Corporate Tax Breaks For Hiring Workers Won't Work

There is chatter today that Congress is considering new tax breaks for corporations that hire unemployed workers. On the face of it this might seem like a good idea; incentivize companies to start hiring again. The only problem is that this is yet another example of a tax cut that won't work. Proponents of tax cuts seem to think they can solve any problem in a capitalist economy, but that argument defies logic much of the time.

I have long argued that cutting the capital gains tax from 20% to 15% (as the Republican-led Congress did under President Bush) did nothing to boost demand for stock market related investments. The argument seemed to be that lower tax rates on profits would encourage more capital being allocated to the market, but that conclusion falsely assumed that the chief reason investors buy stocks is to save money on taxes.

In reality, we buy stocks if we think we can make a profit from doing so. Nobody was avoiding the stock market because of a 20% tax rate of capital gains (which, if anything, would encourage investing since it was lower than the income tax rate). They were avoiding the market because they didn't think they could make good money in it. Cutting the tax rate on stock gains from 20% to 15% doesn't make investing any more attractive to people because a 20% tax rate wasn't what was holding them back to begin with.

The situation with any corporate tax break for hiring unemployed workers is essentially the same. Companies don't hire workers based on tax rates, they hire them based on whether they need them in order to produce the amount of goods and services demanded by their customers. No competent CEO is going to hire a worker he or she doesn't need simply to get a tax break. That would be like making a charitable donation simply to get the tax deduction (you wind up foolishly spending a dollar in order to save 30 cents).

Don't get me wrong, I am all in favor of incentives (unfortunately, our country all too often needs to rely on them to get people to do productive things they otherwise wouldn't), but we have to match up the incentive with the desired behavior. If we don't, it's just wasted time, money, and effort.

The Bull Market in Gold Looks Familiar

Here is a 35-year chart of gold prices. Based on what you see, would you want to jump onto the gold buying bandwagon? I am bearish on gold over $1,000 per ounce and this chart is a good reason to at least be careful with the current precious metal of choice. The latest trend looks very familiar...

Comcast Making Another Bid For Mega Content Deal

You may remember a few years back when Comcast (CMCSA) made a bid for Disney (DIS) only to be turned down. Reports today have them once again making a play for a blockbuster media content deal. Initial reports out of a Hollywood web site last night had Comcast buying NBC Universal outright from General Electric (GE) for $35 billion but that story has conflicted with more reliable news sources today that have Comcast forming a joint venture with GE's NBCU division. Comcast would contribute cash ($6-$7 billion is the rumored figure) and combine its own content assets with NBCU, spin the new company off, and retain 51% ownership (with GE having the other 49%).

As Peridot Capital clients own shares in both Comcast and GE, this deal is of great interest to me. I am not convinced Comcast making a huge push into content is the right move (cable service and content creation are quite different businesses) but I can see why Comcast CEO Brian Roberts might want to expand his net.

After all, they are already the largest cable operator and moves to boost that position will draw anti-trust concerns. Given that phone companies like Verizon are making a big play into cable, not to mention the typical satellite competition, owning solid content providers would make Comcast less concerned with how many people are using their pipes for cable access.

How does this play out for investors? Well, in the short term it will be seen as a negative for Comcast as people wonder if content is really where the company should be turning its focus, especially if it means spending billions of dollars in cash to do so. Longer term, as long as Comcast does not make any significant changes that threaten the profitability of NBCU, it could contribute a nice chunk of stable cash flow and diversify their business.

The impact on GE is harder to predict. On one hand, investors worried about GE's balance sheet would be happy to see the company unload some of NBCU's debt and also collect some cash in exchange for giving up 31% ownership (GE currently owns 80% of NBC, with Vivendi owning 20%). On the other hand, GE would become even more concentrated in cyclical and financial services business lines for its earnings. In a weak economic environment, the stable cash flow from NBCU has been helping, not hurting them.

Overall, I would be slightly more bullish on Comcast should this deal go through, mainly because I think CMSA stock would trade down more in the near term. Comcast is a stock I really like already, and although people will question a foray into media, I don't think Comcast's long term profitability will be negatively impacted by this deal. The uncertainty might just provide investors a nice entry point.

