“Common Sense Investing for Intelligent Investors”

Monthly Letter to Our Clients and Friends

The Inquisition – A Business Primer – Unemployment

Mergers & Acquisitions – Stay with Quality

Kendall J. Anderson, CFA                                         

November 15, 2009  

The Inquisition

Justin recently met with Standard & Poor’s Global Head of Corporate & Government Ratings.  Standard & Poor’s is considered one of the nation’s premier credit rating agencies.  Given what has happened in the credit markets over the past couple of years and given that some question whether fault lies with the credit rating agencies themselves, we considered this meeting a wonderful opportunity to increase our own knowledge. 

In the investment world, it is simple enough to learn new ways to obtain and apply data, but real knowledge, knowledge that is useful, is rare indeed.  After any meeting of importance, we get together as a firm in a process we term “the inquisition.”  Just as in the historical inquisition, one of us is the inquisitor and the other sits in the hot seat.  This time Justin, knowing the process, took his place in the hot seat, while I began the endless questioning.  What are the most important criteria S&P use in setting their ratings?  What are the most important criteria for an upgrade or downgrade in their ratings?   How many upgrades or downgrades were there in the last year?  What comments if any do they have on credit crises?  What is their outlook on the economy?

The questions and answers continued until the final question was asked: How could they rate all those residential and commercial backed mortgage securities AAA? The answer to this question ended the torture, and the answer did not even have to be deduced as it was given freely by Standard & Poors. They fully admitted that the ratings for these mortgaged back securities were determined in isolation from a micro view of the world without consideration of the macro view.

If the ratings were based on the past payment record of the mortgage holders, the diversification of the mortgage obligations, and other various inputs based on historical data regarding the housing and mortgage markets, the use of a Gaussian distribution, or normal distribution, where the data is derived from a generally rising market for real estate prices and the generally declining level of interest rates could give any analyst a false signal that “all was well because it always was.”  They took comfort in the data and took their eyes off of the big, macro, picture of the over-leveraged borrowers.

We should not blame Standard & Poors or any other organization for this approach, as it is the norm in the world of economics and investment analysis.  We have accepted a world of “the specialist,” which in the investment world means the separation of powers.  The typical firm has a Chief Investment Officer and a Chief Economist whose jobs require that they look at the big picture.  The firms also have analysts whose specialties are applied by industry and the companies which fall within the industry group.  This separation of the macro and micro view is usually reconciled by the individual portfolio managers.  However, most organizations will lean towards one view or the other, and it only takes a little success in the preferred approach to lead the entire organization down the wrong path.  It took the near collapse of the credit markets to teach this lesson to, among thousands of others, Standard & Poors. 

Our letter this month will look at the micro view of business and the macro approach to socio-economic growth as emphasized by our current group of lawmakers. We will look at the impact that these two conflicting approaches will have on the level of unemployment and the number of mergers and acquisitions, and the reasons that quality holdings should hold a primary place in your portfolio.  

A Primer on Business Analysis

All of us know that businesses can only survive if they produce profits.  While this profit motive may seem disturbing to some, none of us can be truly honest without recognizing that the profits generated by private businesses have played a major role in creating a great America.  Because our discussion on unemployment, mergers and acquisitions, and quality all have something to do with the profit motive, we want to remind you of the three equations that all successful businesses understand and that all analysts utilize.  Here they are: 

Revenues less Expenses = Profits 

Assets less Liabilities = Net Worth 

Net Worth plus Future Profits = Business Value 

Most of us analytical types will create models that try to estimate what the future holds.  Our Chief Investment Officers will take a macro view while our analysts will look closer at the individual company.  In all cases, we are trying to accurately predict revenues, expenses, asset values and liabilities.  With this in hand, we can then estimate the business value.  These values become the basis for many of the buy, sell and hold recommendations in the securities markets, and the basis for prices paid in private transactions.

Unemployment 

There is no need to share with you the current level of unemployment, as each of you knows that the number is huge.  The facts have been spread throughout the world, and numbers are no longer important to understand as they are so large that each and every one of us knows someone who has been affected by the lack of jobs.  If we are not supporting a family member financially, we are supporting a family member or friend in coping with the psychological damage unemployment or underemployment can cause.  A job not only provides the means to survive; it also adds to our feeling of self worth.

