The run-up to our peculiar national holiday wherein much of the populace is compelled to pretend that it is Irish for a day finds us very pleased to be managing for absolute rather than relative returns. (An aside: I recently had the pleasure of reading the Confession, i.e. testimony, of that great saint who was Patrick, bishop of Ireland. Along with the one other document we have from him, his letter excoriating a corrupt official by the name of Coroticus, it provides a fascinating picture of a great man meeting and overcoming extraordinary difficulties in the twilight of an empire.) By this, I mean that it is good to have the luxury of raising cash into a Market that looks tactically vulnerable but strategically very exciting. In the past month or so, I have raised my cash position by another 5%, to about 16% of investable assets.
Tactically speaking, the Market looks vulnerable, up 30% or so in not quite six months. Gasoline prices have levitated to “sticker shock” levels, though one gets the sense that someone has alerted the Administration that a lot of voters are out of sorts about this. If so, we can expect desperate measures to try to restrain these prices, at least until after the election. The good news on job creation is being played up for all its worth, even if the figures are still pathetically anemic by past standards. Our election year skepticism is further aroused by Gallup data that indicates that employment is actually weakening (the difference being that Gallup does not make the same seasonal adjustments that the BLS makes). Then there is the fact that we are but a few weeks away from when all those articles about “Sell in May and Go Away” will make their appearance. This was pretty good advice in each of the past two years, as the middle months of both 2010 and 2011 saw sharp corrections of -17% and -20%. Even in 2009, it was pretty good advice, despite the Market being in its initial decompression stage.
I think that to make sense of why the economy seems to be all of a sudden outperforming and why there is a very good case that in its current bullish state the Market could be on to something that is too big for any of us to see, we need to consider the ancient Tao. It is noted that “Every extreme condition contains the seeds of it opposite.” Booms are born out of busts, and vice versa. In the moment, I think we are experiencing the fruition of “seeds” that started to be planted this time last year. From the time the price of sweet crude started to soar along with the Arab Spring, but in earnest when earthquake and tsunami did unknowable damage to who-knew-what links in the global supply chain (which caused legions of businesses to elect to err on the side of caution), the recovery got dicey. This spooked investors, but more importantly set them up for revulsion when the gruesome spectacle of Congress wrangling over a debt limit was visited upon us. I will never forget the heartbreak of seeing that underlying our “best minds” projections as to an eventual balancing of the US Budget was an assumption that the economy would grow at an average of 5%! That sense of doom and despair was not helped when September brought the prospect of another global supply chain disruption, this time in the form of monsoon rains and singularly inept flood control in Thailand. But then like so many other low moments we have lived through (albeit, low moments that cannot begin to compare with those met and overcome by the aforementioned St. Patrick), things just kind of stopped getting worse and then started to get a little better. A whole lot of buying and hiring that got put on hold while we lived through all that (Oh, and did I mention the unremitting headlines about the imminent collapse of the Euro project?) has started to happen. There is a whole lot of “hurry up and wait” in the economy. After a six or so month wait, it seems to want to hurry up right now.
The same Tao applies to what could over the next few years take the Market a whole lot higher than any of us are thinking right now. Extreme condition #1: After being extremely unkind to investors for half of the 1960s and all of the 1970s, the Market was very good to investors in the 1980s and 90s. This set the stage for the past decade-plus. Analogous to the “celebration” of unemployment ticking down to 8.3% four-plus off the bottom, we find ourselves this week celebrating the NASDAQ closing above 3000, only forty percent below where it was twelve years ago. With respect to the American investing public, the tide is very, very out right now. Now couple that with Extreme condition #2: the taxation and regulatory environment. As noted in the prior Musings, there are no doubt millions of business decisions that have been put on hold because of the added uncertainties attendant with an intrusive, redistributive government. There is a whole lot of potential investing and hiring that is waiting for an outcome in November. A new Administration, one that understands business and economics at a higher level than comic books and Cliff notes, will unleash this activity, along with a good bit of M&A activity that has been similarly set aside. The Market acts as if it is buying into this actually coming to pass. As someone old enough to remember how in March 1980 “Reagan Trails Ford, Carter”, I am inclined to read into the Market’s newfound ebullience the expectation that the business climate of the US will improve dramatically in 2013. Throw in echos of 1997 around the reception of a new crop of IPOs (predominately Tech, but then there’s Spanx), a willingness on the part of at least some investors to open their mouths, close their eyes and believe the executive summary of the Prospectus, and a raging Bull Market becomes a real possibility.
Even if this scenario of economic recovery finding its way past first gear in 2013 plays out, it seems unlikely that the Market can go up another 20% without first seeing another correction on the order of what the past two summers wrought. 1980 was a watershed election for capital if ever there was one, but two years later we were still wondering if things would ever get better, and two years after that the Bond Market’s reassessment of future inflation was barely getting started. We don’t have Dr. Volcker’s medicine to swallow this time, but we do have a vast number of government programs, which are indeed economic activities in the schema of GDP = C+I+G, that will fail to pass the new boss’ “Is this worth borrowing money from China to keep doing?” test. My sense at the moment is that Market returns for the next five years will be such that being 80% or even 70% invested most of the time will yield a better return than being 100% invested did for you over the past ten years.
