What the real experts say

Anyone who reads the business section is probably sick of the terms "subprime" and "credit crunch." Google "credit crunch" and you'll get 4.2M results. The repricing of risk, the bursting of the housing bubble, the health of companies' balance sheets, inflation, and the impact on the consumer's ability to keep buying stuff, however, keep both politicians and breadwinners up at night.

We should be worried. But we should also ignore most of what we hear. In the stock market--especially stock picking--whose opinion matters? Jim Cramer is good at generating hype; though he is very bright, the Mad Money Jim Cramer persona annoys me. Most news exists not to report accurate and meaningful news, but to report what sells. Panic, greed, and Britney sell. The best source for news is rational economists, reputable business leaders, and other smart independent minds. This site tries to be relevant.

Fortunately, many intelligent independent leaders, et al., have recently made headline comments and observations on the current economic environment.

On U.S. shipping

Scott Davis (CEO, UPS)

UPS's first quarter results illustrate the dramatic slowing in the U.S. economy. At our investor conference on March 12th, we told you that volume growth in January had been up 3%. But in the six weeks prior to the conference, it had been negative. We also said if these trends persisted through March, we would not achieve the earnings guidance we had provided for the quarter. [The] trends did continue. Many have become sharply more negative in the last two months. ... The great unknowns are the severity and the duration of the current economic slowdown. Many of our customers have tightened their belts resulting in a shift away from our premium air products to ground shipments. [Emphasis added]

On housing

April 22, 2008, 2:50 pm

Source: wsj.com

Yale University economist Robert Shiller, pioneer of Standard & Poor's/Case-Shiller home-price index, said there's a good chance housing prices will fall further than the 30% drop in the historic depression of the 1930s. Home prices nationwide already have dropped 15% since their peak in 2006, he said.

"I think there is a scenario that they could be down substantially more," Mr. Shiller said during a speech at the New Haven Lawn Club. [Emphasis added]

On lattes

Slowdown filters through to Starbucks

By Jonathan Birchall in New York

Wednesday Apr 23 2008 18:50

Starbucks (NASDAQ:SBUX) , the coffee house chain, on Wednesday blamed a "sharp weakening" in the consumer economy for an unexpected decline in its US sales, sending its shares plunging more than 10 per cent in after-hours trading.

Howard Schultz, who returned to the role of chief executive in January, said "the current economic environment is the weakest in our company's history", citing the housing slump and rising energy and food costs.

The company said conditions were particularly bad in California and Florida, which account for 32 per cent of its retail revenues and have been hard hit by the slump in the US housing market. [Emphasis added]

What does Greenspan think?

NEW YORK (CNNMoney.com) -- Today's economic condition could likely be seen as "the most wrenching since the end of the second world war," wrote former Federal Reserve chairman Alan Greenspan in the Financial Times on Monday.

And Buffett?

FORTUNE 4/14/2008

Q: The scenario you're describing suggests we're a long way from turning a corner.

A: "I think so. I mean, it seems everybody says it'll be short and shallow, but it looks like it's just the opposite. You know, deleveraging by its nature takes a lot of time, a lot of pain. And the consequences kind of roll through in different ways. Now, I don't invest a dime based on macro forecasts, so I don't think people should sell stocks because of that. I also don't think they should buy stocks because of that."

In the end...

Only in hindsight does "buy low, sell high" mean anything. To actually do that presupposes a contrarian strategy. So when the press talks about the death of equities and new strategies for winning big, ignore most of it. Or even better, short it.

Image: http://conductr.com/assets/2007/8/14/refi-ad.png

Disclosure: none

Books

Have you read Adam Smith? I don't know anyone who really has. Most just lie about it. "Yeah, I read The Wealth of Nations, well, kind of." Many are familiar with comparative advantage, the pin factory (the values of the specialization of labor), and the invisible hand--all of which are important principles. The rest of the book, however, is terribly boring and difficult to read. I've tried reading it at least three times.

This all has a point. Anyone serious about the pursuit of a lifelong personal education is constantly reading and learning. And there are several ways to maximize reading output: learn to read faster; skim more; spend much more time doing it; find a way to live without sleep; and, the method I prefer: always read and learn new things but don't obsess about it. It should be natural.

