| Dear Investors,
Congratulations. I've bought you each a Mercedes. Sort of.
Hold that thought and I'll explain more in a bit.
First - a reminder that the IIM Annual Investor Meeting will
be held on Saturday evening, February 18th, at the newly
renovated Postcard Inn at Holiday Isle here in Islamorada. I'll
be reviewing the companies we own and answering questions. The
meeting is open for both current and prospective investors.
Please RSVP by email here if you're coming. It's going to be
a great night.
At the meeting, I'll also talk a bit more about my outlook
for 2012. To be clear, I am not in the business of economic
forecasting or stock market prognosticating. If you've seen the
movie Moneyball, I'm doing that - but with stocks
instead of ballplayers.
Cheap Assets are Cheap Assets
Think about investing in stocks like a real estate investor
would think about buying an investment property. An ideal real
estate investment is a well-built home in a great location,
with reliable long-term tenants that write a large rent check
once a month - that you can buy when it's on sale for half of
what you know it's really worth.
If you can buy that property for a low enough price, and
assuming you don't fool yourself about what it's really worth,
then you're probably not too concerned about whether it takes
six months or five years to double your money. Now it would be
great to see that money double in a day, mind you, but you
probably recognized that house was only so cheap to begin
because the local real estate market was depressed, or for some
other fairly obvious reason. So your expectations are tempered
when it comes to how long you might need to wait to see that
value realized.
That analogy falls apart a bit when it comes to investing in
stocks here with me. For one, I'm effectively buying that
investment property for you - only it's a stock instead of a
house, there are fifteen of them, and in some cases you've
never heard of them before.
Here's the other reason that analogy is not perfect. Imagine
that right after you bought that property, you noticed this:
Every day, at 4:00pm, there was a shifty-eyed man in a suit
that stood up on the curb in front of your house and started
yelling into his bullhorn something like this:
“The price of homes in this neighborhood is now 0.43%
lower than it was six and a half hours ago. Yeah, I am dead
serious, people. It's crazy. There are really good reasons why
prices plummeted - no, cratered! - by exactly that amount
today, but let's just say you're out of the loop on those sorts
of things - am I right? If I were you, I'd start getting
nervous, because - and you did NOT hear this from me - if crazy
Old Man Johnson decides to dig a giant open sewer pit in his
backyard, this whole neighborhood is screwed. Also, my tie is
silk. Okay, take care. Gotta run.”
This man shouts into his bullhorn some variation of this
same riff, every day, for months. You hear him in your car. In
your living room. You see snippets at the newspaper stand. You
can't watch even a sleepy obese cat fall off a stool on the
intertubes without glimpsing a headline from the Shifty-Eyed
Man.
Every day, you're going to be faced with a choice. Do you
pay attention to Shifty, or do you continue to ignore him? That
house is still worth twice what you paid. Your renters are
still happy, and you can see your bank account continuing to
grow. Plus, Old Man Johnson's backyard is cap rock, and he's
way too lazy to dig through that stuff. Then again, that sweaty
suit has been showing up there on the curb every day for a
while now, and some of the neighbors…well, it sounds
like they're starting to believe him.