Wednesday, March 14, 2012
Wednesday, February 15, 2012
Waitin' for the Flowers to Pop, the Shoe to Drop and the Meddlin' to Stop
Mid-February finds us enjoying the late innings of another Texas winter. Weather experts have warned that the La Nina pattern that set the stage for last year’s epic drought is still in play, but so far this winter couldn’t be more different from last year’s. That one saw innumerable bitter cold days and nights that overtaxed the power grid, almost no precipitation and a nearly instantaneous transition to an endless succession of brutally hot windy days that went on until September. This year has been more like an endless Spring, with (so far) only two or so nights that dipped below freezing, and above normal rainfall. So much for La Nina, and for expert opinion on big picture issues.
While we wait for the flowers to erupt, we also find ourselves waiting and wondering what will cause the proverbial shoe to drop on this inexorable Market rally. Who knows, considering how long it has been since animal spirits of the Bull variety slipped their leash (a good number of the financial service industry’s recent hires weren’t even in high school when we defined what it meant to “party like it’s 1999”), we could be setting up for a big surprise to the upside. That will happen at some point, but more likely, we will first be treated to another stretch of time where we wish we had raised cash more aggressively in the days leading up to it. I might end up leaving some money on the table, but I am going to assume that Sell in May (at the margins, not completely) and go away will once again be good advice. Indeed, I have already raised my cash holdings by about 5%, to about 11% of investable assets, and expect that to edge upward until we get another episode of fear-based pricing.
So what might precipitate the next fire sale? It is looking less and less likely that it will be last year’s imponderable uncertainty, the European debt crisis. The substance of that crisis, which is really nothing more than entropy having its way with erstwhile principalities that were past their prime generations ago (if they ever had a prime), will be with us for the rest of our days. The ability of the keepers of what passes for news to use it to strike fear into the hearts of investors at the margin has subsided. The bogey-man that was Sovereign Debt default seems to have been neutered. It’s all going to work out, at least for a while, and much more interesting events are taking shape. As I ponder what is likely to rouse the VIX from its slumber, something to do with Israel, Iran and Straits of Hormuz come to mind. (That Madonna fans have implored Mr. Netanyahu to wait until after her concert in Tel Aviv suggests that this might be the worst kept military secret ever.) My sense is that if the Israelis do attack the nuclear facilities, the US Navy will be positioned to foreclose any attempts to disrupt the transit of oil beyond a few “precautionary” days of delay. But to a lot of “investors” at the margin, it will be too scary to sit and wait it out. This, from the vantage point of today, is only the most probable catalyst for a sell-off that we can think of. We can be sure that whoever it is who seems to have the influence to “change the cue cards” that exacerbate investor reactions to ever changing circumstance will come up with something. In the mean time, let’s enjoy the rising tide, try to be a net seller of equities (trimming the “good” positions, pulling the plug on at least a few of the one’s that have disappointed, and having a very high hurdle for any purchases) and wait to see what they come up with.
Speaking of sitting and waiting, I had an interesting encounter last weekend that provided an insight into why the US economy has been recovering at a rate well short of half-step. Anecdotal evidence needs to be handled lightly, but this was the microcosm that goes a long ways in explaining the macrocosm. I ran into a fishing guide I had spent a little time with on the Texas coast last year. When I asked about a plan he had to expand his operation, he said he was doing a few little things, but anything major was going to wait until after November. He went on to say that it wasn’t about him, allowing as how listening to talk radio on the ride up to Austin had gotten under his skin. (I advised him, as I advise anyone so aroused, that the Off button can be your friend.) Rather,it was his clients, which would be a slice of relatively but not supremely well-off households, whose good fortunes are more likely than not derived from some involvement with an energy play such as Eagle Ford. It instantly dawned on me that there must be at least a million, probably several million, decision makers out there who are similarly on hold. From tiny operators like this guy up to the private equity titans plotting their next moves, the heightened uncertainty brought about by an unabashedly intrusive State is causing the producers of goods & services to sit on their hands and wait. Even the rent-seekers who have enjoyed this Administration’s fondness for crony capitalism must be hedging their bets at least a little. I can’t help but wonder if herein lies the basis for the next time the Bull goes large. Perhaps an unleashing of a whole lot of pent up hopes, dreams and expansion plans (not to mention in-sourcing of at least some manufacturing back from venues that turned out to be not as low cost as they had seemed) could trigger an economic boom that gets money flowing back into equities in a way that reminds us that debauch that ended over twelve years ago.
It is quite possible, in my opinion, that that November outcome that so many are waiting on has just been sealed. I am referring to the HHS mandate with respect to insurance of contraception, etc. that has lit up the opinion pages of late. The Administration’s decision to proceed with this mandate is either something too politically shrewd for me (or anyone) to grasp, or the dumbest move in history. They seem to have thought they could make it about contraception, a subject on which reasonable people, including faithful Catholics, can disagree on. It’s not. All they had to do is listen to the bishops. It is about freedom of conscience, something sacred not just to Catholics but to all persons of good will. Does the term “endowed by their Creator with certain inalienable rights” ring a bell? By framing it this way, the bishops have instantly drawn in allies from leaders of other faiths and from persons of no religious faith whatsoever. And they didn’t just come up with this stance when the mandate hit the wire. Well over a year ago, the USCCB (Conference of Catholic Bishops) formed an ad hoc Committee on Religious Liberty, comprised of ten bishops and a wide array of consultants, attorneys and lobbyists.
