Independence Day 2009

(A reason why I think the best is yet to come for an Aerospace Super Cycle. 2300 words) 

 The approach of the Independence Day (a.k.a. 4th of July Weekend) always gets me thinking about the state of our Founders’ experiment in ordered liberty. Over the half century or so that I have observed this national holiday, the very meaning of what it means to be an American seems to have undergone a bit of evolution. 2009 seems to be shaping up to be a year of not just gradual evolution but wrenching discontinuity. To the proverbial visitor from outer space, it would seem that America is all of a sudden just another unexceptional State, if exceptional in any way, by virtue of the hurt it has inflicted on other people groups, most notably during the Reign of the Manifestly Evil One (2000-2008). As of a few weeks ago (when the “what should I write for the end of June?” question was starting to percolate), I was seeing a stream of articles suggesting that U.S. defense spending was heading for a precipitous decline. Apparently, the ongoing Apology Tour was going to so bedazzle the various Supreme Leaders and Omar Bongo emulators that surely, the mother of all peace dividends was about to land in our collective lap. Or so it seemed all of three weeks ago. This week’s Musings begs to differ, and not just because the hunger for basic human dignity just boiled up in (among other places) Greater Persia in a way no one (at least in the flaccid West) was thinking less than a month ago. I see very bright prospects for many defense related aerospace suppliers, certainly much more promising than their current valuations suggest. 

I have been following the Aerospace industry for a very long time now and am frankly amused by what investors and the commentators they look to fret about over the course of a cycle. In my view, aviation will grow as long as the global economy is growing and the industry is holding its own with respect to its value proposition (i.e., bringing down the all-in cost of air transport as perceived by the end user). It will also grow to the extent there continues to be conflict in the world and strategic and tactical advantage to be had from “securing the high ground"). A very good case can be made as to why the latest forecasts for air travel growth over the next twenty years are probably overly optimistic, but I will not do so at this time because it does not concern me. What concerns me is current valuation relative to prospects over the course of the next five to ten years. Bottom line: while there are all kinds of reasons why demand over the next decade or two might not live up to expectations, many of the suppliers who have survived the perturbations of the past two decades are positioned to be surprisingly prosperous with even modest and gradual improvement in demand. It is the result of a two decade consolidation undoing the inefficiencies rendered by a five decade buildup of capacity that was driven by geopolitical rather than economic considerations. In my estimation, the point at which diminished long term growth prospects might permanently outweigh positive cyclical factors (improving demand, the onset of significant new programs) is still at least a half decade away. As such, my portfolio reflects the expectation of at least one more cycle of rising earnings and concomitant investor enthusiasm. 

At present, the Bear case seems to be that the global economy is stuck in the mud for the foreseeable future (weighing on demand of aviation capacity) and that a new “realism” entailing a diminished role on the global stage for the  US (i.e., be more like France or Canada) has taken root. It also matters that the really big, game-changing programs like 787 and A-380 have been fraught with delays, prompting doubts about our collective ability to render technological advance. We forget that every past program had its moments of doubt, if not white knuckle terror in the midst of a flight test that only a very few engineers and managers ever heard about. I would suggest that what stands between the 787 today and its place a few years from now driving a protracted retrofit of much of the world’s fleet is an engineering problem. The thing about engineering problems is that as long as the objective is not somehow at odds with the laws of nature, they can and will be solved. It might take longer than you hoped and cost more than you expected, but as long as there are at least reasonable incentives in place (as opposed to the lash of despotic fiat), the left-brain, problem solving crowd always delivers. This is woven into the history of humanity. The ongoing delays are a problem right now for owners of prime contractors who took on more step-change complexity than they could handle. They might not be a problem if they are buying in at today’s prices, and they are certainly not a problem for suppliers who are qualified into specific parts of the programs that will define aviation progress over the next decade. 

