Last Post - Move to Seeking Alpha

Haven't had the chance to write a post strictly for this blog in a while. Between work as a summer analyst and the occasional Seeking Alpha article I haven't been able to find the time. I have been extremely impressed with Seeking Alpha both as a resource and platform, so from now on that's where my ideas can be found.

I would like to thank you for following along and I encourage you to continue to do so here

Alex

Seeking Growth: Analysis of 30 Countries

The 'bond king' of our time, Bill Gross has recently become vocal about his short on the U.S dollar. For those of us left wondering when the tide will turn, I think this investor has signaled to us that indeed it has.

If you have not done so, please read this article Mr. Buffett wrote for Fortune in 2003.

What caught my attention in this article was not the plain and obvious negative outlook for the dollar, but instead remembering how the United States became an economic powerhouse after WW2. I was curious to look around and see if any countries today resemble the post war to 1970s United States. If so, what would the criteria be? I boiled it down to six. Their weightings are included (6 being most important).

• External Debt/GDP - 5
• Median Age - 1
• Last Years GDP Growth - 4
• LPI (Legatum Prosperity Index) - 2
• Tax Revenue % of GDP - 3
• Current Account Balance % of GDP - 6

Here is my explanation for each criteria and the process I used to achieve a score for 30 countries.

1. While some people are looking to Central/South America and even Africa for growth, that growth comes with the risk inherent to developing countries. I therefore started by limiting my search to the top 30 countries as ranked by the 2010 Legatum Prosperity Index (LPI). The LPI consists of 79 variables mostly centering around the socio-economic building blocks of society. This step weeds out investing in places like South Africa and India that still present to much risk to the average retail investor.
2. I then ranked those 30 countries by median age (the best getting a 1 and the worst getting a 30). Aging economies place large financial burdens on both government and the working class. This step can discount places like Japan where the median age is 44.6 and identify opportunities in places such as the United Arab Emirates (UAE) where the median age is 30.
3. We hear a lot about PIIGS and sovereign debt issues, and the problems in those countries are often reflected in their external debt/gdp and their current account balance as a % of gdp. If a country owes too much to debtors outside its borders, it is forced to pay increasingly larger interest payments that eat into their budgets, and ultimately force delicate situations. Any economist knows that running continuous and increasing deficits is never sustainable, and this criteria also received an important weighting.
4. In the end we're looking for countries that can produce above average GDP growth, so naturally, we should look at last years GDP growth. Although the past is never a reliable indication of the future, economies don't change as quickly as companies, so I believe it's still important to include this figure in the weighting.
5. Lastly, I wanted to identify countries that already supported much of their 'size' (GDP) in income (tax revenue). I look at this as almost a price/sales (P/S) ratio for countries. This is not to reward socialist political schemes, but merely to emphasize that if a country is forced to lower a deficit, doing so through changes to the tax code is preferable to changes in spending. The latter is more time consuming, often harder to accomplish, and can have severely negative impacts on different sections of the economy.

Below are my results. Remember that as in golf, the lower the score the better.

Seeing as the PIIGS nations are in the red and China is one of only two in the green, I think we can take these results as being somewhat significant. What's interesting to me are the results in yellow and orange. The Nordic countries and Uruguay seem to offer some safe opportunities for growth in the future. Keep in mind these results only reflect my weighting of the chosen criteria, and the output is only as good as the input.

Still Bullish On Stocks

I'm not an economist, and I only incorporate macro trends into my analysis of companies when absolutely necessary and relevant. This being said, as an investor I think the one relevant macro question to ask on a daily basis is:

What's different this time?

Bears are featured prominently in the news; greed is good, but fear sells better. On any given day you have bloggers and academics throwing countless reasons to get out of the market and stay in cash or get in gold. So, what are the most common bearish arguments today and are any unique or different from the prevailing century?

Trust me I understand how powerful debt is. When companies or countries carry too much debt and cannot make interest payments, they are forced into very dire situations. Although Europe and emerging market debt are very important, I will be focusing on the U.S situation. Here it is:

Above is US Debt (% GDP). I actually think using World War 2 as an example is very smart. Internationally governments were forced to take on extreme levels of debt...and what followed? The US had 25+ years of economic prosperity. This post war boom was truly remarkable and I don't think it was a unique aspect of the War, just economics at work. If you don't believe me, do a little homework.

Hey wait though - the US is running ridiculous deficits right now. The balance of trade is way off and China has got us by the balls...right?

US Federal Deficit (% GDP). Again, it was a hell of a lot worse during the War, and Keynesian economics worked beautifully. Oh I'm forgetting about subprime mortgages and the housing crisis?