It matters that these men were formed, spiritually and philosophically, under the papacy of a man who knew totalitarianism, at its onset, in full bloom and in its dotage, first hand. The bishops consider this mandate to be an unprecedented attack on freedoms that were enshrined in our Constitution. There will be no backing down. It will remain a hot topic, begging the question of what else is in that abomination that calls itself the Patient Protection and Affordable Care Act is waiting to pop out and remind us why our Founding Fathers devised the checks and balances that power mad Nanny Staters wish would go away. A lot can happen in the 260+ days and nights between now and November 6, but this issue has more than enough moral weight and emotional fire to tip the balance decisively in the favor of a prospective leadership that would promise to not be so damn menacing towards people who just want to get on with their hopes and dreams. Perhaps the Markets is discerning a glimmer of this possibility.
While we wait for the flowers to erupt, we also find ourselves waiting and wondering what will cause the proverbial shoe to drop on this inexorable Market rally. Who knows, considering how long it has been since animal spirits of the Bull variety slipped their leash (a good number of the financial service industry’s recent hires weren’t even in high school when we defined what it meant to “party like it’s 1999”), we could be setting up for a big surprise to the upside. That will happen at some point, but more likely, we will first be treated to another stretch of time where we wish we had raised cash more aggressively in the days leading up to it. I might end up leaving some money on the table, but I am going to assume that Sell in May (at the margins, not completely) and go away will once again be good advice. Indeed, I have already raised my cash holdings by about 5%, to about 11% of investable assets, and expect that to edge upward until we get another episode of fear-based pricing.
So what might precipitate the next fire sale? It is looking less and less likely that it will be last year’s imponderable uncertainty, the European debt crisis. The substance of that crisis, which is really nothing more than entropy having its way with erstwhile principalities that were past their prime generations ago (if they ever had a prime), will be with us for the rest of our days. The ability of the keepers of what passes for news to use it to strike fear into the hearts of investors at the margin has subsided. The bogey-man that was Sovereign Debt default seems to have been neutered. It’s all going to work out, at least for a while, and much more interesting events are taking shape. As I ponder what is likely to rouse the VIX from its slumber, something to do with Israel, Iran and Straits of Hormuz come to mind. (That Madonna fans have implored Mr. Netanyahu to wait until after her concert in Tel Aviv suggests that this might be the worst kept military secret ever.) My sense is that if the Israelis do attack the nuclear facilities, the US Navy will be positioned to foreclose any attempts to disrupt the transit of oil beyond a few “precautionary” days of delay. But to a lot of “investors” at the margin, it will be too scary to sit and wait it out. This, from the vantage point of today, is only the most probable catalyst for a sell-off that we can think of. We can be sure that whoever it is who seems to have the influence to “change the cue cards” that exacerbate investor reactions to ever changing circumstance will come up with something. In the mean time, let’s enjoy the rising tide, try to be a net seller of equities (trimming the “good” positions, pulling the plug on at least a few of the one’s that have disappointed, and having a very high hurdle for any purchases) and wait to see what they come up with.
Speaking of sitting and waiting, I had an interesting encounter last weekend that provided an insight into why the US economy has been recovering at a rate well short of half-step. Anecdotal evidence needs to be handled lightly, but this was the microcosm that goes a long ways in explaining the macrocosm. I ran into a fishing guide I had spent a little time with on the Texas coast last year. When I asked about a plan he had to expand his operation, he said he was doing a few little things, but anything major was going to wait until after November. He went on to say that it wasn’t about him, allowing as how listening to talk radio on the ride up to Austin had gotten under his skin. (I advised him, as I advise anyone so aroused, that the Off button can be your friend.) Rather,it was his clients, which would be a slice of relatively but not supremely well-off households, whose good fortunes are more likely than not derived from some involvement with an energy play such as Eagle Ford. It instantly dawned on me that there must be at least a million, probably several million, decision makers out there who are similarly on hold. From tiny operators like this guy up to the private equity titans plotting their next moves, the heightened uncertainty brought about by an unabashedly intrusive State is causing the producers of goods & services to sit on their hands and wait. Even the rent-seekers who have enjoyed this Administration’s fondness for crony capitalism must be hedging their bets at least a little. I can’t help but wonder if herein lies the basis for the next time the Bull goes large. Perhaps an unleashing of a whole lot of pent up hopes, dreams and expansion plans (not to mention in-sourcing of at least some manufacturing back from venues that turned out to be not as low cost as they had seemed) could trigger an economic boom that gets money flowing back into equities in a way that reminds us that debauch that ended over twelve years ago.
It is quite possible, in my opinion, that that November outcome that so many are waiting on has just been sealed. I am referring to the HHS mandate with respect to insurance of contraception, etc. that has lit up the opinion pages of late. The Administration’s decision to proceed with this mandate is either something too politically shrewd for me (or anyone) to grasp, or the dumbest move in history. They seem to have thought they could make it about contraception, a subject on which reasonable people, including faithful Catholics, can disagree on. It’s not. All they had to do is listen to the bishops. It is about freedom of conscience, something sacred not just to Catholics but to all persons of good will. Does the term “endowed by their Creator with certain inalienable rights” ring a bell? By framing it this way, the bishops have instantly drawn in allies from leaders of other faiths and from persons of no religious faith whatsoever. And they didn’t just come up with this stance when the mandate hit the wire. Well over a year ago, the USCCB (Conference of Catholic Bishops) formed an ad hoc Committee on Religious Liberty, comprised of ten bishops and a wide array of consultants, attorneys and lobbyists.