As for GE stock, I still think it represents a good value longer term (assuming you think the global economy will slowly improve) but I don't think reducing its NBC stake would warrant as much of a change for the company relative to the impact on Comcast). I would not chase GE stock if it moved higher on this deal, but if both stocks dropped on the uncertainty surrounding it, both would be good values at the right price. That said, I would give the nod to Comcast for value investors looking to make an initial investment post-deal.

Full Disclosure: Peridot clients owned positions in both Comcast and GE at the time of writing, but positions may change at any time

Evaluating Market Level With S&P 500 Having Reached My Fair Value Target

I have written here previously that my personal fair value target for the S&P 500 index was around 1,050. I got there by using an average P/E multiple of 14-15 and projecting a "normalized" earnings run rate for the index of around $70 annually. The index has now risen 60% from its March low and hit a level of 1,074 intra-day on Thursday, about 2% above my target. Naturally, the next question is "what now?"

First we need to reevaluate my initial assumptions to determine if they need to be revised. Current earnings estimates on the S&P 500 for 2009 are about $54, which is a 9% increase from 2008. Estimates going forward are significantly higher than that, at around $73 for 2010. Does my $70 still apply?

In my mind it does. The idea behind trying to determine "normalized" earnings is to eliminate the long tails of the distribution. Valuing stocks based on earnings during a recession ($50-$55) is not very helpful given that the economy grows during the vast majority of all time periods. Conversely, using the previous peak earnings level ($87) factors in a period of easy credit and dramatic leverage which surely boosted profits to unsustainable levels.

So, I would define "normalized" earnings as the level of corporate profits that we could expect in neither a recessionary environment (negative GDP growth), or a highly leveraged economy (say, 4-5% GDP growth). Put another way, what would earnings be if the economy was growing, but not very fast (say, by 2% per year). Something between $50 and $87 most likely, and the number I have been using is $70 for the S&P 500.

Interestingly, the consensus for 2010 is for moderate economic growth, positive but not at the pace we saw earlier this decade. Given that the current earnings estimate for next year is $73, I believe my $70 figure still makes sense, given what we know right now anyway.

Where does that put us in terms of the market? Well, in my mind we are trading pretty much at fair value, but it is helpful to look at both the more bearish case and the more bullish case to get an idea of what the risk-reward scenario looks like. Comparing your potential upside with the corresponding downside should make it easier for investors to gauge how they should be allocating their investment capital.

First, the bears will argue that earnings are being helped merely by cost cutting and that revenue growth will be non-existent because the economy will remain in a rut for a long time. They will contend that earnings in the $70 range for 2010 is overly optimistic and will cite the $54 figure for this year as a more reasonable expectation in the near term. Assign a 14-15 P/E (the median multiple throughout history) on those earnings and you get the S&P 500 index trading between 750 and 800, or 25-30% below current levels.

Next, we have the bulls on the other end of the spectrum. They believe that slow to moderate growth in 2010 is likely and S&P 500 earnings in the $70 to $75 range are reasonable expectations. They go further and argue that given how low interest rates and inflation are presently, P/E multiples should be slightly above average (the argument there being that low rates and low inflation make bonds less attractive and stocks more attractive, so equities will fetch a premium to historical average prices). They will assign a 16-17 P/E to $73 in earnings and argue that the S&P 500 should trade up to around 1,200 next year, giving the market another 10 to 15% of upside.

From this exercise we can determine the risk-reward using all of these arguments. Bulls say 10-15% upside, bears say 25-30% downside, and I come in somewhere in between at a flat market. Therefore, I am cautious here with the S&P 500 trading at 1,066 as I write this. To me, aggressively committing new money to equities at these levels comes with a fair amount of risk given that the best case scenario appears to only be another 10 or 15 percent. As a result, I am holding above average cash positions and being fairly defensive with fresh capital. There just aren't that many bargains left right now, so I am hoping the next correction changes that.

Anheuser-Busch InBev Update: Nine Months Following BusinessWeek Recommendation

Back in December I was fortunate enough to be chosen by the editors to provide BusinessWeek magazine a value stock idea for their annual investment guide issue. My selection, beer giant Anheuser-Busch InBev, was controversial at the time due to the just-completed buyout of A-B by Belgium's InBev, but despite how disappointed many were with the deal (especially in St. Louis where I resided for ten years) the stock of the combined company was too cheap for me to ignore.