When it comes to the stock market, I suspect you've all
grown very tired of hearing from the Shifty-Eyed Man. And there
are only so many ways I can keeping telling you the same thing;
it's okay to ignore that guy if - and this is an important
“if” - you're in no particular rush to sell your
house and cash out. But I'll say it one more time. I think you all should continue to ignore him. You're paying me to listen to him, frankly. And although I don't particularly enjoy it, I do know that one day before too long the tide will turn, and the Shifty-Eyed Man is going to stand up on that curb, smile wide and say: “Gather round, people! I just got official word - you all are living in gold mines! The prices of the houses around here are going to keep going up, big, for a long, long time. So buy more homes, my friends, and I guarantee each of you is going to get as rich as Larry…ah, Sergey…um…the Google guys!” By then, we'll have doubled our money. And that's the day we're going to sell that house. Like Watching Paint Dry If you had only checked the stock market twice last year - once on January 1st, and then again on December 31st - you'd note the S&P 500 index finished the year just 0.04 points lower than where it started. It opened the year at 1257-and-change, and finished the same. So, you know - it was a dull and boring year in the stock market. Alas, a sample size of two is not statistically significant. 2011 was actually one of the most volatile years on record. Swings in the stock market reached twice the five-decade average. The market dropped seventeen percent in just a few weeks. The S&P 500 Index moved 2% or more on over 60 trading days in 2011. Not too long ago, years went by before it moved that much on a single day. That said, there is a strong case to be made for expecting considerable gains in the stock market in 2012 - with one big asterisk. The fundamentals, in brief, are positive, assuming the world avoids a massive European debt crisis. It appears the U.S. economy in the fourth quarter of 2011 will have grown at the strongest rate since the spring of 2010. Businesses are creating jobs at a more respectable pace. Confidence is up. And using a discounted-from-consensus assumption of 6% earnings growth this coming year, the S&P 500 would have to rise 20% in 2012 just to see the market P/E ratio get back to where it was a year ago - when stocks were already cheap. Now you could argue that stocks are cheap for good reason, and I wouldn't dispute that at all. I'm just saying there should be no argument that shares are looking inexpensive out there. But it's probably that “massive European debt crisis” part that is most on your mind these days. So, let's drill down there. How To Think About Europe What I worry about in Europe is the sudden, sinister-sounding “credit event” that would spread instant turmoil throughout banks across the globe - like what would happen if Greece suddenly declared it would immediately drop out of the European Union and not pay a dime of any debts, ever. That sort of “hard default” would concern me, as it would trigger no small number of those nefarious credit default swaps, and that would make things bad in the markets for a little while. Fortunately, the actual probability of that sort of event occurring is quite low. To be sure, it's elevated now compared to a year ago, but the chances of a hard default in Europe are nonetheless still relatively small. And in investing, it's very much about the probabilities. Eurozone skeptics certainly have valid concerns - up to a point. And independent of Europe, the past several years have also seen a small but growing concern about the threat of a global collapse in the confidence of all paper currencies. Too much printing and what-not. Nonetheless, at a high level, Europe has two primary problems. Well, political risk may be a third, but let's just agree there's no way to analyze all the political variables at play in the 17 different countries in the EU. Shoot, I don't even understand politics in our own country. But I think it's safe to assume that the severity of the crisis in Europe will mean more rock, less talk out of the pols this year over there. The first core issue in Europe concerns the inability of several small countries (Greece, Portugal, Ireland) to pay back their debts, or “insolvency”. The second is an “illiquidity” problem, meaning that several larger countries have debts large enough that in a crisis, they could find it difficult to roll over their existing bonds. Specifically, countries like Italy and Spain don't have the cash on hand to pay off bonds that are coming due, so they need to issue new bonds to both cover old debts and their budget deficits. A lot of them. The good news is that something important happened in Europe while we were all drinking hot buttered rum over the holidays. Or perhaps that was just me. In any case, the European Central Bank pumped about $640 billion into the European banking system. It was effectively a back-door version of the same actions our own Fed took after Lehman Brothers failed in 2008; by lending money to banks for three years in unlimited amounts at very low rates, the ECB decided to effectively support the debtor governments of Europe through a slow-motion recapitalization of commercial banks. Europe's commercial banks can now borrow from the European Central Bank at around 1%. Yields for Spanish bonds right now are a touch over 5.5%. That means a bank can now borrow money from the ECB to simply buy Spanish bonds, and pocket the 4.50% difference. Money doesn't get made any easier, and this is hard to screw up. Even better, it's expected that the new head of the ECB will lower interest rates further in the first half of this year, meaning