As important as the 787 is going to be by 2012 (which after nearly 30 years of looking to the future I can assure you will be here sooner than you think), it is the defense side of the business that really intrigues me right now, especially as it pertains to a mastodon of an aircraft program that is no longer way out there in time. I actually view the Apology Tour as something of a positive, insofar and defense spending remains in large part a hedge against future and so unknown trouble, and nothing stirs up troublemakers like abject groveling. To the extent that a case for peace breaking out, or at least less conflict than there might have been, can be made, I am reminded of a prediction that appeared in Musings shortly after 9/11/01. I predicted that the US would undertake to use Iraq and Afghanistan like giant roach motels. Martyr wannabees would flock by the thousands to those dusty arenas, where US Marines and Special Forces would accommodate their fatal misguidedness. They would check in, but would not check out. I knew we were in for a protracted, if not never ending, struggle. I anticipated, as in all wars, what business calls “execution issues”, but not to the degree that ended up defining 2006. The end result, though, is that untold thousands of would-be terrorists, that distinct minority of the so-called “seething masses” who are actually willing to get off their miserable butts and go stand in harm’s way, now lie in peaceful repose. The problem of people in various places who hate us enough to want to kill us has not gone away, but for the next few years at least it is quite a bit smaller than it might have been. This might be thought of as a peace dividend (i.e., increased likelihood of avoiding blowback from Jimmy-Carter-stupid foreign policy), but not of the sort that is going to move the needle in a defense budget that at least tries to be years ahead of the next threat.

Debates will continue to rage as to which programs should go forward and which branch gets what and how many ships or aircraft, and there will be a few that fall by the wayside. These are inscrutable issues. (e.g., How many F-22s is the right number? I would suggest that as long as we have lots of something that China or Russia cannot dream of equalling in our lifetimes, we will not arrive at the day where we are thankful to whoever had the foresight to see to it that we had them, but if we go with “just enough” that day when we wished we had more just might arrive.) There are some programs, however, which the Administration has clearly signaled will be high priority. Right now, the one program that I do not understand why it is not generating a lot more enthusiasm is the F-35 Joint Strike Fighter (JSF). Perhaps it is because this program was launched a very long (as investors reckon it) time ago, which means it stays in a mental bin called “out there” until it starts showing up in year ahead earnings models. I know this because it was in my “out there” bin until very recently. As is my practice, items in that bin get dusted off from time to time and usually dropped back in. This time, it’s not so out there any more. The volumes this year (14 aircraft) and next (30) are nothing to get excited about. But start pushing a few other numbers around and it gets really interesting.

The JSF is expected to replace the F-16, A-10, AV-8B and all but the most recent (E/F) versions of the F/A-18. An estimated 800 such aircraft are scheduled for retirement by 2024. As impressive as these aircraft have been, the JFS will provide a step-change improvement in “stealthiness”, a several fold improvement in tactical efficiency and many of the ease-of-maintenance features that have found their way into recent aircraft and engine programs. Three variants will include a conventional version for the Air Force, a carrier based version for the Navy and a VSTOL version. It is intended to be the world’s premier strike aircraft, excluding the F-22, through 2040. As of April 2009, the DoD was on record intending to purchase 2443 aircraft. Other nations who have contributed to the development effort have made orders which push the total upwards of 3100. Estimates of potential sales beyond that indicate a market of roughly double that. So what we are looking at is 3000 to 6000 aircraft, the bulk of which will be delivered over fifteen to twenty years commencing in 2015. The plan which prime contractor Lockheed Martin is undertaking is to ramp to an annual production rate of about 240 in 2015. 

These simple numbers, 200+ units per year over a 15-20 years, are presumably a very large slug of earnings and cash flow that has not yet figured into analysts’ models (still in the “out there” bin). However, it’s not so out there anymore. The production ramp between 2010 and 2015 will be a source of “execution” risk and get “lost in the rounding” for Lockheed Martin (389MM shares) and the sole engine producer (UTX subsidiary Pratt & Whitney; 942MM shares. P&W’s F-135 will probably be the sole engine, although a second engine proposed by GE & Rolls Royce seems to have friends in Congress who just won’t quit trying.) Neither of these estimable entities pass my scrutability screen anyway. Better opportunity resides with suppliers who are qualified to provide content into the program in quantities that are meaningful relative to their capital base. At the the top of the list, to the best of my knowledge, would be Esterline Technology. ESL recently noted on a conference call that its content per aircraft in this program had grown past $1MM. (I suspect this reflects the amount of “stealth” being designed into the aircraft.) For the almost twenty years I have been watching, ESL has assiduously avoided over-reliance on “any one program”, to a degree that the success or failure of any one customer program hardly moved the needle on earnings. With JSF, at $1MM+ and 200+ units/year, the leverage across 29.4MM shares stands to be impressive. Other companies I own which are well positioned to see strong growth from the JSF program include Ladish and Precision Castparts, both primarily engine part suppliers. And it really doesn’t matter, in light of today’s valuations, if the stated objective of “one per workday by 2015” (i.e., five workdays per week, less holidays = 240/year) is realized on time or a year or two late. The Market’s valuation of these stocks will in the next few years be based on a decidedly more robust stream of future cash flow than it is today. 

