after this same official stated Japan was facing an "apocalypse". Apparently, this official's statement was at least partially based on the same sensational media reports the rest of us are getting. Hardly a responsible manner of conduct from someone in a perceived position of authority!

In his recent television show, popular host Glenn Beck engaged in what professional investors call technical analysis (the interpretation of charts and chart patterns) and issued dire pronouncements declaring "a collapse of the financial system as we know it [. . .] I'm gonna show you some stuff -- don't kid yourself -- it's coming."

Many watchers may think that such statements carry authority, especially when they are backed up by four charts and someone with a pointer explaining about "trend lines," particularly in the wake of the tragic images from the disaster in Japan. We disagree with his specific line of argument in this example and do not believe that his simplistic explanation of broken trend lines presages the collapse of the entire financial system at all.

The bigger lesson, however, is that in times of crisis, authoritative-sounding voices can get people who probably should know better to panic in ways that they otherwise would not, and that can lead to consequences that they will later regret. We believe strongly that this is one of those times.

The events in Japan are horrible, and we are not in any way making light of them and the human suffering that they have caused and continue to cause. However, that does not argue that investors should throw away their investment discipline; on the contrary, we believe that in such times investors should be more careful to stay within that discipline than ever.

This is what we mean by the phrase, "be centered, be still."

The question of our time, continued

2011-03-14T08:52:00.000-07:00

Here is a recent interview with economist Veronique de Rugy, discussing the tremendous increase in unfunded pension liabilities that state governments in the US have racked up in recent decades.

Dr. de Rugy presents evidence that the problem is much larger than many states are willing to admit, in part because state accountants are projecting that the asset pools they have set aside to pay those benefits will gain average investment returns of 8% per year every year, which may be an overly optimistic assumption.

She also presents evidence that underfunding of these asset pools (which occurs when state governments do not invest in their pension savings at a level that will support the amounts that they have promised to give out in future years to their retired government employees) is largely due to the fact that states were spending the revenues that they were supposed to be saving, rather than being due to major bear markets in 2000-2002 or 2008-2009.

Many who defend the unaffordable government pension system like to claim that everything would have been fine if it hadn't been for these market corrections, but the facts simply do not support that argument. Also, it is contradictory for defenders of these pensions to use assumptions of steady 8% annual returns when calculating the size of the unfunded liability problem, and then to turn around and blame market corrections for creating the enormous unfunded liabilities that they now face.

We have called this issue "The question of our time" in previous blog posts. The good news is that the world seems to be waking up to the problem. Many of the most egregious increases to state-employee retirement benefits were enacted in the late 1990s, such as California's 1999 legislation that allowed many public workers to retire at 50 and draw 90% of their salary for the rest of their lives, along with cost-of-living adjustments (which were made retroactive for those already retired as well, as described in this article).

We have also argued that the most important concept to understand in this whole discussion is the role of economic growth in solving government budget problems (see here and here). This is why it is so important that government does not create obstacles to economic growth, through high taxes, intrusive regulation, or capricious monetary policy.

Investors are well-advised to monitor such obstacles and be alert when they are on the rise (we have written about how to do that, and thoughts about how to invest when they are on the rise, in previous posts such as this one and this one). For this reason, we applaud Dr. de Rugy's efforts to provide good analysis on this important subject.

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For later posts on this same subject, see also:

"In defense of the politicians" 04/07/2011.

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

Inflation is a monetary phenomenon

2011-03-07T08:51:00.001-08:00

We've written before that inflation is everywhere and always a monetary phenomenon. This morning during a brief televised interview, Gerry Frigon made that point and countered the notion that economic growth creates inflation.

The idea that economic growth creates inflation, and that economic stagnation or contraction counteracts inflation, is associated with the Phillips curve, and history has proven the Phillips curve to be wrong.

We have written about this discredited concept in the past, and would recommend investors revisit those posts, since many in the news media continue to base their comments on the idea that growth and inflation are linked together (see for example here and here). We have also noted troubling signs which indicate that high-ranking economists still subscribe to outdated Phillips-curve thinking.

With the renewed focus on inflation, this is an important principle which investors should understand.

