2011 Second Quarter

Posted by David Tillson 2011 Second Quarter

For most of the past several years, investor attention has been focused not so much on individual companies, but on macroeconomic matters, and rightly so, as the recession that ended two years ago was the longest and deepest since the 1930s. As investors, we spend most of our time researching and analyzing companies. Our essential view is that well capitalized, well managed companies, purchased attractively, will reward investors through a combination of capital appreciation and income received. In light of recent downward revisions to US economic growth and daily newsfeeds reminding us of the fragility of debt and financial markets globally, investors’ attention today still remains squarely focused on the macro. While the global unwinding of excessive leverage and deficit spending makes for ugly headlines, we recognize it for what it is: a cycle, albeit an unusually protracted cycle. In the meantime, we remain focused, as we always have, on a bottoms-up search for value and competitive advantage among individual businesses that we believe can thrive regardless of the macro backdrop. However, we also realize that general economic and regulatory conditions will provide either a supportive environment where companies can prosper or a more challenging environment where companies will have to struggle to compete in the global markets. 

During the years leading up to, through, and after what has been referred to as the “Great Recession,” non-US stocks provided substantial outperformance relative to large cap US stocks. After a decade of miserable relative and absolute returns, investors appear hopeful U.S. stocks can build upon the recovery which began two plus years ago. Unfortunately, hope is not a strategy. For this and several other reasons we ask ourselves, if one were to think of the United States not as the second largest economy in the world (the European Union being larger), but rather as a company, does it have the markings of an attractive investment opportunity? If it does, “USA Inc” should, for an extended period, provide a supportive environment where companies can flourish. 

The answer to this question resides broadly in two areas. First, is the business attractive, and second, is it attractively priced? Many factors are taken into account when analyzing the merits of a business but ultimately, it is the entity’s competitive advantage that matters most. Simply stated, competitive advantage is the ability, gained through attributes and resources, to perform at a higher level than others in the same industry or market. The first question then is better stated: Does the US maintain a sustainable competitive advantage? Two extremely important areas where the US does have a competitive advantage are demographics and research and development. 

One of the pillars of economic growth and sustainability is the composition of a country’s population. According to Harvard Professor Richard Cooper in a recent presentation concerning global demographics, the US birthrate equals its replacement rate enabling it to sustain its population. Europe, China, Asia and Japan all experience birth rates meaningfully below their replacement rate and will require immigration merely to sustain their populations. Perhaps more notable is the demographic “dividend” of the ratio of working age to dependent population, which suggests that among today’s major powers, only the US stands to experience a significant (about 22%) increase during the next thirty years in its young adult population. Industrial powers including China, Japan, Germany and Europe as a whole are expecting declines of between 15-33% of their young adults. These factors, in conjunction with a high rate of immigration, bode well for a brighter US demographic future than its Asian and European trading partners. 

Another cornerstone of competitiveness is technological innovation. Adequate investment in research and development (R&D) is critical to enhancing productivity and raising standards of living. US companies are highly sophisticated, innovative and supported by an university system that collaborates strongly with the business sector in R&D. The US has dominated global R&D for the past 40 years and is unlikely to cede this position anytime in the near future. While acknowledging China’s current annual growth in R&D spending is almost 4x that of the US, aggregate dollars spent by the US represent a full one-third of global R&D investment and 2.6x that of China. Thus at current rates, it will be twenty years for China to equal US investment. Combined with the scale opportunities afforded by the sheer size of our domestic economy, these qualities continue to make the United States the preeminent innovator. 


Are there risks to USA Inc.? Looking at USA Inc’s financial statements, we see a near term mixed picture, but longer term, one that is much rosier. The balance sheet is currently constrained by already high levels of government/public sector debt, unfunded liabilities and deficit spending. USA Inc’s unit volume growth (ie consumer spending, business creation, and job growth) is below plan which is keeping revenues from growing to desired levels. Expenses are running at a level in excess of current revenues because many expenses are fixed costs (nondiscretionary items in the federal budget). Further, in the aftermath of the recession, the regulatory environment and a lack of clarity emanating from Washington has adversely impacted new business and job creation. In addition to demographics and R&D advantages, there are many other characteristics in the US to offset these near term concerns. Among these are: the US is natural resource rich and maintains a surplus of agricultural and industrial commodities. The depth and breadth of the US military contributes to making it the strongest and most technologically advanced globally. These qualities taken in conjunction with the transparency of government and a society that abides by the rule of law all underscore why the US consistently resides at the top of the World Economic Forum’s Global Competitiveness Report. We strongly believe that USA Inc would be a very attractive investment on its fundamentals and future outlook alone. Add to this its valuation relative to other countries and it makes for a compelling investment. 

Large well capitalized US multinationals that have operated under the USA Inc umbrella have underperformed just about every other asset class for well over a decade. Many of these companies have balance sheet strength not seen in years, are cash rich, and are earning 40-year-high profit margins. They are also very aware of the higher growth in some foreign markets and have positioned themselves accordingly. Adding strong, USA Inc based companies which are able to generate significant and increasing levels of their sales from abroad seems to us to be a very attractive way to position portfolios. An astute banker once commented that to get the best loan terms, you should borrow money when you don’t need it. This comment also applies to stocks. The time to purchase attractive assets is when the terms are most attractive. We like today’s terms.