As we approach Independence Day, we should reflect on what was being wrought some 233 years ago, the willingness of our forebears to risk and to sacrifice so much on behalf of the generations which have followed. It is entirely possible that we are in the midst of seeing all of that being irretrievably squandered. Damage is being done, and will likely get worse as long as all the trouble in the world stays at a simmer. However, as the good people of Persia have just reminded us, we are never more than a heartbeat or so away from some kind of hell breaking loose. (Postscript: late breaking developments out of Honduras and Argentina are confirming that the willingness push back against Anointed Ones seeking to subvert accountability and render their hold on power permanent is alive and well.) A status quo amenable to beating swords into plowshares continues to be a really dumb bet. Like it or not, as demographic trends lock the major powers into what is shaping up to be a struggle to avoid coming in first in a race to the bottom, the U.S. has no choice but to act like the superpower it still is. This reality, coupled with the porcine reality of employment in hundreds of Congressional districts, will keep defense appropriations aloft for a very long time. We must not despair of an inscrutable  future, but do the best we can with what remains of the small slice of time we have been allotted. If that means owning shares of businesses, I want to own the ones who hold the increasingly scarce keys to air superiority. 

The Specter of Inflation

(2537 words)

That time of year here in South Central Texas when “hot” starts to give way to “really hot”  (which triggers the mass migration of nearly every Texan who can afford to do so to various Rocky Mountain venues) finds us contemplating a horizon which is starting to darken just a bit. The specter of inflation is starting to take some of the zip out to the Market decompression and what sure looks like stirrings of economic recovery. I continue to view the Market as situated similarly to the last time a generational peak (1966) was followed by a protracted bust-of-a-lifetime (1974). My expectation is that the next several years will play out something like the latter half of the 1970s, with investor confidence recovering at a glacial pace but abundant profit opportunities for value investors nonetheless. In that go-round, the Market rose some 56% in the nine or so months after it hit bottom in October 1974. It then corrected a little more than 15% over the next ten months before advancing 30% in about a year. This was followed by a  drop of about 18% in six months. Then, commencing in March 1978, it rose 54% by November 1980, at which point the Bear Market that ended in August 1982 began. My point in providing this data is to show that however dreadfully that era is remembered, there were lots of stocks going up for meaningful periods of time. (And if you owned the right segments, like energy, you did even better than the averages suggest.) Bear in mind, though, that the 11/80 peak was only about 26% above the prior peak 50 months earlier, and this was during that time when that beast that was inflation was finding its way into double digits. 

This edition of Musings will address the role that inflation, or at least signs thereof, are likely to matter in the months, if not weeks, just ahead. Indeed, inflation jitters already seem to be having an effect on the tone of the Market, and I strongly suspect that the specter of inflation will be the catalyst which eventually tips the Market into a correction mode a la 1976. That said, I cannot yet bring myself to assign very high odds to Inflation as Fact of Life in the sense many of us found ourselves resigned to circa 1979. (Think of this distinction as we think of Hunger, the difference between how we often feel around five o’clock, and the sense in which it might have described millions of kids growing up during the Depression. Say, what happened to all the 1930s parallels so lavishing bandied about a few months back?) I don’t see the engine of Inflation firing up, but I do see the specter of inflation rearing up ways that matter to long term investors trying to earn a reasonable, heartburn-adjusted rate of return. That perception often matters more than substance, at least for short periods of time, is all a part of how crazy making the Market can be. In this issue, I will explore why the specter of inflation concerns me at this time.