The unemployment problem is so severe that our President announced this week that the White House will be hosting a forum on jobs and economic growth in December.  President Obama stated: “We’ll gather CEOs and small business owners, economists and financial experts, as well as representatives from labor unions and nonprofit groups, to talk about how we can work together to create jobs and get this economy moving again.”  

Unfortunately, the government, I am sorry to say, may be suffering from the same disease that inflicted Standard & Poors, only the disease is 180 degrees from S&P and looks instead only at the big picture, the macro view.  Because of this, I’m afraid that the actions that will be taken will have only a limited impact on the creation of new and long lasting jobs, and may even have an opposite effect and actually increase the level of unemployment.  Job creation has always been driven by small business. When we speak of small business, we are not talking about the economists’ description of small business, but rather of the real job creators, those small businesses with less than 50 employees.  It is these businesses, according to U.S. Treasury Secretary Timothy Geithner, that have created over 64% of new jobs over the past 15 years, and it is these businesses that are suffering the most in the current recession.  In fact, the suffering is so large that according to Equifax, Inc., bankruptcy filings by small business rose 44 percent in the third quarter from one year ago, a new record.  

To understand why so many small business are failing, and to understand why they are unable to add new jobs, we need to return to our basic equation, Revenues less Expenses = Profits, and to the knowledge that no business, large or small, can survive without profit generation.  A recession by definition is a reduction in revenues.  If revenues decline, then a business must reduce expenses to maintain profitability.  For a small business, the ability to reduce expenses is very limited.  The only fully discretionary expense that is large enough to impact the bottom line is the number of people the business employs.  Given the severity of this recession most small businesses have reduced the number of employees to the minimum number possible.  Even then, the minimum is still not enough to cover expenses, thus the rise in bankruptcies. 

The second largest expense for most small businesses is the level of taxes paid to governments.  The taxes are not only levied on the business owner for each and every employee, but there are taxes required simply to operate (business license), there are taxes on real estate, furniture and equipment (property tax), there are taxes on the operating cost (fuel, utilities, etc.) and there are the biggest of all, income taxes, both corporate and personal.  The only control our small business owner has over the level of taxes levied on his or her business is a single vote.  And all of these single votes taken together are minimal in the big picture of modern politics.   

Can Government Help? 

Obviously, our leaders could take some action to help small business, but will they?  So far, the record is pretty clear: the emphasis has been on large and powerful businesses.  My own industry, Financial Services, has received the bulk of government assistance.  The auto industry and their brethren the labor unions have also received support.  The real-estate industry has received a large amount of funding; not for new construction, but for existing homes.  It seems our leaders have taken a targeted approach to benefit preferred industries, but in almost every instance, benefiting the large and powerful. 

What government could do is address the expense side of our equation by reducing operating costs of our small businesses.  However, here again the record is pretty clear.  Minimum wage has been increased by over 40%.  Most of the minimum wage workers are employed by small businesses.  The health care bill will, without a doubt, mandate a new level of cost on all employers.  A current program that is receiving support from the administration and Congress is mandatory paid sick leave.  The “Paid Leave and the Healthy Families Act” will mandate 56 hours per year of paid sick leave for all working Americans.  In addition, a message is being sent to small business owners that they will bear the brunt of higher taxes on earned income.   

All of these new and proposed laws directly impact small business substantially more than large and powerful companies.  Given this, we can easily see why a small business owner will not be employing new workers anytime soon.  New hiring will only begin when the ability to create profits return.  This will require an increase in revenues or a decrease in expense. We may need to be prepared for a very long period of high unemployment. 

Mergers and Acquisitions 

Warren Buffett has once again made headlines with his acquisition of Burlington Northern, the nation’s second-largest railroad and the biggest hauler of food products and coal.  Mr. Buffett stated: “Berkshire’s $34 billion investment in BNSF is a huge bet on the company, CEO Matt Rose and his team, and the railroad industry….Most important of all, however, it’s an all-in wager on the economic future of the United States.  I love these bets.”  It may be an all-in wager, but Mr. Buffett is one person I can say without a doubt fully understands our three simple equations.  A large company, unlike our small businesses, has the ability to buy revenues.  Remember, Revenues less Expenses = Profits.    