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Blocking out the benefits of free enterprise

2011-03-02T09:25:00.000-08:00

Economist Scott Grannis recently published an excellent discussion of the problem with healthcare in the United States entitled "The big problem with healthcare? It's not a market."

He provides a graph showing that consumers now pay only 12% of total healthcare costs theselves -- the rest is paid for by insurance companies or the government. As his graph shows, this percentage has declined dramatically and consistently since the 1960s, when consumers paid for over 45% themselves.

Mr. Grannis concludes: "It stands to reason that when people don't pay the bill for the services they receive, they are very unlikely to take price into consideration when making a healthcare decision. Why shop around if everything is paid for by someone else?" We agree with him, and his ultimate point that the problem with healthcare in the United States is the steady removal of the beneficial forces of free enterprise and individual choice.

We have made this point in the past, and pointed out that if this is indeed the problem with healthcare, the solution is more freedom, not less. We would advise interested readers to go back to our 2009 article entitled "The healthcare black hole," where we linked to an article written by the late Milt Friedman published in 2001 entitled "How to cure health care."

In that article, Dr. Friedman goes through the history of how we got to the system we have today (which Scott Grannis also explains in his piece), and provides excellent support for his conclusion that "the high cost and inequitable character of our medical system are the direct result of our steady movement towards reliance on third-party payment."

Americans are the beneficiaries of the tremendous positive power of free enterprise in so many areas of their lives. It is unfortunate that they have been increasingly denied access to those beneficial forces in the critically important field of medical care.

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The benefits of in-house research

2011-02-25T13:04:00.000-08:00

We have previously referred to the performance record of the late Bill Ruane (1925 - 2005) of the Sequoia Fund, which he managed along with Rick Cunniff and Bob Goldfarb for many years.

In a letter to shareholders that Mr. Ruane wrote in February, 1997, he makes a point that we believe is very important and a point which is still not widely appreciated in the investment world today. There, Mr. Ruane said:

In a memo written in 1969, we stated that we wanted to do only one thing -- strive for excellence in money management by having the principals concentrate on security analysis and use the results of their own research, as opposed to using outside research, to manage portfolios themselves rather than separate the task between the "research department" and the "portfolio managers." Rick Cunniff and I had been doing research and investing in this fashion for over fifteen years at that time.

This approach is still unusual on Wall Street, some 28 years later. Typically, people start out their careers in an "analyst" function but aspire to get promoted to the more prestigious "portfolio manager" designation which is considered to be a distinct and higher function. To the contrary, we have always believed that if you are truly a long term investor, the analyst function is paramount and portfolio management follows naturally. While we don't go in much for titles at our firm, if we did, my business card would read "Bill Ruane, Research Analyst".

[Sequoia Fund N30D for 12/31/1996, filed on 02/28/1997, SEC filing 811-01976. Italics in the original.]

We believe this emphasis on doing their own research, rather than relying on the research of others, was a key ingredient in their success, and it is a conviction we share as well. The benefits of doing in-house research rather than relying on outsourced research include a greater understanding of the business and the financials of the companies in which one invests, a better understanding of the management team and business strategy, and in general a more personal understanding of the factors which contribute to the crucial decisions of whether to invest, when to invest, and when it is time to sell.

This is not to denigrate the many excellent research firms that provide external research, (many of them completely outside of Wall Street) or to say that others' opinions are never valuable to consult, but rather to say that we believe the primary research should always be personal, and the expert opinions of others can be consulted as supplementary to that.

If you think of the great generals and tactical commanders of history, such as Patton or Rommel or Napoleon, you will find a common conviction among all of them that they needed to see and analyze the terrain themselves. This is not to say that they would not value the insights of their engineers, artillery officers, and other experts who might have conducted additional analysis or reports, but rather that these legendary tacticians would conduct personal analysis themselves, and layer the reports of others onto the understanding which they gained through their own observation and experience.

This is an important point for investors to understand.

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Two worthwhile videos for investors

2011-02-24T09:40:00.000-08:00

Here are links to two videos which we believe are worth investors' time to watch and understand. The first is a recent market commentary from economist Brian Wesbury, entitled "No Bubbles, Sugar, or Dead Cat Bounces."