So what do we mean by inflation? In the broadest sense, it denotes a sustained rise in the prices of goods and services. Note the emphasis on “sustained”. Inflation as an issue of concern is not a one-off, month-to-month rise. It is a systemic condition, not the mere incidence of symptoms, however valid those symptoms might end up being, something which overwhelms the natural correctives of markets (of which there are plenty) and takes root as consensus expectation for the foreseeable future. Although it is difficult to speak to generations of the distant past, an at least benign (benign insofar as it is matched or exceeded by productivity driven growth in purchasing power) rate of inflation at least seems to be normative. The techniques by which economists measure inflation are fraught with shortcomings, but you don’t need academic training to know that it has been a very long time since prices did not have at least a slight upward skew to them.  

A mind numbing array of explanations as to what causes inflation are available. I prefer to understand it simply as the result of too much money chasing too few goods. Viewed through this lens, we would seem at the present moment to be at something of a stand-off. One would have to have been off in some recreational paradise of a sort I can only wish I could afford to NOT know that gobs of money are being pumped into the system, and that even more humongous gobs are being borrowed from our grandchildren to follow that up. That this is not resulting in inflation has been explained by the degree to which there is so much surplus productive capacity in the economy. Ergo, too much money sloshing around in the system, but not enough of it being spent in ways which strain productive capacity and so force prices higher. Of course, other factors have been at work, and as these run their courses, the inflation tune will also change.  

 Indeed, it seems that in recent weeks “too much money chasing too few goods” is actually starting to register. At least three factors which have been keeping a lid on inflationary pressures have started to diminish or will very shortly. (It is also essential to note, in a nod to that streak of cynicism which I cannot quite shake, that we probably find ourselves more aware of inflation because purveyors of both financial products and “news” are attuned to our sensitivities and so vulnerabilities. “When the ducks are quacking...” ) One would be that consumers and businesses have with each passing week become a little less shell shocked and a little more inclined to go out and make purchases that have been deferred for many months now, if not years. The “buyers strike” that was in play for at least six months will continue to become a thing of the past. 

It also matters that the undoing of the Commodities Bubble is itself coming to an end, and early indications are that the Speculative Interest which played such a role in that bubble is inclined to operate as if they still have the political cover which so emboldened them during the 2004-07 era. (We can differ over the degree to which speculative interest “caused” the Bubble. It is ludicrous, though, to suppose that large pools of capital operating with chance-of-a-lifetime incentives tied to short term gains did not seek out and exploit inefficiencies in markets as arcane as rice, powdered milk, uranium and zinc. And in what kind of fairy tale world would there not be at least a measure of collusion, when the “iron is hot enough to be worth striking”, between producers and speculators, who in many countries operate under the same political agency?) It mattered a lot when all of sudden both commercial users and speculators had an urgent need to transition from a couple of years of wanting to have “at least a little more than we’ve got” on hand to wanting to have as little on hand as they can get away with, if not go short.  With the seeming one-mindedness of a flock of starlings, everyone veered from “squirrel some away” to hurry up and de-stock in a seeming instant. The economy was well along in adapting to short supply (e.g., higher prices had made the economics of recycling much more compelling and so created whole new supply sources). This exacerbated the glut and in some instances resulted in a brief interlude of “no bids” markets. Prices over-corrected, which means that in terms of inflation as a statistic based on measures taken monthly, we got a whiff of deflation. De-stocking has run its course, however. Prices are regressing back from having over-corrected, helped along by decision makers all over the globe who are looking ahead and trying to make sure they will have the oil, metal, etc. they need to meet demand as it comes back.

It has also mattered that government actions taken to avert financial catastrophe have had the additional effect of neutralizing an important signal of pending inflation. Open market purchases by the Fed have the purported purpose of driving down interest rates. This is all well and good during times of crisis. However, in a world where the “bond market vigilantes” are supposed to show up when the risk of inflation starts to take root, it also has the effect I would liken to disconnecting the burglar alarm. Indeed, there is an element of inviting the vigilantes to “help yourselves” at work.  The vigilantism is a by-product of what these so-called vigilantes do, not their main event, which is to recognize which way the wind is blowing and position themselves to profit accordingly. They know to jump in along side the Fed, adding impetus to restraint against rising rates, but this will only last so long. Then they move on to the next game. Many of us have taken comfort in the bond markets seeming non-reaction to activities that strike us as patently inflationary. With the “sweet spot” re being “long US Treasury bonds” slipping into the rear view mirror, this source of comfort seems to be diminishing of late.