the “spread” the banks pocket will be even larger. That should make much of Europe better positioned to be able to grind it out the next few years. And here's to hoping that those rescued bankers now have the decency to lend some of that new money out - as opposed to, say, give themselves enormous bonuses. So with the LTRO (never mind) announcement in December, the ECB has now addressed the Eurozone's illiquidity problem. No more banks should fail. Only fiscal austerity is going to address that insolvency issue, though. And to the extent you've been paying any attention at all to Europe the last few months, you've seen a high-stakes game of chicken. The markets and the most indebted European governments have basically been begging the European Central Bank to start bailing them out, while the ECB and Germany have been talking tough in order to force real commitments to reform. It is a technocratic approach, to be sure, and it is painfully slow, but, knock on word, it also appears to have started working. Now even the ECB's latest program and fiscal austerity measures combined won't solve all of Europe's problems. The odds seem high that the most indebted nations over there will suffer from long-term structural recessions. And there is certainly much more to consider than the simple borrowing spread above when assessing the future health of the Euro-banking system - most notably what economists call a balance of payments issue among the Euro countries themselves. Not to mention the presence of other potential landmines the next few months ranging from those busy sovereign bond auction schedules, elections in Greece, and (like Friday) downgrades by major ratings agencies. But my point is that the ECB has bought the Eurozone more time to now tackle its considerable insolvency issues. How much time? On a conference call last Friday, CEO Jamie Dimon of JP Morgan Chase stated he thought Europe had given itself at least a year. I take that as a pretty good estimate. In the interim, at some point this year we'll no doubt hear more about Europe addressing the insolvency issue more aggressively - specifically, further sovereign debt restructurings in Greece and probably Ireland. I also think it's not unreasonable to think that Europe could roll out some version of our own TARP program before too long to more rapidly recapitalize the biggest banks if needed. None of this will be easy, or quick, and as with everything political these days, rationality may have nothing to do with it. But while I do not intend to ignore the possibility of a very grim year in Europe, I don't intend to overestimate it, either. There is very good reason to believe that Europe will be able to grind it out this year and avoid the nightmare scenario. I'd say there is a 75% probability the European Union ends the year intact. There are probably going to be times this year when Europe's survival feels like a 50/50 proposition, and Greece in particular is a mess, but there is now a pathway forward, albeit a difficult one, even for that government. It very much comes down to the most un-analyzable of the many factors at play here - politics. Regardless, much of the doomsday sentiment about Europe lately completely fails to acknowledge both recent developments and historical support for the EU's currency, the euro. Too Euro to Fail? I'm going to assume that by now you're all familiar with the pessimistic case for Europe these days, if only at a high level. So what's to like? Well, in Europe we've now got new governments in Spain, Italy, and Greece that are led by technocrats committed to fiscal austerity. We've also now got aggressive ECB bank liquidity measures, and should soon have rate cuts. The permanent European Financial Stability Facility starts up in July of 2012. Europe is in general making slow progress towards fiscal union, and the IMF has emerged as a potential provider of aid to the Eurozone as well. Not to be forgotten here is our own Fed's Operation Twist that I mentioned last fall. In conjunction with the ECB's latest moves, you might say that two huge players in the global financial system are now slowly and quietly flooding the world with easy money. It's not a huge stretch to presume that China might eventually join in, depending on how well it manages its own slowing growth, and a deep recession in Europe would certainly ripple through many emerging markets. And if both of those prove to be the case, then it's not too hyperbolic to suggest that the entire world could be pumping money by the end of this year. And that would be good for stocks, actually, although it certainly comes with some rather large potential side effects that we'll discuss another time. Incidentally, that line of thinking partially explains some of the recent changes in Tarpon, including adding a gold mining company to the portfolio. But, again, that's all for some other time. Perhaps more important right now in thinking about Europe's fate is the historical international support for the euro that has existed since the currency was formed. Specifically, both the U.S. and China each have separate but strong interests in maintaining the euro. From the perspective of U.S. exporters, Europe is simply too big to fail. It's a significant market for our goods, and despite all the tough talk from D.C., I think it strains credulity to believe there is any scenario where the U.S. Federal Reserve (or the ECB for that matter) would stand idly by while bond traders took down the euro. It would all just strike a little too close to home. Don't forget the Fed already coordinated one effort among the world's central banks to respond to the Euro crisis - the liquidity swap measures announced at the end of November - and if the Fed's (formerly