It matters that these men were formed, spiritually and philosophically, under the papacy of a man who knew totalitarianism, at its onset, in full bloom and in its dotage, first hand. The bishops consider this mandate to be an unprecedented attack on freedoms that were enshrined in our Constitution. There will be no backing down. It will remain a hot topic, begging the question of what else is in that abomination that calls itself the Patient Protection and Affordable Care Act is waiting to pop out and remind us why our Founding Fathers devised the checks and balances that power mad Nanny Staters wish would go away. A lot can happen in the 260+ days and nights between now and November 6, but this issue has more than enough moral weight and emotional fire to tip the balance decisively in the favor of a prospective leadership that would promise to not be so damn menacing towards people who just want to get on with their hopes and dreams. Perhaps the Markets is discerning a glimmer of this possibility.
Tuesday, January 31, 2012
Puffing Along the Road to Web 2.0
As the first month of the New Year gives way to the month in which we acknowledge if not quite honor past presidents and the patron saint of lovers, bee keepers and happy marriage, the Market is going through the motions of a long overdue pause. Volatility seems to have gone on sabbatical even as the media labors to amp of the drama of Greece’s refinancing. This will be a week to see if, as we have suspected in the previous Musings, that concocted boogyman that is the European debt crisis has started losing its power to trigger tradable “risk-off” days. Based on its frozen rope trajectory of the past several weeks, the Market is certainly vulnerable to a bout of profit taking, but it keeps showing the kind of resiliency that makes this long time observer feel that this is a Market that really wants to go up.
Much of that resiliency is due to what the earnings releases have been showing a global economy that took a licking and kept on ticking. Sure, there were exceptions, there always are, where the earnings came up a little short of expectations and the stock has a real bad day ahead of what will likely be a months long stay in the proverbial doghouse. Within the “major bets” of High Road Value, our aerospace bet hit just that sort of “miss”- induced air pocket. At least within the high-end metallurgy world, where Allegheny Tech and Precision Castparts are our chosen vehicles. My strong sense here, informed by having followed the likes of PCP since it was PCST and had only a couple of million shares, is that companies didn’t so much miss as the analysts guessed too high. There was strong momentum in the industry in the June and September quarters as the OEMs started stepping up production rates on (mostly narrow-body) legacy commercial programs. This marked an early phase of a long ramp up that, strictly speaking, is neither a step function nor a continuous function, but a slightly unpredictable blend of the two. The momentum rendered palpable by the midyear acceleration did not abate in Q4, but it didn’t pick up speed either (That will be coming along shortly.) So couple a little overestimation of a ramp rate with the undoing of a squeeze in raw material prices (i.e., nickel reverting to a more normal price, which provides an incentive for customers to purchase as little as possible ahead of quarter-end surcharge adjustments) and you get the kind of disappointment that just sent a few marginal holders to the exits. Pity them. We are still in the very early innings of what is shaping up to be the greatest commercial aircraft build rate ramp ever, with “bump-ups” coming like clockwork more or less every quarter for a couple of years at least.
A more sanguine picture emerges around earnings reported by the companies that make up our rather old school bet on Web 2.0. Specifically, that part of the tech food chain defined by Intel, its enablers (capital equipment providers) and hangers-on. But as impressively as Intel has been at confounding its naysayers, the most lip smacking piece of the pie has been our bet against the imminent demise of the hard disk drive (HDD). To be fair and honest about it, the outsized nature of my present bet (about 18% of my investable assets in STX, WDC and supplier HTCH) is more than anything due to Seagate having quite literally been at the right place at the right time (i.e., unlike WDC, Hitachi and Toshiba, having all of its production outside the flood zone in Thailand). Completing its acquisition of Samsung’s HDD assets, which cemented an alliance between these technology leaders that will get very interesting over the next few years, as well as the first moves in a broad, impressive and seemingly long overdue product refresh, helps a lot, too. But hats off to WDC and its suppliers, including HTCH, for a magnificent recovery from the adversity of coming in and finding a big portion of one’s equipment under 6+ feet of greasy, stinky water. Much work remains to be done to bring the HDD supply chain back to normal, a projects that including the rebuild of buffer stocks will carry into next year. The Market has already applauded the adroit execution that has taken prior “worst case” scenarios off the table. The question is what will there be to applaud about once things are back to normal.
My sense is that the Thai Flood Crisis has lent even more impetus to the idea that the HDD world will find itself with a new and improved “normal” on the other side of the ongoing consolidation. We, and most importantly, the customer base, just got a whiff of just how not-to-be-taken-for-granted the availability of hard disk storage might become. One would think that the big buyers of HDD got a glimpse of what the world would be like if this supplier base which they have used and abused for so many years unto decades were to lose its ability or will to re-invest in itself. The consolidation was about to make it clear that a price-taking HDD industry can no longer be taken for granted. The flood induced shortage is driving home that point.
