Woody Hayes Economy

Company Name Value Expectations

With one economist after another cutting GDP forecasts, August was a busy month in regards to the heated debate of a possible Double Dip for the US economy. Economist Robert Schiller, a bear's bear, predicted that the U.S. economy has a better than 50/50 chance of entering a double-dip recession if the government doesn't step in to help the unemployed. Federal Reserve monetary-policy makers decided the economic recovery wasn't as strong as it had previously anticipated, and announced that they would reinvest maturing mortgage-backed securities in government debt so that its balance sheet does not shrink "“ a moved dubbed as the beginning of QE II.

On the corporate front, August was defined by a series of M&A activities: BHP went hostile for its desired $39 billion takeover of Potash; Intel snapped up McAfee for $7.7 billion; Sanofi-Aventis SA offered to buy Genzyme for $18 billion; and HPQ won a highly publicized bidding war to acquire 3 Par for $2 billion, just to quote a few. Those M&A activities failed to bid the market into positive territory, however, as the S&P500 index lost almost 5% in August. In our Market Forecast Project - Issue #14, we have a question regarding the heated M&A activities:

What are the drivers of the recent heat-up in M&A activity in the past few weeks? A healthy prospect of the Global Economy? Cash burning holes in CEOs' pockets? Valuation for the acquisition targets is compelling?

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We think the answers are probably the first two. As we mentioned in the July Monthly Market Review, large cap non-financial US companies are sitting on record cash and have the resources to expand. The World Bank is still projecting the world GDP to grow an average of 3.4% in 2011 and 2012, with the developed regions expected to grow at an average rate of 2.6% and developing regions at 6%. According to Standard &Poor, among the 250 companies in the S&P500 which report full foreign data, foreign sales consistently account for approximately 45% of their total sales. In addition, Information Technology, Materials, and Energy sectors have the highest foreign sales percentages. Large firms have the capacity to chase GDP around the world and hedge the majority of monetary risks inherent to different countries and states. Therefore, it is not surprising to see the large firms in those sectors snapping up smaller competitors, after such a long period of slow to no M&A activity. In addition, after all, does anyone really think the typical CEO can resist the excitement of a takeover? Small to Mid-sized firms, however, tend to rely more heavily on domestic sales and are more subject to regulatory and policy changes without much hope of arbitraging those risks. The only thing they can do in the face of uncertainty is to be cautious, stop expanding, and preserve what they have, in order to stay at bat and wait for a good pitch to come along in the way of rational and stable policies from Washington. This has largely resulted in the sluggish employment environment we face, and helping Small and Mid-sized businesses has become a campaign slogan for both parties as the mid-term election approaches. The key question though is how? As always we will share a few opinions here and discuss the likely ramifications for a stock investment strategy.

First, let us briefly review our position in the last 18 months, and why we held those beliefs.

In January 2009, the country was in a honeymoon phase with President Obama and his non-partisan, "transcendental approach to politics". Yet a naïf could understand by viewing the President's track record: He was in fact a very partisan politician, whose desired policies were very left of center "“ that is neither good nor bad, just a fact that has economic implications. He aggressively wanted to create a massive, government-spending-based stimulus program, raise taxes on capital and income, advocated massive redistribution polices through health care reform, insisted on taxing carbon energy to the point coal-based power was uneconomical, wanted to abandon secret ballots to allow easier union organization, and generally favored a much larger, more active Federal Government. In general, you could sum up these policies as being anti-growth and pro-redistribution.

From a business perspective, it did not take much foresight to realize the economy was not likely to experience a typically strong and robust economic recovery. Simply applying the lessons from econ 101 provided the answer - as the price of a good goes up, demand tends to go down. So it is with labor or supplying capital. New mandates on health insurance, higher taxes, extended unemployment benefits, and increased regulation over the financial sector combined with the belief that the new administration wanted a seat at the table for every decision, left business managers, owners, and potential entrepreneurs thinking, "Why should I take risks to grow when success is punished?" Who can blame them? Just recently it was discovered that a new provision in the Bank Reform bill requires public companies to disclose the ratio of pay between its CEO and median worker salary. How many more costly worthless surprises are lurking in the health care and banking bills rammed through Congress? If investors are unhappy with the firm's policies they will arrange to fire the CEO. They don't need the government to create silly disclosures to help them. Just ask Steve Jobs during his first spin at Apple.