Mergers and acquisitions are driven by this simple equation.  If organic growth of revenues is not to be, then a viable option for a large company with ample cash, or with the availability to borrow or use their own company stock as currency, is to purchase revenues.  Of course, increased revenues alone will not create profits.  Our large companies address this problem by combining support functions, which is funded by, you guessed it: fewer employees.  Locally we are very familiar with this...  just think of Wachovia and the Bank of America, where layoffs were rapid and large.   

Purchase prices are determined by our final two equations, Assets less Liabilities = Net Worth and Net Worth plus Future Profits = Business Value.  A large business can use these days of reduced expectations of future profits and lower valuations of assets to purchase revenues at prices not available in normal times.  Mr. Buffett is fully aware of this, as are most CEO’s of large and powerful businesses.   

Once again, our government has taken steps to encourage this activity.  The policies in place that we briefly touched on in our discussion on small business have the opposite impact for large businesses.  As more and more small businesses fail, the level of competition decreases.  In that most small businesses are supplied by middle sized companies, those that employee 500 to 5000, the loss of their customers reduces their own revenues. These middle sized businesses are by and large family owned.  These families are looking at their own future and, given the current state of our economy, many are willing to sell at what would be considered a bargain price just a few years ago.  The buyers of these businesses are the same large and powerful companies with ample cash.  Mergers and acquisitions will continue unabated until revenues begin to increase organically.  This could take far longer than anyone anticipates. 

Stay with Quality 

There is no question that the road to wealth in America has been though the profits generated from business.  Most of us have chosen not to own and operate a business in the classic sense.  Yet the wonders of our laws and the development of markets give each of us the ability to become a miniature Warren Buffett.  And just like Mr. Buffett, we are given the opportunity through purchasing common stocks to “love our bets.”  By understanding the three equations of business, our job as CEO of our investment portfolio becomes equivalent to Warren and every other business owner.  We can choose to place a bet in any type of business at any time.  We can choose to play the game of risk based on the three equations or the micro view, or we can choose to roll the dice, as so many do, and base our decisions on macro views, the broad economy, and economic activities.  At Anderson Griggs, our choice has always been to remember the three equations while also applying the impact that the broad economy has when directing our choices as to what type of business we choose to own.    

The fact remains that at all times, good or bad, a business will strive to create profits.  There are times when our economy is favoring small businesses.  There are times where our economy is favoring large businesses.  There are also times when our economy is directing us not to play the game of risk at all.  The current economy, with the new rules placed on it from our own as well as just about every government in the world, is directing us to stay with the highest quality investments available.  Over the next few years, whether a full economic recovery takes place or we fall into a second recession, the forces at work will favor the large and powerful companies. 

Until next time, 
  

Kendall J. Anderson, CFA _____________________________________________________________________________AAnderson Griggs & Company, Inc., doing business as Anderson Griggs Portfolio Management, is a registered investment adviser with the US Securities & Exchange Commission.  Pursuant to laws and regulations Anderson Griggs also maintains notice filing with several individual state regulators including North and South Carolina.  Anderson Griggs only conducts business in states and locations where it is properly registered or meets state requirement for advisors.  This letter has been sent to you for information purposes only and is not an offer of investment advice.  The purpose of this letter is to provide information about us.  We will only render advice after we deliver our Form ADV Part II to a client in an authorized jurisdiction and receive a properly executed investment Management Agreement.  Any reference to performance is historical in nature and no assumption about future performance should be made based on the past performance of any Anderson Griggs Investment Objective, individual account, or index.  The authors of publications are expressing general opinions and commentary.  They are not attempting to provide legal, accounting, or specific advice to any individual concerning their personal situation.  Anderson Griggs Portfolio Management’s office is located at 113 E. Main St., Suite 310, Rock Hill, SC  29730.  The local phone number is 803-324-5044 and nationally can be reached via its toll-free number 800-254-0874. 

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