Pricing and so margins will recede as capacity comes back into balance and inventories are replenished. This is not a question of Whether or even When but to Where relative to what in the era consolidation (wherein aggressive pricing might have long term, strategic benefit to compensate for short term pain) was considered normal. “Normal” is going to be very different when Seagate and WD have upwards of 80% of the market. Even if WD’s “remedy” for the EU’s purported concerns about the HGST acquisition (just how a discrete increment of capacity can be severed from such an integrated undertaking remains to be seen) were to spawn a new competitor, it would still be a technology follower at a single capacity point with marked economic disadvantages. The big drama over the next several quarters, the one that will be hyped for all its worth by the multitude of analysts who follow this industry, will be couched in terms of where ASPs end up relative to before the flood. And that, in my estimation, is in the hands of the management team of the producer presently at the margin, which is WDC. I believe it will boil down to whether they are sufficiently competent and judicious to manage the latter phases of their recovery in a way that balances the near term needs of the customer base with the long term growth in value for the owner base. Having listened in on the last dozen or so conference calls (and sized up more managements than I care to even think about), I am as confident as an investor can be that Messrs. Coyne, Leyden and Nickl are more than smart enough to split this difference in a way that the Market will stand up and cheer. If so, then for at least that three-to-five year future that purportedly matters so much for serious investors, the new “normal” is likely to be gross margins in a narrow band not far off of 30%, rather than that recent range that tended to drift down into the teens and get stuck there, and commensurately higher net margins and so EPS. End users will continue to benefit from, and probably take for granted, that this industry has made data storage “almost free and getting more so”, and are not likely to notice that they are paying a few dollars more per device. And who knows, these stocks might even find their way of their bizarre parallel universe where a single digit P/E ratio is considered normal for a growing, dominant and cash rich enterprise.
Obviously, such a margin re-set, coupled with even modest growth in units and adroit deployment of surplus cash along the lines of what Seagate is already doing (dividend boost and aggressive share repurchase) should boost both WDC and STX much further than recent analyst “Target Prices” would suggest. But what about suppliers like HTCH? Owing to a long list of surprises, this one has ended up being one of those “problem children” we always seem to have at least a few of. Potentially life threatening challenges have been met and largely overcome, albeit at the cost of the balance going from seemingly pristine to a source of concern. HT’s position with the customer base appears to be programmed to improve in each of the next several quarters, which in my estimation will drive the volume necessary for a return to profitability. The flooding may have been a setback in their plan to become the low cost producer of suspension assemblies, but it was only a setback. Indeed, the value of their diverse locations gained currency as a result of the flood. Assuming that HTCH continues execute on its debt refinancing plan, recognition should start to set in that HTCH does not deserve the “left for dead” status implicit in its recent share price. I am expecting “back from the dead” appreciation over the next couple of years akin to what happened in the latter half of 2009.
Investing in HDD companies right now could be compared to finding a very old cigar butt. The naysayers (led by investment bankers who would rather shill for companies that need gobs of capital rather than ones that have too much of it) say that at 50+ years old it is a worthless has-been that should be tossed away. Like the “visionaries” I recall from thirty years ago who said that technology would bring about a “paperless office” and so doom the paper industry, someday they will be right, and disk storage will go the way of the crank starter on automobiles or the mimeograph. But that someday is nowhere in sight, and there are even signs that the purportedly supplanting technology is actually boosting demand for mass storage the way things like faxes, cheap printers and then email did for a couple of decades before “paperless” starting happening in earnest. If HDD is an old cigar, it still has at least one might fine puff left on it.
Much of that resiliency is due to what the earnings releases have been showing a global economy that took a licking and kept on ticking. Sure, there were exceptions, there always are, where the earnings came up a little short of expectations and the stock has a real bad day ahead of what will likely be a months long stay in the proverbial doghouse. Within the “major bets” of High Road Value, our aerospace bet hit just that sort of “miss”- induced air pocket. At least within the high-end metallurgy world, where Allegheny Tech and Precision Castparts are our chosen vehicles. My strong sense here, informed by having followed the likes of PCP since it was PCST and had only a couple of million shares, is that companies didn’t so much miss as the analysts guessed too high. There was strong momentum in the industry in the June and September quarters as the OEMs started stepping up production rates on (mostly narrow-body) legacy commercial programs. This marked an early phase of a long ramp up that, strictly speaking, is neither a step function nor a continuous function, but a slightly unpredictable blend of the two. The momentum rendered palpable by the midyear acceleration did not abate in Q4, but it didn’t pick up speed either (That will be coming along shortly.) So couple a little overestimation of a ramp rate with the undoing of a squeeze in raw material prices (i.e., nickel reverting to a more normal price, which provides an incentive for customers to purchase as little as possible ahead of quarter-end surcharge adjustments) and you get the kind of disappointment that just sent a few marginal holders to the exits. Pity them. We are still in the very early innings of what is shaping up to be the greatest commercial aircraft build rate ramp ever, with “bump-ups” coming like clockwork more or less every quarter for a couple of years at least.
A more sanguine picture emerges around earnings reported by the companies that make up our rather old school bet on Web 2.0. Specifically, that part of the tech food chain defined by Intel, its enablers (capital equipment providers) and hangers-on. But as impressively as Intel has been at confounding its naysayers, the most lip smacking piece of the pie has been our bet against the imminent demise of the hard disk drive (HDD). To be fair and honest about it, the outsized nature of my present bet (about 18% of my investable assets in STX, WDC and supplier HTCH) is more than anything due to Seagate having quite literally been at the right place at the right time (i.e., unlike WDC, Hitachi and Toshiba, having all of its production outside the flood zone in Thailand). Completing its acquisition of Samsung’s HDD assets, which cemented an alliance between these technology leaders that will get very interesting over the next few years, as well as the first moves in a broad, impressive and seemingly long overdue product refresh, helps a lot, too. But hats off to WDC and its suppliers, including HTCH, for a magnificent recovery from the adversity of coming in and finding a big portion of one’s equipment under 6+ feet of greasy, stinky water. Much work remains to be done to bring the HDD supply chain back to normal, a projects that including the rebuild of buffer stocks will carry into next year. The Market has already applauded the adroit execution that has taken prior “worst case” scenarios off the table. The question is what will there be to applaud about once things are back to normal.