With that political/economic reality in the background, we never bought into the notion of a sustained, robust recovery. Instead we advocated the BOHICA AA economy, in essence preaching that so long as these policies were to dictate the economic environment, the psychology driving the economy would tilt towards a no-growth defensive mentality by the private sector, and subsequently low to no job growth, outside of artificial, temporary government spending. That in turn drove our belief that the market would under-perform historical norms as it was pricing in a recovery that was unlikely to materialize. Whether the economy undergoes a formal double dip is not the relevant question. The more important question for investors was "“ should one have paid for a robust recovery? Our point was no!

As we saw and see it, the core problem is confidence about a better economic environment in the long term, in which capitalists willingly take risks and pursue growth. Policies or events which foster such a change in capital owners' mindsets will likely lead to renewed economic activity. As we mentioned earlier, companies have the cash to spend and invest, so a Richard Koo scenario of decades' long balance sheet recession is not likely in the US. What corporate America needs is confidence in the future that the business environment will reward success. The President's policies did not provide for such confidence.

Secondly, let's comment on what is happening right now leading to what is shaping up to be a fascinating Mid-term election.

We believed and called out that President Obama began his tenure with a poor economic strategy, namely wanting to punish the returns on capital and highly skilled labor, while favoring lower skilled workers and redistributing wealth. Every strategy begets a set of tactics that carry out the plan. However, great tactics will never trump a poorly conceived strategy "“ I am sure Napoleon had great generals, but attacking Russia was just a dumb strategy. Passing health care reform, increasing government spending, encouraging tax increases on capital gains, dividends, and highly skilled labor were all great tactics to carry out the President's overall strategy, but as the strategy was ill-conceived to generate economic growth, so have all of his tactical moves failed to move the growth needle.

Recently, however, President Obama has decided to become a tax cutter. He laid out a proposal on Wednesday that would allow companies to write off 100% of new investments in qualifying plant and equipment in the first year, rather than over 3 to 20 years. He proposed that this tax break extend through 2011. While this proposal seems to suggest a tactic rather inconsistent with the President's grand strategy, and possibly indicate a willingness to change his approach, we believe it is not and has a number of flaws that will hinder its effectiveness:

1. Small businesses that spend less than $800,000 a year on certain equipment can write off up to $250,000 according to an existing tax ruling. Therefore, small businesses would have to spend more than $250,000 on equipment in 2010 or 2011 to see an additional tax benefit. However, it is not very common for small businesses to spend more than $250,000 on equipment in any given year.

2. While the proposed tax break will likely encourage some businesses to hurry up and buy equipment since it's temporary, this is basically "cash for clunkers" for businesses, and its effects will likely be no different. Recent research from The University of Chicago shows that such programs merely shift the timing of likely purchases, rather than stimulate new real demand. In other words such a program is nice for incumbent politicians facing a 2012 election cycle but unlikely to generate real sustainable economic growth. Further, businesses still have to weigh how likely tax increases down the road are going to offset the one time benefits they get from investing in the equipment now.

3. The capacity utilization rate for the US industrial sector was 74.8% in July, 570 bps higher from a year earlier but 580 bps below its average from 1972 to 2009. We are skeptical of the effectiveness behind a temporary equipment investment tax break like this, with so much excess capacity that businesses have yet to work through.

4. Our fundamental problem with this approach to tax policy is that it continues to create a shifting and temporary set of rules. The business environment at the moment needs more clarity, not less. Business owners are not stupid and this type of short-term carrot does nothing to alleviate their longer-term concerns.

Therefore we believe this "nice little" tax cut tactic does nothing to alter the grand strategy the President has embraced, which has put a great burden and increased uncertainty on businesses. Should the proposal pass, it merely gooses the economy heading into a new election cycle.

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Thirdly, let's discuss the Mid-term election.