The second is a video interview of technologist and author George Gilder by Steve Forbes.

Both discuss many subjects we have written about in this blog over the years, and we believe both are excellent examples of the kind of "unconventional wisdom" (or "antidotes to conventional wisdom," as Brian Wesbury likes to say) which investors should seek out and examine carefully.

Backing and Filling

2011-02-22T10:08:00.000-08:00

It is our view that investors should not focus too much on the markets but rather on the fundamentals of the underlying companies in which they invest.

In line with that, we don't put much store in technical analysis, which is primarily focused on analysis of market moves and the short-term factors of security market supply and demand that create changes from day to day. We believe investment decisions are better made based on the fundamental analysis of a business and its business prospects.

However, we do think readers should be familiar with the concept of "backing and filling," which is what we call the market's need to pause and consolidate after a long period of broad market gains.

The general market has enjoyed almost uninterrupted gains since late August of last year, and we have been saying for some time that it is probably past due for some consolidation. It's similar to piling up loose earth into a huge mound -- at some point you have to tamp it down in order to build a more solid base.

It seems that the markets are finally using the ongoing turmoil in the Middle East as an excuse to sell off. It would not surprise us if this turns into a period of "backing and filling," and it would probably be healthy for some of that to take place. The important thing for investors to remember is to focus on the fundamentals of their investments and not to allow market-based gyrations to have an undue impact on their thinking.

Another point about the recent events in the Middle East, which can be safely described as a complete surprise in their timing and nature, is the danger of making speculative bets on the short-term movement of things such as commodity prices or the strength of US dollar. While many look at Fed policy and conclude that it will likely lead to inflation and the weakening of the dollar relative to other currencies, unexpected geopolitical turmoil typically creates demand for US Treasuries and a strengthening of the US dollar. Such a scenario caught many foreign exchange speculators who had bet against the dollar off-guard in 2008.

For more on this subject, we recommend investors revisit our 2007 whitepaper entitled "Gambling, Speculation, and Investment" as well as previously published posts such as this one and this one.

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Globalization

2011-02-15T15:44:00.000-08:00

Today's news confirming the acquisition of the venerable New York Stock Exchange by the Deutsche Borse brings the issue of globalization home to many investors.

Free to Choose TV, which makes available all ten episodes of Milt Friedman's original 1980 television series Free to Choose, as well as all five episodes of the 1990 version of the same series, also contains a link to the excellent discussion of globalization by renowned economist, economic thinker, and advocate of the benefits of the rule of law and capitalism to reduce poverty worldwide Hernando de Soto.

The series is entitled "Globalization at the Crossroads," and it should be required viewing in the nation's schools (especially in the universities, where poverty is often blamed on everything but its real cause).

In the remarkable video, Mr. De Soto explains that on the major exchanges, symbols of property (such as stock symbols or cattle futures) can be traded, unlike the situation that pertains in many parts of the world, where there are no formal mechanisms for representing ownership of property (such as written titles and deeds). Without such mechanisms, as shown in the video, individuals cannot use property that they own -- such as their home -- for borrowing (to start a business for example).

Mr. De Soto offers a unique and insightful explanation for the root of the word "capital," which of course derives from the Latin word for "head." He maintains that the concept of capital is not simply wealth that can be used for production, but the ability to conceptualize wealth, in exactly the same way that the Chicago Exchange can trade hundreds of thousands of cattle futures without actually having to bring hundreds of thousands of cattle onto the floor of the market (which would be required in societies that have no systems for the symbolic representation of ownership).

Thus, the New York Stock Exchange, that most prominent example of the American ability to allocate capital through the rule of law and the symbols of ownership (in this case, stock in companies), is a perfect symbol for the power of globalization that Mr. De Soto is discussing, the ability to participate in commerce with people from all different cultures and groups. On a symbolic level, the merger of the NYSE with the German exchange should be welcomed by all those who believe, as we do, that globalization is beneficial to all participants.

We have referred to Mr. De Soto's work before, in this previous post. We commend him for his strong work in support of the rule of law and the increased ability for people everywhere to add value to others and to improve their own situation.

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