Case Shiller National Home Price Index (Inflation Adjusted). This is one area where the bears have a respectable point. We did have an unprecedented housing bubble. I admit, a housing bubble is far more detrimental than a bubble of any other commodity - oil would be the only thing to even come close. But hey! I thought we were value investors? Contrarians. I think it's wise going forward to ignore many of the bearish arguments that don't center around housing. No one should reasonably expect a return to the 2006 high of 210, but with the index currently at 137 and the historical mean/median of 112, I see very little downside.

Unemployment?

It has peaked. That's all that can be said here. Perhaps the 'rate of recovery' is not fast enough for those in power, but for investors who have seen enormous returns off March 2009 lows, its not an issue. Trust me, my heart goes out to every person who is looking for work, honestly, but skyrocketing or even increasing unemployment figures are not to be expected.

Now after discussing some of the big topics, do I consider any bearish arguments to be of major concern? Only one

The Baby Boomers

The aging workforce is definitely going to be a damper on GDP growth going forward, and I do think that will limit market returns for the next 20 years. This is what is different between now and WW2 where the baby boomers fueled economic growth. It may sound terrible, but the retired elderly are bad for business. They don't buy houses, they don't shop, they don't raise families or educate the next generation, and of course they are an incredible cost to the government when you look at healthcare. I think that this is definitely a legitimate negative trend in developed countries. I also think that when you look in comparison to Japan, the US (and Canada) aren't necessarily in the hole.

This is also a problem that people in power are and have been aware of and are discussing. This is good, we're looking for solutions. Obama is an angel for markets. His healthcare reform is good on all fronts. Appeals to the standard Republican lexicon (when in doubt, yell Socialist!) are just that, and should not be accepted as legitimate arguments. Please read this for more convincing.

Interest Rates


This is undoubtedly the single biggest contributing factor. Every economist with half a brain knows what near 0 rates can do to an economy. Banks are getting to play the game for free. In turn, small businesses and multinational corporations benefit. When they benefit, consumers benefit. It's as simple as that. These rates are steroids for the economy. The argument that rising rates will kill the recovery is just bad logic. It will mean profits get taken down a notch, sure, but the benefits have already been sewed into the fabric of the economy. So, am I worried about inflation? Honestly, I'm not in a position to say. If I was, the game would be too easy. All I can say is that there are some very smart people that monitor those numbers everyday. As of now I don't see any threat to the US dollar due to inflation. I admit, I'm not smart enough to know or even have a good opinion, but my gut says inflation won't be the story of the next decade.

Commodity Bubble


Again, I think volatility is just finding a new home. I'm not touching any precious metals or energy. Soros and Paulson are heavily invested in Gold, but of course they know its a bubble - they just want to ride it. Please read my post

I'm not ruling out a correction this summer - but I am ruling out a double dip recession and/or depression. Remember to buy great companies at a good price, steer clear of excessive debt, and that cash is king.

In Defence of Warren Buffett

Currently the press is slamming Warren Buffett and Berkshire Hathaway for the sudden resignation of David Sokol and his questionable involvement with Lubrizol before the Berkshire deal. For more background please read Buffett Misses Chance to Show Moral Courage

I think it likely that an SEC investigation (already announced) and further questioning of Sokol will lead to more answers, but in my view, Buffett's reputation is being unnecessarily damaged. A true contrarian/value investor would look at this news, compare it to Buffett's (and Berkshire's) history, and realize that the street is wrong once again. Lets look at some facts:

• Berkshire's compounded annual gain (from 1965-2010) is 20.2%

• Buffett's annual base salary is $100,000
• Supported Barack Obama and advocates for taxing the rich 

• Convinced Sokol to stay at Berkshire twice
• "Lose money and I will forgive you, but lose even a shred of reputation and I will be ruthless" is taken out of context

The first point is just to reiterate that we are in fact discussing the most successful investor of all time. His performance is in a league of its own, and I think this puts the onus on his detractors to prove anything contrary to his sterling reputation.

The importance of the next two points cannot be understated. Warren Buffett is perhaps one of the most humble and honest people in the investment business today. His philanthropy, his views on social justice, and his 'walking the talk' all contribute to a person that can't be described as greedy or above the law.

The final two points support Buffett's innocence in the Sokol affair. If Buffett respected Sokol enough to convince him to stay at Berkshire twice, how can we possibly expect him to have been aware or even suspicious of wrongdoing on Sokol's part. Also, how can one expect Buffett to be ruthless with an employee that has already resigned? Are we realistically expecting the 80 year old man to publicly bash a good friend and employee of over a decade? Is this rational?

The press is holding the Oracle of Omaha to a much higher moral standard than the rest of the industry, and very soon people will realize this. The street is merely channeling bearish sentiment from one likely insignificant issue (who historically cared about Libyan oil?) to another. If anything, I take this 'Buffett Bashing' as another indicator of the small correction we're having in the midst of an extraordinary bull run. Sokol's mistake is not a "credit negative" for Berkshire and the issue is being blown out of proportion.