Nearly nine months later I figured I would publish an update to that investment idea given that many people read the BusinessWeek issue and some surely wound up purchasing the stock. Shares of Anheuser-Busch InBev (AHBIF) have more than doubled in value (+119%) since the issue hit newsstands, soaring from $21 per share to a current $46 quote.

The reasons for such a large move have turned out to be the very same arguments I made when I made the pick; the stock was deeply oversold after millions of new shares were sold to finance the A-B deal, and profit margins have increased smartly thanks to the synergies captured from the merger.

The company recently reported financial results for the first half of 2009. While revenue rose only 3% (the beer market is fairly mature in most parts of the world), normalized EBITDA rose 22% thanks to margin expansion. In fact, gross margin rose from 50% to nearly 53%, and EBITDA margins rose from under 30% to over 36%. Simply put, thus far the company has succeeded in hitting its post-merger operating goals.

The doubling of the share price has increased the equity market value of A-B InBev to $73 billion. Combined with $53 billion in net debt (much of which was borrowed to buy A-B and will be repaid in coming years with free cash flow), the stock's enterprise value sits at $126 billion, or 9.8 times current run-rate cash flow. My valuation model back in December pegged a fair value price for the company at 10 times cash flow, so the stock now appears close to fair value of ~$47 per share.

As a result, Anheuser-Busch InBev stock is no longer dirt cheap. For investors who own large positions, it may be wise to consider paring it back. I have not sold it completely for my clients because there remains decent upside over the long term as the firm's massive debt load is repaid. Every dollar of debt that is repaid (assuming constant operating cash flow) will translate into more value for equity holders.

Although the easy money has already been made, I think the stock will do fairly well longer term as the company de-levers its balance sheet and further integrates the two beer giants into one company. Translation: the stock is no longer a screaming buy, but rather a very solid hold.

Full Disclosure: Clients of Peridot Capital were long shares of AHBIF at the time of writing, but positions may change at any time

Barrick Gold Pressured To Lift Hedges Despite Elevated Gold Price

Tuesday evening we learned that gold producing giant Barrick Gold (ABX) has decided to issue $3 billion in new common equity shares in order to buy back all of its remaining gold hedges, which are currently in the red to the tune of $5.6 billion.

In the company's press release Barrick explained that investors have expressed disappointment that the company has hedged 9.5 million ounces of production below market values. Barrick claims such a fact has put pressure on its share price, and therefore seems to have concluded that lifting their hedges is good for shareholders.

The press release also included reasons why the outlook for gold was positive (as would have to be your view if you decided to lift out-of-the-money hedges), but is this really the best time to be lifting hedges? I'm skeptical about the timing of this decision and therefore am glad that I am not a shareholder in Barrick.

As you may have seen, gold prices have risen sharply in recent weeks (chart below) and now trade near $1,000 an ounce for the third time over the last couple of years. The metal never seems to stay over $1,000 for long, even in the depths of the credit crisis. Barrick has decided, seemingly based entirely on pressure from shareholders, to go 100% long on gold just as the metal is nearing its all-time high. I thought we were supposed to buy low and sell high?

Barrick is going to pay $5.6 billion to lift its hedges, which is the mark to market loss it has on the books right now. On 9.5 million ounces, that means the company is underwater by $589 per ounce and must pay that much to get out of them. That means Barrick is partially hedged at $411 per ounce with gold at $1,000.

Now, I am not saying that hedging gold at $411 per ounce makes a lot of financial sense in current times. I certainly understand that investors want to see them lift those hedges. After all, if you are long ABX stock, you clearly think gold is going to rise in price, and therefore would want to benefit if that view proves correct. Still, from a financial management perspective, Barrick is essentially buying at the top of the market.

Why not wait for gold to drop to $800 or $900 before lifting the hedges? That would be a "buy low" type of move and even buying at $900 per ounce would save the company $1 billion in cash, versus making this move right now.

The converse argument would be that gold might not trade back down to $900 or lower, but that seems unlikely. The chart above shows us that gold prices couldn't even stay above $1,000 during the worst credit crisis we have ever faced. In fact, gold traded at $700 less than twelve months ago, at $800 earlier this year, and at $900 just a few months ago.

Gold is typically seen as an inflation hedge as well as a flight to safety when fear is the paramount emotion on Wall Street. We have clearly already lived through the scariest part of this recession. In addition, inflation is unlikely to rear its head anytime soon because firms have little or no pricing power with such a weak economic situation (consumers and corporations are cutting back whenever possible, and demanding low prices, thereby rendering near to intermediate term inflation risks mute).