That said, below is an attempt to list categories of books. This should make it easier to decide what is really worth reading.

1) wikipedia knowledge (e.g., Seven Habits--if you care)
2) historically significant well-written books
3) books to avoid (self-help books and most popular business books)
4) books for information and/or vocation
5) pleasure reading
6) other (haven't figured out what this is yet)

Be selective about what you read. But be balanced. You'll become a better investor. And don't worry if you've never read Adam Smith, most honest people have not.


Image: http://www.library.hbs.edu/hc/collections/kress/kress_img/adam_smith2.jpg

Management Pay

When Michael Jordan retired in 1998, the NBA, was doing well: sell-out crowds dominated, sales of licensed goods soared and companies anxiously sought endorsement deals with basketball's newest superstars. Fans paid the salaries. Jordan commanded $30M per year deals. Few if any complained about his pay--though he arguably deserved more.

The public today is up in arms about the "egregious" practices of executive compensation, and understandably so. In a typical illustration of Wall Street's excesses, under pressure from board members and shareholders, Bob Nardelli last year jumped from an ailing plane called Home Depot with his clichéd "golden parachute." How was his landing? He walked with a cool $210M. Was he worth it? During his six-year tenure as chief executive he received $123.7M while the stock fell 5.6%. Meanwhile, rival Lowe's saw it's stock triple.

A nauseating look into a past Home Depot 10K exposes an 8400-word mess of legal jargon, colossal promises, and the root of his staggering severance. His December 2000 pay contract reveals a convoluted pay structure of millions of options, a $10M loan, accelerated vesting of stock options upon "resignation with good reason," and even a part that states: "Nothing contained herein shall prevent the committee from paying an annual bonus in excess of the maximum amount." The contract is devoid of operating improvement incentives, talk of long-term share price increases, and reasonable limits to the size of his severance package. It's little wonder he jumped when he did.

This example of corporate gluttony is worthy of scrutiny. There were too many guarantees for thumb sucking. Nardelli received a Grasso-like package to destroy value.

Few gripe, however, when high pay is commensurate with strong stock performance. In response to concerns about Gillette's James Kilts' options grant worth about $150M for a one year post-acquisition contract with P&G, Warren Buffett, a staunch voice against high executive pay said, "Jim quickly instilled fiscal discipline, tightened operations and energized marketing. Jim was paid very well—but he earned every penny." Even Buffett approves of the stratospheric compensation for those who can create substantial shareholder value by deftly navigating treacherous competitive waters.

That said, egalitarians lament the increasing disparity in top-level and "everyman" pay. Higher taxes, more regulation, and capped salaries are proposed tools to bridge the pay gap. Though their intentions may be good, such measures would likely be detrimental. Top talent would gravitate to higher pay and less regulated arenas such as hedge funds and private equity. According to a study by Steven Kaplan of the University of Chicago, for every $1000 in excess public corporation profits, management keeps $3. For private equity deals, the numbers are more lucrative - $63 dollars on every thousand in excess profit. In essence, public shareholders are getting a deal.

What does "excess" mean and who should make that determination? It's often quoted as excess when it meets a certain multiple of average worker pay (30x is ok; 1000x is not so good--or so it goes). Ultimately, it's in the hands of market forces. Aflac is set to become the first US company to allow shareholders to have a direct say on executive pay starting in 2009. But could draconian pay restructuring at the hands of investors alienate management? This is possible. According to a survey by Ira Kay, of Watson Wyatt, a consultancy, 90% of institutional investors feel management is "dramatically overpaid." Shareholder input could be harsh and speed the exodus of talented managers into private firms Conversely, one could argue that institutional investors are sophisticated (read: smart) enough to realize the downside of dramatic pay restructuring.

High executive pay largely represents the value the market places on ingenuity and value creation. I prefer to see management as business owners, not short-term joy riders. To align management with the interests of shareholders, effective tools are: executives' stock option vesting periods to be no shorter than a 5-7 year range; a separation of market uncontrollables (e.g., high oil prices in the case an oil company) from the compensation equation.

In addition, short-term operating objectives such as inventory management, cost controls, and divestment of value-destroying projects should figure into the compensation formula. Established hurdles based on top-line organic revenue growth would encourage companies to honestly evaluate the supposed synergies and operating efficiencies of a potential acquiree; long-term stock price appreciation would be the reward for the well-executed merger or acquisition.