My sense is that the Thai Flood Crisis has lent even more impetus to the idea that the HDD world will find itself with a new and improved “normal” on the other side of the ongoing consolidation. We, and most importantly, the customer base, just got a whiff of just how not-to-be-taken-for-granted the availability of hard disk storage might become. One would think that the big buyers of HDD got a glimpse of what the world would be like if this supplier base which they have used and abused for so many years unto decades were to lose its ability or will to re-invest in itself. The consolidation was about to make it clear that a price-taking HDD industry can no longer be taken for granted. The flood induced shortage is driving home that point.
Pricing and so margins will recede as capacity comes back into balance and inventories are replenished. This is not a question of Whether or even When but to Where relative to what in the era consolidation (wherein aggressive pricing might have long term, strategic benefit to compensate for short term pain) was considered normal. “Normal” is going to be very different when Seagate and WD have upwards of 80% of the market. Even if WD’s “remedy” for the EU’s purported concerns about the HGST acquisition (just how a discrete increment of capacity can be severed from such an integrated undertaking remains to be seen) were to spawn a new competitor, it would still be a technology follower at a single capacity point with marked economic disadvantages. The big drama over the next several quarters, the one that will be hyped for all its worth by the multitude of analysts who follow this industry, will be couched in terms of where ASPs end up relative to before the flood. And that, in my estimation, is in the hands of the management team of the producer presently at the margin, which is WDC. I believe it will boil down to whether they are sufficiently competent and judicious to manage the latter phases of their recovery in a way that balances the near term needs of the customer base with the long term growth in value for the owner base. Having listened in on the last dozen or so conference calls (and sized up more managements than I care to even think about), I am as confident as an investor can be that Messrs. Coyne, Leyden and Nickl are more than smart enough to split this difference in a way that the Market will stand up and cheer. If so, then for at least that three-to-five year future that purportedly matters so much for serious investors, the new “normal” is likely to be gross margins in a narrow band not far off of 30%, rather than that recent range that tended to drift down into the teens and get stuck there, and commensurately higher net margins and so EPS. End users will continue to benefit from, and probably take for granted, that this industry has made data storage “almost free and getting more so”, and are not likely to notice that they are paying a few dollars more per device. And who knows, these stocks might even find their way of their bizarre parallel universe where a single digit P/E ratio is considered normal for a growing, dominant and cash rich enterprise.
Obviously, such a margin re-set, coupled with even modest growth in units and adroit deployment of surplus cash along the lines of what Seagate is already doing (dividend boost and aggressive share repurchase) should boost both WDC and STX much further than recent analyst “Target Prices” would suggest. But what about suppliers like HTCH? Owing to a long list of surprises, this one has ended up being one of those “problem children” we always seem to have at least a few of. Potentially life threatening challenges have been met and largely overcome, albeit at the cost of the balance going from seemingly pristine to a source of concern. HT’s position with the customer base appears to be programmed to improve in each of the next several quarters, which in my estimation will drive the volume necessary for a return to profitability. The flooding may have been a setback in their plan to become the low cost producer of suspension assemblies, but it was only a setback. Indeed, the value of their diverse locations gained currency as a result of the flood. Assuming that HTCH continues execute on its debt refinancing plan, recognition should start to set in that HTCH does not deserve the “left for dead” status implicit in its recent share price. I am expecting “back from the dead” appreciation over the next couple of years akin to what happened in the latter half of 2009.
Investing in HDD companies right now could be compared to finding a very old cigar butt. The naysayers (led by investment bankers who would rather shill for companies that need gobs of capital rather than ones that have too much of it) say that at 50+ years old it is a worthless has-been that should be tossed away. Like the “visionaries” I recall from thirty years ago who said that technology would bring about a “paperless office” and so doom the paper industry, someday they will be right, and disk storage will go the way of the crank starter on automobiles or the mimeograph. But that someday is nowhere in sight, and there are even signs that the purportedly supplanting technology is actually boosting demand for mass storage the way things like faxes, cheap printers and then email did for a couple of decades before “paperless” starting happening in earnest. If HDD is an old cigar, it still has at least one might fine puff left on it.
Thursday, January 19, 2012
A Great Year Ahead, Unless...
It’s a New Year and we’re back. Something about the solstice time of year seems to keep my Muse at bay, as if it goes off in search of days not so short, light not so muted, to where it won’t be reminded of just how many Christmas seasons have come and gone in my life time. The itch to hold forth on the prospects for the year ahead seem to have brought it back. Besides, 2011 was a beastly year for anyone practicing the craft of reconciling share price activity with the prospects of enterprises those shares represent, so much so as to make one wonder why we bother to even paying attention to such inexplicable nonsense. For those of us trying to produce an acceptable, risk-adjusted return, 2011 was heaped up with frustration. It was as if one set out swim across a river and after the exertion of many miles of both frantic dog paddling and effortless back stroking, all the while on the alert for (mostly) imaginary alligators, ended up exhausted at more or less the same place he started.