This $5.6 billion long bet by Barrick Gold with the metal trading at $1,000 an ounce looks like a bad idea to me and I would not be buying gold investments right now. Unfortunately, it appears that the company was forced to act by its shareholders, who likely have a biased view of exactly where gold prices are going to go from here.

If I were running Barrick Gold I would tell my shareholders, "look, we understand where you are coming from, and will look to lift the hedges when it makes sense, but not when prices are approaching all-time highs. Maybe on a pullback we will take swift action."

Time will tell whether this move pays off for Barrick's investors or not. In the meantime I believe it is a good time to be cautious on gold.

Full Disclosure: No position in ABX at the time of writing, but positions may change at any time.

Introducing Smartphones Unlikely To Save GPS Hardware Firms Like Garmin

Many investors often confuse good products for good stocks. Surely the two can go hand in hand, but that is not always the case. Although they make great products, I am wary of standalone GPS hardware companies such as Garmin (GRMN). With smartphones quickly becoming multipurpose devices, including GPS, the market for standalone GPS devices is likely going to suffer from lower unit volumes and even more importantly, pricing pressure in the not-too-distant future.

There is no doubt that I envision a time five or ten years from now when all new cars come equipped with GPS in their dashboards, but the odds of price erosion not playing a role in such volume increases are slim. Companies seem to understand this likely future trend. In fact, Garmin is getting ready to launch its own smartphone to get into the GPS-enabled cell phone market. I feel comfortable predicting a Garmin phone will not be very successful.

The longer term trend will likely result in unimpressive volume growth for standalone GPS devices and large price cuts. It is very difficult to maintain profit margins at reasonably high levels when a service like GPS becomes commoditized and available through additional channels. With such market dynamics, it is reasonable to expect revenue could rise while profits actually fall, which would severely hurt the stock prices of GPS device makers like Garmin.

The stock today, fetching more than $31 per share, isn't all that expensive on an earnings basis (~12.5 times 2009 estimates), but it is the profit estimates that I would be worried about. In fact, the consensus thinks GRMN's earnings will drop 12% next year, on flat sales, so people do realize Garmin faces headwinds going forward.

The price-to-sales multiple on GRMN would worry me further if I owned the stock. Hardware firms typically have low profit margins and thus low revenue multiples (Apple is a rare exception because their brand and unique product lineup fetch higher prices), but Garmin trades with an equity market value of $6.34 billion, which is more than 2.3 times revenue of $2.7 billion. That is a high sales multiple for a hardware company.

Garmin's strong balance sheet ($1.5 billion in cash, no debt) likely contributes to the loftier-than-average valuation, but no amount of cash will be able to change the market dynamics for GPS device companies in coming years. If I owned GRMN stock I would closely monitor the situation at the very least. If I was looking to pair some shorts up with longs in the technology space, GRMN would be one to consider in terms of firms facing technological and pricing headwinds over the intermediate to longer term.

Full Disclosure: No position in GRMN at the time of writing, but positions may change at any time

Speculative Trading Lends Credence To "Rally Losing Steam" Thesis

A disturbing recent trend has emerged in the U.S. equity market and many are pointing to it as a potential reason to worry that the massive market rally over the last six months may be running out of steam. Investment strategists are concerned that a recent rise in speculative trading activity is signaling that the market's dramatic ascent is getting a bit frothy.

This kind of trading is typically characterized by lots of smaller capitalization stocks seeing massive increases in trading volumes and dramatic price swings, often on little or no headlines warranting such trading activity. Indeed, in recent weeks we have seen a lot of wild swings in small cap biotechnology stocks as well as some financial services stocks that were previously left for dead.

For instance, shares of beleaguered insurance giant AIG (AIG) soared 27% on Thursday on six times normal volume. Rumors on internet message boards (not exactly a solid fundamental reason for a rally) which proved to be false were one of the catalysts for the dramatic move higher, which looked like a huge short squeeze.