Polls from all sides are suggesting the GOP has a noticeable advantage in taking back the House this November. Polls also suggest that while voters trust the Republicans more than the Democrats in managing the economy, they doubt that Republicans have a clear plan for the country should they win control of the House or Senate in November. In general we have little confidence in politicians as a race/breed/species to advance the human condition, so the prospects of the two political tribes fighting to cancel each other out is likely a positive for the economy and in turn the market. Given the mood in the country to reduce the size and scope of government, there may be a new breed of politician emerging who understands Washington needs to work for the people, not exist to only take from them for personal gain. Again this is a lesson both parties need to learn. Democrats recently promised to drain the swamp, only to create a "Let's Make A Deal" Congress. As the party outside of power, Republicans are promising reform and good behavior "“ only time will tell if they can deliver as their past turn did not. However, it is noticeable that this week, House Minority Leader John Boehner outlined a plan to moderately shrink government by cutting non-security related government spending for the next year back to FY 2008 levels. We applaud the sentiment, but advise his plan needs additional work to truly tame the ravenous appetite Washington has developed for spending its Citizens' hard-earned wages.

We would like to see each party propose long-term economic policies, with transparency as to how such policies will treat all business and wage earners. The plans need to clearly articulate both tax and spending plans and should be easy to understand. Further it should treat income equally across businesses, sectors, and industries "“ after all who really thinks an elected nobody knows better than the market how to allocate capital. Rather than promoting sound economic decisions, the tax code has too often been used as a vehicle to reward companies and groups that take care of politicians with expensive dinners, nice trips, and high paid jobs for friends and family. While such a desire is unlikely to ever be achieved, we can always hope.

Fourthly, how to invest proceeding to the likely positive change in business environment?

The main take away from the current political environment is a new divided government, which we view as a lesser negative for the economy and the market. Further we see this as the basis for increased, though modest, economic activity, which leads us to shift away from our pessimistic BOHICA AA stance. Instead, we are now more inclined to view the coming two years as the Woody Hayes economy "“ "Three yards and cloud of dust"- meaning we will have some renewed economic activity, but not the sustained, robust growth to be expected coming out of such a long slump. As attractive as a divided government turned out during the Clinton Presidency, we do not feel the same conditions apply to President Obama. The primary reason is that President Clinton failed so miserably in trying to enact a national health care program. This policy failure during his first two years, allowed him to redefine himself as the political winds changed. Further, while President Clinton passed income tax increases, which slowed down the recovery he inherited, he was very open to massively cutting capital gains tax rates. In fact he signed a bill reducing capital gains taxes by 33%! Conversely, President Obama has been very successful with his initial policy agenda, and that success defines him as a President and future candidate. Therefore it is unlikely he will follow Clinton's radical policy pivot and embrace a pro-growth agenda. Instead he will seek marginal policy changes, such as the tax break he recently proposed, which will be temporary in nature.

Let us sum up our view on the investment environment and a strategy. We believe the move towards a divided government is a positive for both the economy and the market. By preventing additional redistribution policies, a split government will likely loosen some purse strings by investors and businesses to invest, hire, and grow. However, we do not believe we will see any meaningful policies that will change the overall economic condition and thus warrant a radical revision of our mid-term view of equities as an investment. We believe a divided government will end the BOHICA AA Economy, but not create the conditions required to stimulate robust, sustainable growth, thus the Woody Hayes economy. We advocate taking a deep look at big banks, large Pharmaceutical companies, Consumer Discretionary stocks, and cyclical Technology stocks. Many great companies in these areas are down more than 30% from their May highs and look attractively priced at current levels. Interesting enough but not surprisingly, the market does react earnestly to policy and regulation changes. According to an AFG research study conducted in early August, when we examined each sector's attractiveness by looking at its sector median Economic Margin, we found Financials and Healthcare to be two of the most attractive sectors in the Russell 1000, as their implied EM based on recent market values show the greatest negative discrepancy when compared to their 7 year EM medians. The landmark healthcare and financial reform bills passed by the democrat-controlled administration and congress have fundamentally changed the landscape of those sectors in a negative way, but there could be opportunities for some companies whose perceived prospects have been overly brutalized. On the other hand, Consumer Staples appears to be the most unattractive sector, as its implied EM exceeds its 7 year EM median by more than 300 bps. While Consumer Staples' "safe haven" status may rightfully justify some market premium, we would advise caution towards asset allocation in this group. The graph below (AFG's August 2010 Servicing Review) plots the actual versus implied Economic Margins across sectors for the R1000 and R2000 groups.

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