Can 2012 be much better? Based on the preponderance of knowable factors that tend to set the Market’s trend, it seems more likely than not. Of course, even a cursory look at how unpredictable so much of what made 2011 so interesting should remind us of the folly of presuming too much on the future. Those surprises included regime changes (or more specifically, fear of knock-off effects from disruptions to energy supplies) and acts of Nature which disrupted (and threatened unknowable further disruption) numerous, finely-tuned global supply chains (i.e., one of the strongest earthquakes ever recorded, the tsunami it produced, and that tsunami finding out a design defect in a backup system at a nuclear power plant, and extraordinary monsoon rains in Thailand.) These natural events probably had a bigger impact on global industry than the regime changes did, and they were certainly more substantive than that most histrionic of events that has been the European debt crisis. So before I spell out the factors that make me think that, absent surprises of the sort just reprised, the prevailing trend for share prices in 2012 is likely to be up, a few thoughts on the Crisis du jour are in order.
As previously noted in Musings, one of the lingering effects of the global financial panic a few years back is that it undid much of what was retarding the slow motion decay of that gaggle of erstwhile principalities we once called the Old World and still call Europe. A rising tide that once lifted even the leakiest of boats rushed out unexpectedly and exposed an awful lot of dry rot. Three years later it seems barely able to creep back in. What was marginally imprudent based on what seemed real in 2006, like the “right” to lavish vacations and early retirement, has been revealed as preposterous by a much harsher new light of day. A financial day of reckoning seems all but inevitable. However, what has come to matter more for investors than whatever the actual outcome ends up being (as if there will be an actually end point resolution to that decay that is older than Europe itself) is the narrative that has sprung up to describe it. 2011 was a year when mere constructs, the terminology of what at times seemed like an assiduously tended narrative, carried more weight than either the generally (albeit, modestly) encouraging economic recovery or the genuinely disruptive natural disasters that have since found their way down the Memory Hole.
The era when the day to day tone of the Market gets set by reactions to stories about “default”, “contagion” or “the next Lehman” is still with us, but like all narratives that are only tenuously tethered to reality, its days are numbered. These words are the minions of a concocted boogyman, meant to incite fear rather than to provide clarity. “Contagion” is a metaphor derived from medical science, as if the fleas from Greek debt are looking to bite the rats residing in the Bank of Italy. There is no comparing, in terms of uncertainty and surprise, what is taking place in Europe with what led up to the demise of Lehman Brothers. It’s like comparing the Little Ice Age with the Great Blizzard of 1888. The demise of Lehman, et al might have been years in the making, but the perfect storm formed like the proverbial thief in the night. (In early 2007, “derivatives” had been a scare word for so long that almost none of us paid them any more than lip service). The “never mind” on the Triple-A rating on nobody knew how much bank capital, the uncertainty around “mark to market” rules and how regulators would apply them, the emergence of “toxic” to describe assets that no one could know exactly what was they actually consisted of but have subsequently performed more or less as advertised, and even the exquisitely timed relaxation of market “uptick” rules, were all highly synergistic elements of a once in a generation bonfire.
There will be trouble in Europe, but nothing like what overtook the big banks in 2008. There will likely be “default”, but so what? Is that inherently awful? “Default” gets bandied about as if legions of creditors are about to be wiped out. Sometimes “wipe out” actually happens, as when the assets securing the liabilities are impossible to liquidate. Default is really nothing more than a formalization of a verdict the Market has already rendered. Debt issued at 100 but trading at 50 gets re-valued to 55% of original issue, or something like that. Then with its terms made more manageable for the debtor it ends up being worth 70 or more. For a preponderance of current debt holders, this falls somewhere between “not awful” and a good thing. It is quite likely that 2012 will see something like this happen in European debt. The lead up will be yet another series of frightening, “risk-off” days, but the outcome will manifest itself in a collective sigh of relief that nudges risk assets higher.
So absent unpredictable factors like well-placed (from mayhem’s point of view) 9.0 earthquakes or an Iranian sucker punch that ties up oil shipments for weeks or months, I favor the likelihood of strong positive returns from equities in 2012. The boogyman that has been the Euro crisis is probably losing his power to cow investors, but he will keep trying in 2012, and not without at least some short-lived effect. On the other side of the ledger, we have an economy that took some (mostly precautionary, fear driven) knocks during 2011 but kept on ticking and might even be picking up some momentum. A pathetic recovery to be sure, but a recovery nonetheless. If, over the course of 2012 it becomes apparent that 2013 will see a new Administration less antagonistic towards commercial success and obdurately ignorant of what drives prosperity, hiring, capital spending and M&A activity will likely return towards more normal levels. Even more encouraging, at this point in time, would be the Price Reality of US equities. It matter a lot that the Lost Decade for equities (the natural corrective to the Bubble that culminated with Y2K) has lingered on. And while we are coming up on three years since the bottom that was 3/9/09, it is not as if the Market has not repeatedly taken the trouble to purge excessively bullish spirits (that gruesome Q3 11 being the most recent). Fixed income investments have been marked up to where they cannot possibly meet the objectives of all but a very few investors, and commodities have already shown how unreliable a store of wealth they can be. Equities are undervalued relative to commercial prospects and historic norms, and under-owned relative to the needs of investors. Keep mayhem out of the picture, or contained in episodes of obviously finite duration, and stocks should go surprisingly higher in 2012.