Consider an interesting statistic cited by CNBC's Bob Pisani on the air yesterday. Trading volume on the New York Stock Exchange (NYSE) registered 6.55 billion shares on Thursday. Of that a whopping 29% (1.9 billion shares) came from just four stocks; AIG, Freddie Mac (FRE), Fannie Mae (FNM), and Citigroup (C). Overall trading volumes this summer have been fairly light anyway and the fact that such a huge percentage of the volume has been in these severely beaten down, very troubled companies should give us pause for concern.

While not nearly as exaggerated, speculative trading like this is very reminiscent of the dot com bubble in late 1999 when tiny companies would see huge volume and price spikes simply by issuing press releases announcing the launch of a web site showcasing their products.

I am not suggesting the market is in bubble territory here, even after a more than 50% rise in six months, but this kind of market action warrants a cautious stance. Irrational market action is not a healthy way for the equity market to create wealth.

Fundamental valuation analysis remains paramount for equity investors, so be sure not get sucked into highly speculative trading unless there is a strong, rational basis for such investments. Companies like AIG, Fannie, and Freddie remain severely impaired operationally and laden with debt.

As a result, potential buyers into rallies should tread carefully and be sure to do their homework.

Full Disclosure: No position in any of the companies mentioned at the time of writing, but positions may change at any time

Income Tax Rates Must Rise To Offset Higher Deficits? Not So Fast.

Per one's request, my latest quarterly letter to Peridot Capital clients included a section on the current macro-economic outlook for the United States. The question they wanted me to address had to do with possible hyperinflation resulting from ever-increasing budget deficits at the federal level. As with any question like that I try to completely ignore everything I have heard and instead rely on what the numbers tell me to form an opinion. Numbers don't lie, people do.

The latest set of numbers I have looked at are very interesting and so I thought they were worth sharing. The consensus viewpoint today is that higher budget deficits will ultimately lead to higher income taxes on Americans, which is likely to hurt the economy over the intermediate to longer term. Interestingly, historical data does not necessarily support his hypothesis. Let me explain.

Despite current political debates, which are more often than not rooted in falsehoods, the United States actually saw its level of federal debt peak in 1945, after World War II. Back then the federal debt to GDP ratio (the popular measure that computes total debt relative to the size of the economy that must support it) reached more than 120%. Even after a huge increase over the last decade, currently the ratio is around 80%. As a result, our federal debt could rise 50% from here and it would only match the prior 1945 peak.

Given all of that the first question I wanted to answer was "how high did income tax levels go after World War II to repay all of the debt we built up paying for the war?" After all, the debt-to-GDP ratio collapsed from 120% all the way down to below 40% before President Reagan spent all that money in the early 1980's. Surely tax rates went up to repay that debt, right?

The reality is that the top marginal income tax rate went down considerably over that 35 year period and even if Congress maintains the top rate at 39.6% (up from 35% under President Bush) the rate will still be near historic lows since the income tax was first instituted nearly 100 years ago.

Below is the actual data in graphical form. All I did was plot the top marginal income tax bracket along with the federal debt-to-GDP ratio. This makes it easy to see what was happening with tax rates as debt levels were both rising and falling over the last 70 years.

As you can see from the data, tax rates did not go up even as debt was paid off dramatically. As a result, it appears to be a flawed assumption that increased federal borrowing automatically means we will have to pay higher taxes in the future. Political junkies won't like what this data shows, but again, numbers don't lie.

Chevy Volt Could Get 230 Miles Per Gallon

This seems like the kind of thing that could get more people into GM showrooms and help them recapture lost market share, even if most consumers do not purchase the new Chevy Volt, due out in late 2010.

According to an Associated Press story today GM announced that the Chevy Volt rechargeable electric car should get 230 miles per gallon in city driving, more than four times the mileage of the current mileage leader, the Toyota Prius.From the story:

"The Volt is powered by an electric motor and a battery pack with a 40-mile range. After that, a small internal combustion engine kicks in to generate electricity for a total range of 300 miles. The battery pack can be recharged from a standard home outlet."

Despite a hefty initial price tag (expectations are ~$40,000), the car could still be cost effective. Why? According to the story, "If a person drives the Volt less than 40 miles, in theory they could go without using gasoline."

If we want to reduce our use of foreign oil in a meaningful way, this is exactly the kind of innovation that could do it. Not only will less of our money go to the Middle East region, but we will be reducing pollution and Americans will be able to keep more money in their pockets by saving on the cost of gas. Count me as very much looking forward to the launch of more electric cars in the United States.