Value vs. Growth

For the average person a bull market is a fantastic thing. Those with jobs outside the financial sector aren't following the markets daily and have portfolios filled mostly with mutual funds, etfs, and maybe a few bonds. For the average investor, bull markets are strange. Obviously when the index is skyrocketing there is a greater chance that any individual stock will rise, but it also makes it much harder to outperform - the goal of all fund managers.

The value investing method, historically, provides the greatest rate of return. This is not arguable, it is fact. When in a bull market, however, investors are often tempted to seek growth instead of value. This is perhaps the single greatest mistake an investor can make, and I'd like to show why.

Book Value + Future Retained Earnings + Dividends = Stock Price

This is the bare bones way to value a business. Ben Graham's defensive investor focuses on the net book value and dividends portion of the equation, while the majority of investors today are consumed with forecasting earnings growth. The logic here is wrong.

When looking at a company's balance sheet, it is very easy to decipher what the assets are worth. Without oversimplifying it, generally the more liquid an asset is, the more favourable it is. Cash can be used to buy new businesses, buy equipment and land, and can also be returned to investors as dividends and stock buybacks. This is why I prefer to spend my time focusing on the assets of a company. If a company sits on a mountain of cash: that is a huge check mark. It also means that companies with massive inventories and slow turnover are a big red flag. The other side of the equation is the liabilities section. Even if a company reports low total liabilities (giving a higher book value), we can still look to see what proportion is short-term versus long-term debt. If a retailer has a higher proportion of long-term debt at a high interest rate, then the business may need to re-finance to stay competitive. If all of a company's debt is short-term and you know the company's earnings are questionable, this would be a potentially deadly situation as well.

Doing this analysis is easy, not time-consuming, and with some common sense can provide insightful investment opportunities. Here the hope is that the market realizes that the assets are undervalued or the liabilities are not an issue, and raises the stock price as a result (often called mean-reversion).

The problem with focusing only on forecasting future earnings is that it is extremely hard to do. Here is just a short list of some of the problems:

1. For companies with diverse operations, it is often difficult to make predictions on multiple business divisions (for conglomerates, it may be impossible)
2. For global companies impacted by various economies it is almost impossible to predict how currencies/population trends/product trends will go when the company operates in several countries
3. Although it may be easy to say a product or service will increase in demand, the effects on the bottom line are very hard to tell and in some cases revenue really does go through a corporate 'blackbox' before it ends up being reported as earnings per share
4. Even if the company has a stated plan to grow earnings, there is always the possibility that a failure to execute means earnings those are not realized

These problems increase with the size and complexity of the company. For example, it would be much harder for me to predict EPS for General Electric (GE) than for Avalon Rare Metals (AVL), a Canadian small cap with a few mines.

The problems associated with value investing are not nearly as bad as with growth investing. It is my belief that the value method provides a more accurate appraisal the of a company's worth, and involves less assumptions and consequently less risk.

The chart above shows what a dollar invested in 1927 would be worth in 2006. For picking value stocks it identifies low p/e, low p/fcf, low p/b, low p/s, and high dividend yields. For growth it uses high p/e, high profit margin, high roe, and high sales growth.

There is a reason you never hear Warren Buffet or Ben Graham talk about growth: they don't believe in it. The logic is all there, and I hope you'll see it to.

Rethinking Diversification and My Top Pick

It's probably the toughest question you can ask yourself, but if you can't answer it (or even attempt to) then you need to reevaluate your investment criteria.

Question: If you could invest in one thing, what would it be?

Now by 'thing' I mean as specific as possible; not just asset class, you have to pick the individual stock/bond/commodity. Many people would no doubt find this difficult, it's troubling to think about a portfolio with 0 diversity, with all your eggs in one basket. The key lesson here is simple:

If your uncomfortable making something 100% of your portfolio, then don't bother 

I'm talking more to retail investors of course but the lesson holds true even for the big players. Even the math that supports diversification says that having roughly 20-25 individual holdings is the optimal portfolio, anything greater than that adds no benefit. This number is cut down even further when considering ETFs.

With that in mind, what is my top pick?

Asset Class: Equities (historically the best)
Market Cap: Small-Mid Cap (historically the best)
Strategy: Value (historically the best)
Method: 4 metrics (Price/Free Cash Flow, PEG, Price/Sales, Price/Book)

Results

My last step is to evaluate individual balance sheets looking for large cash and low debt. The list I'm left with is usually between 10-50 companies long (this is also another simple way to judge how the market is valued). Out of what is left I usually prefer strong brands and simple businesses.

My Top Pick: GameStop (NYSE: GME)

Hugely shorted with earnings forecasts that are far too bearish for a company that consistently performed extremely well until the crash. Innovation in gaming technology (Kinect, Wii, etc.) will ensure growth opportunities for this business.

Disclosure: I do not own nor do I plan to buy shares of GameStop in the next 72 hours