Can 2012 be much better? Based on the preponderance of knowable factors that tend to set the Market’s trend, it seems more likely than not. Of course, even a cursory look at how unpredictable so much of what made 2011 so interesting should remind us of the folly of presuming too much on the future. Those surprises included regime changes (or more specifically, fear of knock-off effects from disruptions to energy supplies) and acts of Nature which disrupted (and threatened unknowable further disruption) numerous, finely-tuned global supply chains (i.e., one of the strongest earthquakes ever recorded, the tsunami it produced, and that tsunami finding out a design defect in a backup system at a nuclear power plant, and extraordinary monsoon rains in Thailand.) These natural events probably had a bigger impact on global industry than the regime changes did, and they were certainly more substantive than that most histrionic of events that has been the European debt crisis. So before I spell out the factors that make me think that, absent surprises of the sort just reprised, the prevailing trend for share prices in 2012 is likely to be up, a few thoughts on the Crisis du jour are in order.
As previously noted in Musings, one of the lingering effects of the global financial panic a few years back is that it undid much of what was retarding the slow motion decay of that gaggle of erstwhile principalities we once called the Old World and still call Europe. A rising tide that once lifted even the leakiest of boats rushed out unexpectedly and exposed an awful lot of dry rot. Three years later it seems barely able to creep back in. What was marginally imprudent based on what seemed real in 2006, like the “right” to lavish vacations and early retirement, has been revealed as preposterous by a much harsher new light of day. A financial day of reckoning seems all but inevitable. However, what has come to matter more for investors than whatever the actual outcome ends up being (as if there will be an actually end point resolution to that decay that is older than Europe itself) is the narrative that has sprung up to describe it. 2011 was a year when mere constructs, the terminology of what at times seemed like an assiduously tended narrative, carried more weight than either the generally (albeit, modestly) encouraging economic recovery or the genuinely disruptive natural disasters that have since found their way down the Memory Hole.
The era when the day to day tone of the Market gets set by reactions to stories about “default”, “contagion” or “the next Lehman” is still with us, but like all narratives that are only tenuously tethered to reality, its days are numbered. These words are the minions of a concocted boogyman, meant to incite fear rather than to provide clarity. “Contagion” is a metaphor derived from medical science, as if the fleas from Greek debt are looking to bite the rats residing in the Bank of Italy. There is no comparing, in terms of uncertainty and surprise, what is taking place in Europe with what led up to the demise of Lehman Brothers. It’s like comparing the Little Ice Age with the Great Blizzard of 1888. The demise of Lehman, et al might have been years in the making, but the perfect storm formed like the proverbial thief in the night. (In early 2007, “derivatives” had been a scare word for so long that almost none of us paid them any more than lip service). The “never mind” on the Triple-A rating on nobody knew how much bank capital, the uncertainty around “mark to market” rules and how regulators would apply them, the emergence of “toxic” to describe assets that no one could know exactly what was they actually consisted of but have subsequently performed more or less as advertised, and even the exquisitely timed relaxation of market “uptick” rules, were all highly synergistic elements of a once in a generation bonfire.
There will be trouble in Europe, but nothing like what overtook the big banks in 2008. There will likely be “default”, but so what? Is that inherently awful? “Default” gets bandied about as if legions of creditors are about to be wiped out. Sometimes “wipe out” actually happens, as when the assets securing the liabilities are impossible to liquidate. Default is really nothing more than a formalization of a verdict the Market has already rendered. Debt issued at 100 but trading at 50 gets re-valued to 55% of original issue, or something like that. Then with its terms made more manageable for the debtor it ends up being worth 70 or more. For a preponderance of current debt holders, this falls somewhere between “not awful” and a good thing. It is quite likely that 2012 will see something like this happen in European debt. The lead up will be yet another series of frightening, “risk-off” days, but the outcome will manifest itself in a collective sigh of relief that nudges risk assets higher.
So absent unpredictable factors like well-placed (from mayhem’s point of view) 9.0 earthquakes or an Iranian sucker punch that ties up oil shipments for weeks or months, I favor the likelihood of strong positive returns from equities in 2012. The boogyman that has been the Euro crisis is probably losing his power to cow investors, but he will keep trying in 2012, and not without at least some short-lived effect. On the other side of the ledger, we have an economy that took some (mostly precautionary, fear driven) knocks during 2011 but kept on ticking and might even be picking up some momentum. A pathetic recovery to be sure, but a recovery nonetheless. If, over the course of 2012 it becomes apparent that 2013 will see a new Administration less antagonistic towards commercial success and obdurately ignorant of what drives prosperity, hiring, capital spending and M&A activity will likely return towards more normal levels. Even more encouraging, at this point in time, would be the Price Reality of US equities. It matter a lot that the Lost Decade for equities (the natural corrective to the Bubble that culminated with Y2K) has lingered on. And while we are coming up on three years since the bottom that was 3/9/09, it is not as if the Market has not repeatedly taken the trouble to purge excessively bullish spirits (that gruesome Q3 11 being the most recent). Fixed income investments have been marked up to where they cannot possibly meet the objectives of all but a very few investors, and commodities have already shown how unreliable a store of wealth they can be. Equities are undervalued relative to commercial prospects and historic norms, and under-owned relative to the needs of investors. Keep mayhem out of the picture, or contained in episodes of obviously finite duration, and stocks should go surprisingly higher in 2012.
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