secret) transfers of billions of dollars to European banks in 2008 are any indication, it will help prop the euro up again more directly if push really comes to shove. That aside, China exports more to Europe every year than it does to the U.S. - and a collapse there hurts them more than us. The Chinese have already expressed their desire to eventually diversify their foreign currency reserves away from the dollar, so the euro is ostensibly attractive to them for that reason. China could fairly easily make direct investments in Europe at large scale and get access to sensitive technologies that it has not been allowed access to in the U.S. - all while winning the respect and allegiance of the those countries it helps bail out. It would seem to be the smart move, politically. So I think the odds are decent that if things degrade even more in Europe, China could step up this year and help address some of those solvency woes in Greece, Portugal, Ireland and/or Spain. To not do so could conceivably mean the failure of the euro, and that in turn would mean huge losses on Chinese bond positions, a dramatic revaluation of the yuan and, by extension, huge losses in exports. Same for the U.S., actually. The difference is that exports have been the rocket fuel powering China's (now slowing) growth, and any significant drop-off there could mean a jobs crisis of unmanageable proportions in China. I don't know how you say “avoid civil unrest” in Mandarin, but I'd bet it probably sounds a lot like “we must support the Euro, comrades.” The Question No One is Asking In short, the world's biggest economies are committed to keeping the euro viable. Plenty of risks remain, the debts involved are huge, and some problems over there are even worse than the headlines would indicate. In particular, I think it's insanity that hedge funds owning credit default swaps on any sovereign Euro debt are even allowed in the room when it comes to negotiating voluntary restructurings - as appears to be happening right now in Greece. These guys have all the incentive in the world to force a default. It's nuts. Nonetheless, despite the headlines, the odds are that things in Europe are going to have improved by this time next year. So with regards to how all this specifically relates to investing your money here, I want to underscore the following points: 1 - The share prices of many companies are being held down by concerns about the European debt crisis. 2 - I anticipate an eventual positive revision in the expectations surrounding Europe at some point this year. And as an investor I think one of the most intriguing questions to ask about 2012 right now is: What happens if the Eurozone survives? That Thing About The Car Back to that earlier comment about the Mercedes I bought you. Okay, I'm not Oprah. I didn't actually buy you each a new car. And if I had, you can bet your tuckus it would have been used. Seriously - do you know how fast a new car depreciates? Anyway, apologies if I got your hopes up there. In my own defense, though, if I'd just blurted out that I'd been buying you shares in a European company, you might chip a tooth on your keyboard, no? But, yes, to lay all the cards out on the table now - I have in fact been shopping for stocks in Europe. Now if upon reading that your face suddenly scrunched up like you ate a bad oyster, do not panic. That is normal. What I would tell you, though, is that the company I bought us all shares in is Daimler, the company that manufactures Mercedes automobiles. What you actually own is a very small fractional interest in Daimler, which in my old-fashioned way of thinking means you can now claim ownership of a very small percentage of each new Mercedes that rolls off the line. Like, maybe half of the tiny nub on top of the little black screw cap on the tire valve. On the spare. In the trunk. In Tarpon I bought us all shares of Daimler at $40.63 each in mid-December. Shares have since traded up 18% to $48.08 as of last Friday's close. I am confident shares are ultimately worth much closer to $90. And I am not alone. Daimler owns one of the most valuable luxury brands in the world - Mercedes-Benz - and we bought a piece of it at a great price. What about all those problems in Europe? The economics of the business and that terrific brand aside, a declining euro actually helps us as Daimler owners. To demonstrate this simply - in a business like Daimler's with 7% profit margins, and assuming all its cars were sold abroad, then if the value of the euro also declined by 7%, those profit margins would double. In reality it's not quite so straightforward, as Daimler still sells a ton of cars in Europe. Nonetheless, Daimler does have another tailwind in that as the euro has been declining, the yen has been strengthening - and that gives the company a pricing advantage over Japanese competitors in key places like the U.S. and many emerging markets. For several years the growth rate for Mercedes-Benz in Brazil, Russia, India, and China has ranged between 35% and 125% per year. China has actually been the largest market for the S-Class for two years now. Plus, Mercedes introduced eight new models last year, including the next-generation C-Class. And all of that is good. So in Daimler we bought a great house for an absolute song. We got it cheap because of all the smoke hanging in the air above that particular neighborhood. But not everything in there is on fire. And at some point, the sky will clear, the fear will be gone, and we will be rewarded handsomely. It's just going to take some time. I'll have more to say about Daimler and the other companies in Tarpon at the annual meeting on the 18th. Please don't forget to RSVP. I hope to see you there. - Cale | 
Cale's
Notes: 