A portion of the pay should be determined by an ex-post independent board. Board independence with cogent short-term operating metrics and lucrative long-term stock option plans based on value-creation, i.e., increase in stock price, would limit the possibility of Nardellisms. This would piss fewer people off and help public companies find and keep the next Jordan of corporate superstars.


Disclosure: none

MSCI: it's the valuation, stupid

Most people can name a great business. Coke is one. Disney is awesome too. Defining exactly what makes it great, in business terms, is more difficult. Often this involves ugly buzzwords. Intuitively, however, most people can name some traits of greatness. This may include: a product or service that is highly desired or needed (diamonds, gasoline); one with an advantage due to scale, patents, or brand (Wal-mart, Pfizer, Coke); a business that makes a lot of money while investing little back into it (MSCI. NOT Delta Airlines). We keep things simple.

Not all fabulous businesses are good stocks. Why not? Price.

The high free cash flow generated by MSCI (MXB) through its international investment indices is what makes this business great. If you buy an emerging market index, a bit of the fees you pay goes to MSCI. MXB produces indices and risk and return portfolio analytics for ~3,000 clients with "over 100,000 indices calculated daily and over 3 trillion USD of assets globally benchmarked(1)" to the company's indices. The firm's clients are geographically diverse: 53% of clients in the Americas; 33% Europe, the Middle East and Africa (EMEA); 8% Japan, 6% Asia-Pacific.

It derives just over half of sales through fees tied to investment indices; the other half comes from portfolio analytics--this includes portfolio modeling tools used mostly by institutions. Growth has two stories: the passive index side is growing at 20% plus year-over-year (yoy) while the analytics side is at ~9% yoy.

The business model is compelling given its 90%+ retention rate and a sales model based largely on recurring annual subscriptions. But, what is is worth?

Valuation: what's it worth?

At it's current valuation of $3.3B, MXB is trading at close to 9x sales, 25x forward earnings and 16x book value. Is it worth it? Let us turn to a simply 10-year discounted cash flow (DCF) model.

Let's optimistically include management's mid-teens revenue growth goal coupled with recent FCF yield of 29%. A multiple of 15x cash flow at the end of the forecast period plus the cash flows of years 1-10 discounted at 10% per year, reveal a per share value of $24--a 27% discount to the current price. This of course is an estimate.

Key concerns

• share dilution: 6% increase in share count in 2007

• margin expansion: current free cash flow yield (FCFY) of 29% is almost unheard of; mean reversion would have significant impact on valuation: FCFY of 20% would reduce the per share value by over 30%

• portfolio analytics business (50% of sales) is less protected from competition
  

Some thoughts on management
The use of EBITDA (earnings before interest, taxes, depreciation and amortization) multiples is classic managementspeak (2). Charlie Munger refers to EBITDA as "bullshit earnings". Interest and taxes are a reality. They should not be excluded. Nor should depreciation and amortization (where appropriate). An emphasis on real cash flow, both for reporting and compensation purposes, would be more useful. Avoid bullshit.

Last July MXB paid a special dividend of $973M with $325M of cash, and the rest, you guessed it, was borrowed. With no significant capital expenditures and the operating leverage (ex: sales rise 10%, costs rise by less than 10%) of the business, a dividend is understandable but only if the company can't put that cash to work for a higher return elsewhere. The flexibility of a cleaner balance sheet would be welcomed. Borrowing money in this case was a mistake.

Gold star: the company does not provide quarterly guidance. It's refreshing to see people avoid this bad habit.

So what?
At the current price, MSCI is a great business whose valuation more than fully reflects the quality of the business. It's the valuation, stupid.


Quick Overview
Pricing power: average
Oligopoly: yes
Recurring revenue: yes
Brand strength: strong
ROIC > Cost of capital: yes
Balance sheet: average
Valuation: not attractive, yet.



Notes: (1) MSCI Q4 2007 Earnings Conference Call; (2) MD&A section of 2007 10K
Dislosure: No position in MSCI. If you believe markets are efficient, please disregard this post and invest passively, and in regular increments, into index funds.
Image: http://www.midwestcheerexpo.com/images/clipart/money%20machine.bmp