The Long Flat Summer

Tuesday, July 31st, 2012

Second quarter 2012 Investment Commentary

“Uniform-gate: They were really made in China!

In a rare show of bi-partisanship, (with emphasis on the “show”),  Senate Majority leader Democrat Harry Reid and House Speaker Republican John Boehner both loudly condemned the US Olympic Committee and fashion designer Ralph Lauren when it was discovered that the 2012 US Olympic Team uniforms were manufactured at a factory in China.  At his news conference Senator Reid bellowed that these “outsourced uniforms should be burned.” Congressman Boehner was more restrained but pronounced it a bad choice.

The outrage from the congressional leadership is comical at best, but a closer look at the Ralph Lauren Company is quite revealing.  The Senator and Speaker should not be surprised that the leading US brand name apparel companies do operate globally.  A recent research report on the Ralph Lauren Company was full of praise for its “China manufacturing presence,” which gives it a competitive edge, and may have saved the US Olympic team some money.  Perhaps Senator Reid should take a look at his computer, I-phone or even the components of the car (no doubt a GM or Ford product) which carts him around in DC and Nevada.   What might be worth railing against about “Uniform-gate” is the US Olympic Team wearing uniforms manufactured by a company where shareholders have about as much input as the population of North Korea. Founder and CEO Ralph Lauren controls 75% of the voting power of the company while owning just 1% of the common stock: he owns 90% of the B shares voting stock which does not trade publicly. Facebook has a similar structure which contributed to their badly botched IPO.  Officially Mr. Lauren is paid a salary of $1.3 million, but in 2010 he managed to end up with about $28 million in his designer pocket from benefits he grants to himself through a board he controls:  holding 90% of the voting power he can appoint 10 of the 12 directors. According to Morningstar Research the firm also pays for Lauren’s personal travel which came to over $500,000 in 2010 and “he has used company employees for his personal use in the past.”  Wonder what that means…exactly.  So here is a more important question which should have been addressed by Messrs Reid and Boehner: why does a US firm which lacks any semblance of reasonable corporate governance and is run as a personal fiefdom by its founder in a way that would make Rupert Murdoch envious receive the contract for the US Olympic Team Uniforms?  As is the case with many other issues our political leaders seriously lack the ability to see the forest or even look at the right trees.

Typical Sound and Fury Not Signifying Too Much

It is fair to say that for the past three years, financial markets have over reacted on the downside to fiscal indecision and continuing economic uncertainty in the US and the threat of more sovereign debt bailouts in Europe.  Conversely the expectation of further credit relief as a result of these ongoing problems produces over reactions on the upside. Despite the Federal Reserve flooding the credit markets with cheap money, it does not seem to end up on the hands of people who can use it. The US economy is limping along at less than 2% growth which is too slow for a meaningful recovery, and new business formations are hampered by both regulatory and economic qualms. So during the summer the economy and the financial markets will likely plod along at a slow snail’s pace which will be seen as progress by some and failure by others.  As a former Fed governor aptly put it at the recent Jackson Hole economic pow-wow: “Yes, the Fed still has bullets, it always does and can buy anything it wants. But it may be unable to hit the target.”

Nevertheless, despite the continued kicking-the-can down the road monetary fixes-or maybe because of them-the markets are holding their own but the performance is not earnings driven which is worrisome.  The investment index that is most meaningful for our clients is the 60% equity/40% bonds Vanguard Balanced Index which is up 5% through June 30.  The S&P 500 is ahead by 8% but that reflects a huge gain for Apple which is now the largest component of the index, followed by Microsoft which had a 17% gain in the first six months.  The Dow Jones Industrials which does not include Apple but is heavier on energy is ahead 5.3% through June 30.  Finally, showing that the first six months of 2012 have been difficult to navigate, the FPA Crescent Mutual Fund, the five plus gold star best of breed balanced fund for the past 3, 5 and 10 year periods according to Morningstar showed a very paltry 1.8% return through June 30.

So how to invest in a 2% growth environment? For the past four  years, the same argument has been made for investing in high quality dividend paying stocks and high yield corporate bonds:  they are the best houses in a lousy neighborhood and the alternative, getting paid almost nothing from Treasury Bills and CD’s at the bank is not going to cut it. Select municipal debt also offers a viable alternative but much of that is being called and re-issued at lower rates. The current yield on a 5 year Treasury is 0.66% and the 10 year is 1.53%. The drum beat argument for owning stocks and corporate debt has not changed much recently although some investment analysts are now arguing that the dividend paid by a blue chip company such as Johnson & Johnson backed by the world wide demand for band aids might be more reliable than the Treasury note backed by the full faith and credit of the USA. China will continue to need band aids; whether they will need US Treasury bonds to the same extent is debatable.  The J&J credit rating is still AAA and after raising their dividend, something they have done pretty consistently since Hoover was President, the dividend yield currently stands at 3.7%, more than double that of the ten year US Treasury note. The comparatively attractive dividend yield of stocks and Exchange Traded Funds can be enhanced by strategic covered option strategies that we continue to employ at JMR. The ability to generate consistent cash flow from investments that are not tied to a stagnant domestic GDP will be the heart of the matter for investors and in the long run more important than who is elected in November.  In the meantime let us all enjoy the Olympics and those sporty designer uniforms!

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