With these factors playing out the way they are, I would look for the specter of inflation to have an increasingly chilling effect on the economy and the Market over the balance of 2009. We are already seeing it in the recent uptick in mortgage rates, and I suspect that the “price at the pump” is going to start taking toll as well. Economic recoveries might look like slam dunks in hindsight, but they never feel that way a day at a time. It is at this juncture that the distinction between “specter” and the actuality as recalled from the late 1970s needs to be fleshed out. In an economy that is reasonably market based, the price increases we think of as inflationary stirrings tend to produce corrective phenomena. Higher prices prompt additions to supply, and the higher rates which register as credit markets anticipate prospective erosion in purchasing power start to choke off economic activity. I believe that it takes an extraordinary degree of dysfunction for these self-correcting mechanisms to be enfeebled to the point that a 1970s style inflation can take root. In that era we were well along in a generation-long boom, but saddled with labor, transportation and financial market policies and regulations that can only be described as Depression era.  We were also confronting the stark difference between a world with OPEC and a world with no OPEC (as opposed to the difference between OPEC with a semblance of discipline and OPEC members cheating as much as they can). Unfortunately, we cannot know the extent to which dysfunctional policy undoes the self-correcting nature of markets until after the fact.

As a long term investor, I presently find myself more concerned about the specter than the actuality (i.e., can see a rough patch ahead that might seem like the edge of an abyss but probably is not) but am nonetheless aware that “one thing might lead to another” and the engines of  the sort of inflation that outstrips wage growth and diminishes creditors could fire. The Bear case, if you will, and the thing to be watched, to be sure, revolves not surprisingly around the interface between government and commerce. Two venues come to mind. The lesser of these, but still worth paying  attention to, is the ongoing role of the speculative interests. It is never a healthy thing when seemingly unlimited pools of capital are also able to secure political cover for their activities, an arrangement which has accumulated generations of practiced obfuscation and feigned helplessness. Speculation can and does play an important role in the function of healthy markets, but not always, and certainly not when the speculators carry on as if they have license to “get away with it”. 

The larger concern revolves around the fallacy of excess capacity as seen in the presently low level of capacity utilization. The lumping together of such a wide range of activities into a single value is inherently dangerous if it is to be the basis of economic decisions.  “Capacity” can be a tricky thing to measure. The global economy has become inscrutably complex, and the more complex a system becomes, the more susceptible it is to inadvertent upset. As we enter an era of marked increase in the government’s inclination to tinker, we should be concerned that the capacity of our exquisitely finely tuned system might in fits and starts be diminished by what one supposes are the unintended consequences of meddlesome officialdom.

A splendid little example of this, almost a parable, appeared in the WSJ a few weeks back (June 2) in an article by I.O. Pecepa, “I was a Car Czar”.  Apparently Gen. Pacepa was the highest ranking Soviet bloc officer to defect to the West. The way he tells of running the Rumanian auto industry reveals either a very droll sense of humor on his part or a deeply ironic situation. The punch line, if you will, was how when ordered to produce a car for export from a network of 166 plants, they were at best only able to produce at about 2% of capacity. As he tells his tale of mandates and meddling, one does not necessarily conclude that the infinitely more complex US economy might be mismanaged to a similar degree, but the warning is crystal clear. My take is that not just the auto industry, but parts of the economy we aren’t even thinking about today are going to find that “capacity” isn’t what we thought it was, if only for a season, as the “tinkerers” are let loose. To the degree this happens, the “too much money” that is floating around out there will no longer be chasing “way too much goods”. “Bottlenecks” pop up like cockroaches in managed economies. These sorts of system upsets tend to eventually correct, but with politicians involved cannot be expected to do so quickly. 

In any case, a season wherein the weight of the anecdotal and statistical evidence confirm the fears of the stagflationists is likely to produce a “double digit, better part of a year” pullback in the Market even if in the end these fears prove to be overstated. That said, it is probably still too early for long term investors to stop picking through the wreckage for great little companies that will be worth a lot more in five or ten years than they are selling for today, and start selling for the sake of taking money off the table.  Every once in a while, the Chicken Littles are right but usually they scare each other into zigging when they should be zagging. There will likely be good reasons for reducing one’s exposure to equities in the months ahead, but for my money, not just yet.